Felix Salmon

The downgrade FAQ

By Felix Salmon
August 8, 2011

I’ve received some fantastic responses to my post about the S&P downgrade, so let me answer a few of the questions raised. Call it a downgrade FAQ:

S&P is making a political statement in keeping with the current climate of deficit hysteria, and I don’t know why anyone continues to give them the time of day.

Besides, Congress is the most dysfunctional it’s ever been, and they managed to get the ceiling raise passed. Is there really reason to believe it will get WORSE? I mean really, the debt ceiling debate bordered on the absurd. Why are you so fatalistic about future Congresses? Surely, surely they can do better.

These are both good points from loudnotes. There’s a lot of fuel for the deficit-hysteria fire in the S&P statement, much of which can reasonably be filed under “unnecessary at best and incendiary at worst”. For instance:

Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options. In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability.

There are three messages here which I would take serious issue with. The first is that the higher the immediate discretionary-spending savings, the better — we need less spending now, rather than more. In fact, short-term changes in discretionary spending are, to a first approximation, utterly irrelevant to the long-term fiscal position of the United States. The second is that entitlements in general — something which includes Social Security — need to be reined in for the purpose of “long-term fiscal sustainability”. In reality, Social Security is fine: it’s medical cost inflation that is the real problem. And you don’t necessarily fix that by making Americans entitled to less in the way of medical services if they’re poor or old.

Most importantly, there’s a hidden syllogism here: that if we don’t get onto a path of long-term fiscal sustainability, we’re more likely to end up defaulting in the future. I’d really like to see this spelled out, in a world where the U.S. borrows only in its own currency. There are certainly problems associated with big debts and big deficits, but it would be helpful if S&P spelled out how those problems mean an increased likelihood of default. There is real value to the exorbitant privilege of being able to borrow in dollars when the dollar is not only your own currency but also the global reserve currency — and a large part of that value, it seems to me, is never having to default unless you want to. The U.S., as the home of the dollar, really is special, but the S&P statement never addresses that fact, instead simply comparing U.S. debt ratios to ratios in other countries as though all triple-A countries are equal in this respect. They’re not.

That said, however, political realities alone are sufficient to rob the U.S. of its triple-A rating, and S&P had enough maturity to wait until after the debt-ceiling debate concluded before it went ahead and downgraded. There was definitely a point in the debate at which the triple-A was lost, and you can’t really blame S&P for that: you have to blame Congress in general and the Tea Party Republicans in particular. Can future Congresses do better? Yes. Will they? We don’t know. And if we don’t know, then America doesn’t deserve a triple-A rating.

We’ll always pay our debts back in full, if necessary just by printing the dollars to do so, but what does that matter if we need high inflation in order to do that? Devaluing our currency by printing money is just default by another name.

This is both true and untrue at the same time. Yes, inflation eats away at the value of Treasury bonds as surely as a default would. But that doesn’t mean it is a default. When a government issues debt, inflation expectations are baked in to the price the market will pay for those bonds; the ratings agencies emphatically do not consider inflation to be a default. If they did, then there’s no way that the U.S. could have had a triple-A credit rating through the 1970s and early 1980s. In order to default on your debt, you need to default in nominal dollars. That’s what the ratings agencies care about.

S&P should have made it clear that this problem was made by the Republicans.

I have a lot of sympathy for this, but I can also see how, on a practical level, it doesn’t help S&P to be considered a Democratic-party partisan. And S&P did actually single out the Republicans for implicit censure:

Compared with previous projections, our revised base case scenario now assumes that the 2001 and 2003 tax cuts, due to expire by the end of 2012, remain in place. We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act.

S&P is saying here that it cares about fiscal sustainability; that increased revenues are a key part of any credible fiscal-sustainability pact; and that the Republicans seem to have a veto over increased revenues. It doesn’t take all that much reading-between-the-lines to see S&P singling out the Republicans for blame here.

S&P should have made it clear that this problem was entirely a function of the fact that we have a debt ceiling in the first place.

Yes. I think it’s fair to say that if there wasn’t a debt ceiling, the downgrade would not have happened.

S&P didn’t downgrade after Bush and a GOP-held Congress inflated the federal deficit to mammoth proportions eight years ago. Or right after the midterms. That would have been acceptable… it would have been like an ‘independent’ referendum on what happens when you let crazy people run your country.

