Rarely has a rating agency’s rating of a single country been met with such anticipation and followed by so much commentary. On August 5, Standard & Poor’s downgraded US long-term sovereign debt from the maximum of “AAA” to “AA+” adding an “Outlook Negative” to the picture. As mentioned all over the press, this is the first time to happen. What is particularly interesting about the downgrade is the motivation. Surely, United States has a huge public debt—of a size that causes even the most Keynesian-minded economists to take it seriously. But the motivation is barely economic at all. As seen in “Research Update: United States of America Long-Term Rating Lowered To ‘AA+’ On
Political Risks And Rising Debt Burden; Outlook Negative” the motivation is mainly political. In fact, it is one big blow in the face of the US politicians. S&P strongly criticizes the behavior leading up to the increase of the debt ceiling, and raises serious doubts about the politicians’ capabilities of living up to the promises embedded in the compromises which prevented the de facto shutdown of the federal government on August 2. Listen:
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.
Somehow it is difficult to disagree. Somehow it is also strange, to the degree of spooky, that a private organization working out of a seasoned and respected publishing company (McGraw Hill) suddenly can create a near-panic state among market participants, commentators, state leaders and economists all over the globe. And stock markets did plummet today all over the world. Ironically, however, the yield on a 10-year US Treasury Bond dropped by 20 bp since Friday (as of Monday 2.30 pm New York time).
This is enormous power that lies in the hands of a company who is probably not better or worse in judging the American debt problems than other similar institutions or branches of financial institutions, or even single economists. Indeed, some find that they are not even that good at it. Recently, Mike Konzal has written a great piece on rating agencies’ (lack of) good predictions of public debt. This power, however, can be used affect long-term interest rates better than the Federal Reserve would wish it could do. Indeed, in the current motivation for the downgrade, S&P resembles a central bank trying to signal future intentions:
We could lower the long-term rating to ‘AA’ within the next two years if we see that less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our base case.
So, if the S&P’s powers take effect, one could definitely see an interest-rate increase coming, and then we will get another downgrade. If this talk gains momentum in the markets and becomes credible, it can therefore severely worsen the fiscal problems of the US. All because of the opinions of a rating agency?
Well, the US asked for it, as its Securities and Exchange Commission has approved Standard and Poor’s as a NRSRO—Nationally Recognized Statistical Rating Organization. Nevertheless, it does raise a lot of complications with large dominant rating agencies. Simple forecasters now cannot rely on economy analysis, but must also try to forecast what the rating agencies will think about this and that. Also, I couldn’t help thinking about insider trading. With such obvious market power, employees at these institutions sit on valuable, really valuable, information. Obviously, Standard & Poor’s have codes of ethics that forbids employees to use such private information (pdf):
“Employees will not use or share Confidential Information for their personal benefit, including to buy, sell, or sell short Securities about which they possess Confidential Information” (par. 5.5.)
That is reassuring, but I would like to know whether a breach of these ethics is illegal, i.e., subject to the laws of insider trading, or just a way of getting fired from S&P? One could probably live with that if the return is high enough.
Finally, it may be worthwhile to let all market participants and politicians read a bit further into the codes of ethics of S&P:
“Credit Ratings do not constitute investment, financial, or other advice. Credit Ratings are not recommendations to purchase, hold, or sell a particular Security or to make any other investment decision. Credit Ratings do not comment on the suitability of an investment for a particular investor and should not be relied on when making any investment decision. The assignment of a Credit Rating to a Rated Entity does not guarantee the performance of the Rated Entity. Standard & Poor’s does not act as an investment, financial, or other advisor to, and does not have a fiduciary relationship with, any Issuer, investor, or any other person. Credit Ratings are not verifiable statements of fact.” (par. 7.7.)
So true, so true. So maybe the world could please coordinate on an equilibrium where less emphasis is put on “AAA” versus “AA+”?