The downgrade FAQ

By Felix Salmon
August 8, 2011
post about the S&P downgrade, so let me answer a few of the questions raised. Call it a downgrade FAQ:

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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.

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