Why now? After the debt limit has been raised (for nearly two years)? I suppose it’s still acceptable to downgrade now, but I think it shows where the ideology of S&P lies, don’t you?

I don’t buy this, from Sprizouse. S&P didn’t downgrade based on mammoth Bush deficits for the same reason that it didn’t downgrade based on mammoth Obama deficits — deficits alone are not sufficient for a downgrade. Similarly, the fact that we managed to get the debt ceiling passed is a short-term fix to a fundamental problem, which is the existence of the debt limit in the first place. If the debt limit were a theoretical thing, like it is in Denmark, then that would be OK. (The Danes are currently 38% of the way to hitting their debt ceiling.) But it’s not: the debt limit is only ever raised in small increments, necessitating another vote shortly down the line.

There are Republican notes in the S&P statement — the talk about entitlement reform, for instance — and there are Democratic notes too, like the bit about revenue increases. Basically, S&P is just being fiscally hawkish and that’s something which cuts across both parties. The most fiscally prudent administration in living memory was Clinton’s. Bush was gratuitously bad on the fiscal front: he didn’t need to enact those monster tax cuts. Obama was necessarily bad on the fiscal front: he inherited a recession and had no choice. But the flip-side of stimulus spending in a recession is tax rises when the economy starts to recover so that you can pay for all that stimulus. If Congress refuses to enact any such tax hikes, that’s a problem. And so it makes sense that the downgrade came now, when Congress’s intransigence came into full focus.

You defended S&P by saying that even though it helped cause the problem, at least it’s correct in pointing out that the problem exists. Couldn’t you defend the Tea Party on the same basis?

Very clever, John Quiggin.

Isn’t this a conspiracy between S&P, on the one hand, and the big Wall Street primary dealers, on the other? If they’re short Treasuries, S&P is doing them a massive favor.

No. Even if Wall Street was short Treasuries, no one on the Street would welcome a U.S. downgrade. Virtually everything that Wall Street does in the fixed-income area is built on the distinction between rates and credit. S&P has now muddied that distinction in an extremely unhelpful manner. Wall Street banks are much easier to run when Treasury bonds are a safe place to park cash and the further away from Treasuries you move, the riskier your position is. S&P is ushering in a much more multivalent world, which massively complicates just about every risk management system. And risk management is already hard-to-the-point-of-impossible, if you’re a major Wall Street institution. Besides, Wall Street was long Treasuries, not short.

What qualifies S&P to be uniquely suited to pass such judgments on sovereign debt?

Nothing. Lots of people, myself included, make these judgments on a regular basis. People listen to S&P more than they listen to me and part of that is due to the fact that S&P has official status as a Nationally Recognized Statistical Ratings Organization. In an ideal world people would not privilege S&P’s opinions — but in an ideal world, everybody would do their own due diligence on issuers’ creditworthiness before buying bonds. And that doesn’t happen. And in that ideal world the U.S. wouldn’t be getting artificially cheap borrowing rates due to the fact that Treasury bonds are the first-choice asset for everybody from foreign central banks to tri-party repo operations. We live in a world where certain entities have privileged status due to their position. And that cuts both ways.

Should we accept S&P as an authority on this matter?

No, for reasons which commenter http spells out. Krugman’s right about this, at least: given how disastrously S&P behaved during the subprime bubble, we shouldn’t consider them particularly reliable in this instance. But one good thing that has become clear in the past couple of days, since the downgrade, is that no one is accepting S&P’s judgment unquestioningly.

Finally, there are three very good questions from Jay Rosen, which encapsulate a lot of the questions here.

1. Compartmentalization: You have some theory of compartmentalization here that needs to be spelled out. From my reading, S&P’s performance on mortgage debt revealed a company with institutional integrity and domain competence very close to zero. I understand (meaning: I read Tyler Cowen’s post and your endorsement of it) that I am supposed to be dismissed as unsophisticated, a cover-up artist, or an agent of distraction for mentioning any of that in this context, but here’s what I don’t get… How is it that S & P was capable of a pathetic default in responsibility on mortgage debt, but the same company is now shrewd, reasoned, prudential, tough-minded and basically right about government debt? You must have some theory of corporate culture, or compartmentalization, that you are not articulating. I want to know what it is.

My point here is that there are two issues. The first is whether the U.S. deserves to be rated AAA; the second is whether S&P is competent. We can argue the latter as much as we like, but let’s not let the latter argument interfere with the former. I’m saying that if S&P were shrewd, reasoned, prudential, tough-minded and basically right, then it would have downgraded the U.S. I’m taking no position on whether S&P is shrewd, reasoned, prudential and tough-minded and basically right. Hell, I even take issue with their reasoning! It’s only their conclusion I’m agreeing with.

