The credibility and integrity of S&P’s ratings action

August 6, 2011
Treasury's official response to the S&P downgrade has arrived, and it makes for pretty depressing reading.

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Treasury’s official response to the S&P downgrade has arrived, and it makes for pretty depressing reading. Treasury’s taking a shoot-the-messenger approach: S&P made a mistake in its debt-sustainability calculations, they say, and therefore “the credibility and integrity of S&P’s ratings action” must be called into question.

Paul Krugman takes a similar tack:

it’s hard to think of anyone less qualified to pass judgment on America than the rating agencies. The people who rated subprime-backed securities are now declaring that they are the judges of fiscal policy? Really? …

This is an outrage — not because America is A-OK, but because these people are in no position to pass judgment.

Tyler Cowen warned about this:

As a simple rule of thumb, if at this point, in response to this news, a commentator attacks the ratings agencies for their previous mistakes and stupid, corrupt behavior, it’s a sign the commentator is trying to muddy the broader issues.

Yes, the ratings agencies were in large part responsible for the financial crisis. But their mistake there was having too many triple-A ratings. If you were looking for a sign that they’d learned their lessons, it would be that they were downgrading triple-A borrowers before crisis hit. And also that they didn’t place overmuch stock in official models. Whatever else S&P is doing here, it isn’t repeating its mistakes of the subprime bubble.

Treasury says that “the foundation for S&P’s initial judgment” was its debt-sustainability calculations, and that S&P only pivoted to a more political willingness-to-pay argument when the initial econometric argument fell apart. But this doesn’t make sense: S&P has no particular incentive to downgrade the US, and every incentive not to.

Instead, to understand S&P’s actions, you just need to understand two basic facts. The first is that S&P is not judging the quality of Treasury bonds as an investment. There’s a key difference between S&P, on the one hand, and Moody’s, on the other: when rating sovereigns, S&P doesn’t care about or look at the likely recovery in the event of default. If the US ever did default, investors would ultimately get back 100 cents on the dollar, interest included. Shorting Treasury bonds into that kind of a default wouldn’t make you much money. But it would still be a default — and S&P is trying to gauge the likelihood of such a thing happening.

Secondly, and more importantly, all sovereign defaults are political, not economic — especially defaults by countries which borrow exclusively in their own currency. S&P and Moody’s can look at all the econometric ratios they like, but ultimately sovereign ratings are always going to be a judgment as to the amount of political capital that a government is willing and able to spend in the service of its bonded obligations. If Treasury really believes that S&P based its judgment fundamentally on debt ratios and the like, it’s making a basic category error about what it is that sovereign raters actually do.

This part of the S&P statement isn’t some kind of hurried fallback justification for the downgrade, it has to be central to any decision to downgrade the US:

The downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges…

The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge.

Any student of sovereign default knows that it is born of precisely the kind of failures of governance that we saw during the debt-ceiling debate. That is why the US cannot hold a triple-A rating from S&P: the chance of having a dysfunctional Congress in future is 100%, and a dysfunctional Congress, armed with a statutory debt ceiling, is an extremely dangerous thing, and very far from risk-free.

Yes, there’s a lot of fiscal math in the S&P statement. But at heart, any sovereign ratings decision is political, not economic: the economics is there to provide a veneer of empirical respectability to what is fundamentally a value judgment. We saw the values of Congress during the debt-ceiling debate, including various members of the House who said with genuine sincerity that they’d actually welcome a default. In that context, S&P’s judgment is hard to fault.


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