Sunday, August 7, 2011

S&P: Not wrong, but out of line

Felix Salmon has a post up this morning defending the S&P downgrade against criticism by Krugman and the administration. Felix's broad point is clearly correct: whatever fault you might find with S&P, US debt isn't risk-free and deserves to be downgraded. That's what matters most here, not the hypocrisy or incompetence of S&P.

That said, it does matter some whether S&P has an intellectual leg to stand on, and whether its decision was motivated by politics. And here, Felix's argument falls a bit short.
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.
Felix's point here is that S&P rates the likelihood of any sort of default -- even a short-lived technical default. It doesn't matter that the US would likely meet any missed commitments eventually -- that's beyond the scope of S&P's predictions. If the odds of a technical default increase, then the debt rating should fall.

And fair enough -- except his argument is undermined by the timing of the downgrade. The debt deal (and the precedent it set) might have increased the odds of a default in the long term. But the deal also dramatically decreased the odds of technical default in the near future. The risk that the US would commit some sort of technical default surely peaked in mid-July, as debt ceiling negotiations were imploding and Treasury was actively preparing to pass the August 2 deadline. An agency truly dedicated to rating the probability of default should have downgraded us then... and should have been reassured by the debt deal, which proved that most of the American political system has no real appetite for default, and will strike a pretty crappy bargain to avoid it.

The downgrade's timing hounds Felix's second argument, too:
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.
Again, his basic reasoning is perfectly sound. But it doesn't jibe especially well with what S&P actually did. US debt is threatened by political gridlock. But we didn't need to wait until August to understand how bad that gridlock actually was. If anything, the debt deal actually opens up a little space for the opposite argument: there's certain lengths to which Congress won't go, and certain catastrophes that it will work together to avoid.

Instead, by waiting until after the deal was struck to downgrade the US, S&P has signaled that they were taking the content of the deal into their considerations. And the content of the deal shouldn't be terribly important to them. The features of the US political system that endanger bondholders existed before the deal, and remain unchanged after it. The deal itself might alter the economic outlook for the US, but it didn't alter the country's political fundamentals. And as Felix himself points out, the nation's economic outlook should be of secondary importance for S&P.

Ultimately, I can't disagree with the S&P downgrade too much. But I can disapprove of the political game S&P is trying to play. It's inserted itself American fiscal policy in a manner that both endangers its own mission and distorts the US political process. If recent history is any indication, the rating agencies aren't especially good at their own jobs. So I don't especially want to see what happens when they try to do Congress's job as well.

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