That said, I do think that there is real compartmentalization going on at S&P, in particular between the structured-credit group and the sovereign group. The two groups have very little in common and mistakes at the former don’t commute automatically over to the latter. I’m willing to believe that the sovereign group has some kind of integrity even if the structured-credit group didn’t.

2. Lesson learning: You seem to be suggesting that an utterly incompetent, asleep at the switch, failed-in-the-clutch company has somehow learned its lessons and is now trying to get ahead of the next crisis. So I am curious: did you find evidence of this stock-taking and lesson-learning, some sober, coming-to-grips with massive institutional failure, in the testimony of the ratings agencies heads before Congress and the FCIC? I did not see any evidence of that. But maybe you did. Please advise.

No, I didn’t. And I’m not saying that S&P has learned from its mistakes. I’m just saying that they’re not making the same mistakes again.

3. I take your point that this a political assessment, and not really a by-the-numbers call on the economics of the debt. I certainly agree with that. But you seem to be saying (correct if I am wrong) that Standard & Poors made a bold, candid, clear-eyed and realistic political call by downgrading the U.S. I’m sorry but I cannot believe you. For a bold, candid, clear-eyed and realistic political judgment would not mince words about what has changed; it would say flat out, “The Republican party has changed. It is now willing to de-stabilize the system and introduce radical doubt about the willingness of the U.S. to make good on its promises. This is new. This is unprecedented. And it is this development that has brought us to the point we are at now.” But nothing like that appears in the S&P opinion, which I have read. It goes all “both sides” on us. Why? If I believed your analysis, I would expect far tougher and more candid language than we actually see in the opinion.

I’m not convinced that the S&P statement does the “both sides” thing — the Republicans are criticized by name, while the Democrats are mentioned only in the context of not being able to agree with the Republicans.

Should S&P have come out with a partisan statement singling out for particular opprobrium the Republicans in general and the Tea Party in particular? I, for one, would have enjoyed that. But there are good reasons why S&P, as a Nationally Recognized Statistical Ratings Organization, can’t do that. Remember all that empirical mathematical veneer in the statement — it’s there to make the rating look Statistical. Political rhetoric has the opposite effect.

When markets open today, they will be weak, but they won’t crash. And that’s because the S&P rating is ultimately being received exactly as it should be received — as a considered opinion from one organization, rather than as some kind of revealed Voice of God judgment of U.S. creditworthiness. If the downgrade has further weakened public opinion of the ratings agencies, that’s a good thing: we want the ratings agencies to have less power. But that doesn’t mean that S&P was wrong in this instance.

14 comments so far | RSS Comments RSS

Give S&P a break. It only had a couple of hours to rewrite its report after Treasury blew a hole in it.

Posted by RZ0 | Report as abusive


Can you explain why S&P making it “clear that this problem was made by the Republicans”, which you accept is a factual conclusion, would have resulted in it being “considered a Democratic-party partisan” ?

Is it your contention that whenever facts favor one political party, economists, analysts and commentators should hedge or fudge them in order to retain the “non-partisan” label ?

Posted by Cedare | Report as abusive

Did the RSS feed stop updating for anyone else?

Posted by TPN | Report as abusive

Felix Salmon FAQ:

1. Doesn’t like debt ceilings.

2. Doesn’t like Tea Partiers but likes politics as long as doesn’t interfere with high finance.

3. Likes ratings agencies especially if “they’re not making the same mistakes again.”

Did I miss anything? ..

Posted by Woltmann | Report as abusive

Let me get this straight. S & P is defined as a “Nationally Recognized Statistical Ratings Organization, ” BUT “[r]emember all that empirical mathematical veneer in the statement — it’s there to make the rating look Statistical.” So they are making a political statements beyond their recognized mission and phony them up (called “veneer” in polite circles) with authority from their recognized mission by pasting the two together. Hmmmm. Furthermore, is this rating down grade somehow meant to please their largest customers demands? S & P was only pleasing its largest customers in the CDO rating debacle, weren’t they? Are they now pure?

Posted by golew | Report as abusive

“And I’m not saying that S&P has learned from its mistakes. I’m just saying that they’re not making the same mistakes again.”

