S&P Pantsed by US Treasury
I have been reluctant to condemn the credit-rating agencies for sovereign downgrades because it seemed like shooting the messenger. As the bond markets have noticed, a few European countries have serious fiscal problems. Blaming the raters for also noticing did not seem like an effective response.
However, I think that Standard and Poorâ€™s decision â€“ alone among the major raters â€“ to downgrade the US has severely discredited the agency (bad pun intended). The US Treasury has posted a stinging note about a calculation mistake underlying this decision. Interestingly, the magnitude of S&Pâ€™s error was equal to the amount by which it judged the US deficit-reduction plan to fall short: $2 trillion over ten years.
Paul Krugman emphasizes the amateurish nature of S&Pâ€™s mistake. But what strikes me is that, when Treasury officials pointed out the error, the agency just changed its main rationale for the downgrade and immediately proceeded with the public announcement. It seems that S&P had made up its mind and did not want to be confused by the facts.
A few commentators have tried to defend S&P by claiming that its initial assumptions were as legitimate as, or more realistic than, the Treasuryâ€™s assumptions. I am no expert on American budgeting, but I do not think that is the issue.
My reading of the Treasuryâ€™s post is that S&P costed the deficit deal based on one assumed baseline and then subtracted the result from a different baseline. Doing so would be wrong, whichever baseline is right.
ï»¿UPDATE (August 7): Andy Watt from the European Trade Union Institute has more.
UPDATE (August 8): Krugman has more.
UPDATE (August 8): Some US blogs have already posted this statement by David Levey, Director of Sovereign Ratings at Moodyâ€™s from 1985 through 2004. I would argue that US taxes are too low more than that they are â€œdistortionary,â€ but he makes some good points about the downgrade.
The recent S&P downgrade of the credit rating of US Treasury bonds is unwarranted for the following reasons:
1) The US dollar remains the dominant global currency and no viable competitor is on the horizon. The euro is heading into dangerous and uncharted waters while deep and difficult political, economic and financial reforms will be required before the renminbi could become fully convertible for capital flows and Chinese government bonds a safe reserve asset.
2) US Treasury bills and bonds, along with government-guaranteed bonds and highly-rated corporates, will for the foreseeable future remain the assets of choice for global investors seeking a â€œsafe haven,â€ due to the unparalleled institutional strength, depth and liquidity of the market. Although there are several advanced AAA-rated OECD countries with lower debt ratios and better fiscal outlooks than the US, their markets are generally too small to play that role. Since ratings are intended to function as a market signal, it makes little sense to implicitly suggest to investors seeking â€œrisk-freeâ€ reserve assets that they reallocate their portfolios toward these relatively illiquid markets.
3) Despite the above positive factors for the US, it is certainly the case that the US long-term debt outlook is deteriorating under the pressure of rising entitlement costs and an inefficient, distortionary tax system. Failure to reverse that trajectory would eventually make a downgrade unavoidable. But the recent discussions signal to me that – finally – public awareness of the fiscal crisis is growing and beginning to influence Washington. There is still a window of time – perhaps as much as a decade – within which structural reforms to spending programs and the tax system could reverse the negative debt trajectory.
4) The bottom line is that the global role of the dollar and the central position of US bond markets make somewhat elevated debt ratios more compatible with an AAA rating than is the case for other countries, another version of the USâ€™s â€œexorbitant privilege.â€ But that extra leeway is finite and serious reforms to entitlement programs, particularly Medicare, must be made in a reasonable time horizon. If not, global investors will eventually conclude that our political system is incapable of making the needed changes and turn away from US assets, regardless of the institutional strengths of US markets.