Some Thoughts on the S&P Downgrade

In a way it will be puzzling if the S&P downgrade--despite all the blather about its historic significance--changes anything at all. Certainly, the news should not have come as a surprise: the agency has been talking about it for weeks and the rating for US government debt had been under formal negative review before the announcement. If there is a surprise, it is mainly that the agency had the nerve to go through with it.

More fundamentally, what new information did the downgrade and the analysis supporting it provide? None. After their performance of the past few years, rating agency analysts have, or should have, little credibility in any case. Reports of the initial $2 trillion misunderstanding in S&P's examination of the Treasury's books (they used the wrong CBO baseline) lend a tragicomic note, and run their reputational capital down even further. And all this would be true even if US Treasuries were arcane instruments that few investors could afford to monitor carefully, forcing them to rely on the agencies for lack of anything better. In fact, of course, US Treasuries are the most widely and intensely analyzed obligations on the planet. What does S&P know about them that you and I don't? The informational content of the downgrade is precisely zero.

When it comes to judging market impact, two complications arise. One is the rules that some investors have adopted--or have had forced on them by regulators--obliging them to hold AAA assets. If those assets have to be dumped, the market implications would obviously be severe. According to what I read, these rules should not be triggered by a downgrade to a notch under AAA at just one agency. Federal regulators in the US, for instance, have already said that the news will have no effect on risk-based capital requirements for US banks.

What if the other agencies do what S&P just did? I doubt they will, just yet. S&P is a competitor. The others will be hoping that it just made a colossal fool of itself: a bungled downgrade that needlessly sends the markets into a panic would be the best result for them. S&P put its head above the parapet and had it ripped off. They will give that scenario a chance of playing out before they move, I dare say. (Later, if governments turn on all the agencies and try to diminish their role in the overall regulatory scheme--as indeed they should--we may see more solidarity.)

The other complication is market psychology: animal spirits, and all that. Markets move in unfathomable ways, especially in the short term, so who knows what will happen on Monday? But I know what ought to happen because of this news. Nothing.

Having said this, is the downgrade correct on its merits? I would say not just correct but (as I have noted before) overdue. S&P's analysis in support of the downgrade (baseline issues aside) is not entirely convincing, but their conclusion is correct. The Treasury's debts should no longer be scored as AAA.

The reason for this is not that US debts might soon outstrip the country's capacity to pay. True, debt is on a dangerous long-term trajectory; but in the medium foreseeable term--which is what the agencies say they are concerned with--there is no chance that the US will be unable to meet its obligations. This question simply does not arise. The extra medium-term risk associated with a debt-ceiling deal that tentatively cuts $2 trillion over the next ten years rather than tentatively cutting $4 trillion makes little real difference in my view. In either case, one needs to see spending cuts and tax increases actually implemented before declaring victory on long-term fiscal policy. For downgrade purposes, the numbers being argued about in the debt-ceiling fiasco were largely beside the point.

The new thing that really does demand a downgrade is the demonstrated willingness of Congress and the White House to walk right up to the brink of a voluntary default during debt-ceiling negotiations. That willingness is a significant new risk factor. No country whose politicians are willing to use the threat of default as a tool for political advantage should command a AAA rating. But Washington's willingness to do precisely that is not something we just found out last week. US politicians have been playing this astonishing, suicidal game  for months now. If I were a rating agency (Crook's: the name might need work) then US debt would be rated less than AAA until a law is passed to prevent any future hostage-taking over the debt ceiling. The debt ceiling itself has to go.

I can hear cries of outrage from liberals over the previous paragraph. What do you mean, Washington's willingness? It was the GOP that took the economy hostage. Don't blame both sides, blame the wrongdoers. Yes, I agree. It's the Republicans that forced my hand on this occasion. But, speaking purely as a rating agency, I am also struck by the reaction of many Democrats to this defeat. Obama gave in to hostage-takers. You should never negotiate with  such people. You stand your ground, at any cost. Let them wreck the economy: then, maybe, people will see what they are dealing with.

What is one to conclude from this? Next time, neither side will give way as default approaches? Meet lunacy with lunacy? That's why I say "Washington", and why I am seriously considering a further downgrade.