Now this is sheer lunacy. S&P–whose sin was too use models that understated risk in setting overcollateralization requirements for MBSes–misstates the amount of collateral available (93% v 85% per its projections) and then says, “Well, the collateral available doesn’t matter.”

True, they’re claiming that something that is overcollateralized is undercollateralized, instead of the reverse, but it’s Really Silly to claim that they’re making “new” mistakes.

If you really believe S&P, put your money where your mouth is: shift your investment account allocations into French or UK bonds (both still AAA) and short US ones.

Posted by klhoughton | Report as abusive

I think that S&P (and the other ratings agencies) blew up much of their credibility a few years ago.

I think that the current market action is reacting to far more than the S&P downgrade, especially since Treasuries are RISING! which is the opposite of the normal response to a downgrade.

Three major issues in play here:

1. Movement towards austerity budgets in Europe and US;
2. Central banks trying to create fake money to pump into unproductive financial system; and
3. European and US political leadership behaving like unruly kindergarten class.

I think the markets are staring at the outcome of these three themes as Depression and Deflation which is why it is the stock and commodity markets imitating a falling rock while precious metals and large country bonds are rising.

The S&P downgrade is just white noise.

Posted by ErnieD | Report as abusive

Take your point #1. Look at the word: S&P said “discretionary”. They didn’t say “non-defense discretionary” and they easily could have. One can’t argue our military spending is under control. Heck, the chiefs of the services argued 2 weeks ago that we need to spend more, not less because who knows how many wars we may have to fight.

The problem is the GOP will take the issue and limit it to “non-defense discretionary”. So they’ll nickel and dime: reduce appropriations to the EPA, cut even more funding that helps pay for college. The total they can cut is a pittance compared to the defense part of the discretionary budget but that’s the insanity. The head of Tea Party Nation posted that we need to build more aircraft carriers one week after he argued we need to cut spending.

Posted by jomiku | Report as abusive

Methinks I detect some long term CYA going on in Felix’s answers to some of his critics.

But let’s take one more run at this by going back to Felix’s Friday post, the one he offered “even in ignorance of the details” for why the downgrade had been delayed.

Thus, at:

http://blogs.reuters.com/felix-salmon/20 11/08/05/why-the-sp-downgrade-was-delaye d/

Felix presents the argument that political realities, at least as he saw them, completely trumped “econometric” factors, as he calls them, as a rational basis for the downgrade:

“[T]he US does not deserve a triple-A rating, and the reason has nothing whatsoever to do with its debt ratios. America’s ability to pay is neither here nor there: the problem is its willingness to pay. And there’s a serious constituency of powerful people in Congress who are perfectly willing and even eager to drive the US into default. The Tea Party is fully cognizant that it has been given a bazooka, and it’s just itching to pull the trigger. There’s no good reason to believe that won’t happen at some point.”

Now, let’s stipulate that Felix Salmon – and, in the face of the existing evidence, but what the heck, for the sake of argument, the boys at S&P too – are competent when it comes to “econometric” matters.

It does not follow from this that Felix’s – not to mention S&P’s — political judgment, “There’s no good reason to believe that won’t happen at some point,” where “that” is the Tea Party crowd actually getting what Felix thinks is their wish for an actual default, has any more credibility as an informed judgment than, say, my own.

What to do? What to do?

Well, how about we turn to some perfectly respectable analysis from what I’ll call the Political Science wing of the expert spectrum, which suggests strongly that even the Tea Party crowd had its bluff called and backed away from the abyss of default as a result.

You can find it here, at Nate Silver’s blog:

http://fivethirtyeight.blogs.nytimes.com  /2011/08/01/what-the-white-house-left-o n-the-table/

After reading Nate – who does not mention Felix and why would he since Felix is not in the business of tracking actual votes and Nate is – I’m minded to adapt Felix’s obiter dictum to apply to, well, Felix:

“You can gussy up your rationale for why there is good reason to think that there will be a default in the future with as many of your ersatz intuitions as you wish about how the political process works, but at heart it’s a matter of how we can expect politicians to actually vote.”

Not to mention how they actually did vote.

Watch what they do, Felix, not what they say – or said.

Oh, and there is another place we can look to see whether we should be as concerned as Felix is about the materially increased probability of a default down the rod. It’s called, um, the market. And I’m overwhelmed by the how spooked the market is right now about that increasingly probable default — as they pour into Treasuries and send down the yield.

But, of course, Felix does his CYA dance on that one too – without for a moment noting that this downward movement in the yield does not lend what any reasonable person would call support to his argument that it’s all about political will.

As a final note, I’m still waiting for Felix to prevail on someone at S&P to send him a red-lined copy of their downgrade document, you know, with the econometric reasoning – and not just the phony numbers – contained in it. Let everyone decide for himself whether the political argument was always a slam dunk and in no need of econometric gussying up.

Posted by billyblog | Report as abusive

“Remember all that empirical mathematical veneer in the statement — it’s there to make the rating look Statistical.”

This is why the $2T error in baseline is so damning. S&P is plainly incompetent at assessing the credit of sovereigns. The actual stats show that they systematically overestimate the risk of defaults by both sovereigns and sub-sovereigns. They try to maintain the illusion of having some kind of special expertise, but the fact is that anyone who actually WAS better than average at that kind of judgement would go work for an actual bond trader, rather than going to work for a ratings agency. The pay is poorer at S&P, and they’re not actually allowed to exercise their judgement, because political considerations (buttering up private bond issuers and furthering the party line of the CEO class) override any actual analysis.

Also, what Cedare and golew said.

Posted by Auros | Report as abusive


http://fivethirtyeight.blogs.nytimes.com  /2011/08/08/why-s-p-s-ratings-are-subst andard-and-porous/?hp

Read it, weep, and then go wash your mouth out with regression analysis soap for even suggesting that there was reason to trust S&P in its downgrade – even in its political judgments.

And don’t even be tempted to try to seize on the part where Nate says:

“None of this is necessarily to disagree with the downgrade in the United States’ rating. A rating system based on objective factors, like debt-to-G.D.P. ratios, might plausibly have the U.S. rated even lower than AA+.”

Because that’s where Nate’s statistical expertise leaves off and Krugman’s macroeconomic picks up on how to analyze debt-to-GDP levels in the case of the U.S. In short, the seeming life-vest that this throwaway remark of Nate’s offers is actually a noose for you, because it puts us squarely back in “gussy[ing] up” econometric territory, which you have argued is not the point.

Posted by billyblog | Report as abusive

“That said, I do think that there is real compartmentalization going on at S&P, in particular between the structured-credit group and the sovereign group. The two groups have very little in common and mistakes at the former don’t commute automatically over to the latter. I’m willing to believe that the sovereign group has some kind of integrity even if the structured-credit group didn’t.”

Correct me if I’m wrong, but isn’t a signficant part of this based on the fact that the rating agencies got paid by the entities putting out the structured-credit products, whereas they do not get paid by the sovereigns whose bonds are being rated? (More a matter of subtle corruption than competence, to my mind . . .)

Posted by retr2327 | Report as abusive

What if S&P has actually done us a bizarre, accidental, and backhanded favor? I think most (ok, many?) people would agree that based upon historical spending and revenue numbers (as percents of GDP) that expenditures have to go down significantly, but revenues have to come up quite a bit, as well. This just completed debt ceiling negotiation was thus sub-optimal in that it had no revenue component. It ended up that way because Democrats wanted revenue increases, Republicans wanted no revenue increases, and Republicans were willing to negotiate in a more forceful manner. Put simply, Republicans threatened to let us “default” if they didn’t get the package they wanted, and Democrats were unable/unwilling to accept that.
That relationship appears to be the core of what S&P used to support the downgrade. They have been clear however, that there is no risk that principal (or interest) won’t be repaid, merely the possibility that for political reasons these payments might be delayed while the sausage gets made.
Maybe this is a benefit. If the risk of such a default (short term, no haircuts, etc…) is priced in, then that strategy loses its effectiveness. If whatever party is being (slightly) more reasonable in the future can say “no, I won’t agree to that,” with the knowledge that the market understands that there may some payment delays but there is absolutely no risk of non-payment, perhaps there is a chance that we’ll get an agreement that moves us significantly towards a balanced budget.

Posted by AlexBBB | Report as abusive

klhoughton, you might be waiting a while for that trade to pay off given S&P cut long term ratings only.

Mr Salmon, you are off course assuming that the liabilities are not inflation linked. The UK for instance has a ton of off-balance sheet debts that would make Enron blush but apparently not Gordon Brown. They are for the most part inflation linked. The unfunded public sector pensions are also inflation linked. No idea about the US but would be suprised if there is not also a bit of this monkeying about.

Posted by Danny_Black | Report as abusive

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