At least one economist burst out laughing on hearing about the S&P announcement. “They did what?” exclaimed James Galbraith, a professor of economics at the University of Texas in Austin, who formerly served as executive director of the Congressional Joint Economic Committee. “This is remarkable! It certainly will confirm the suspicions of those who have questioned S&P’s competence after its performance on the mortgage debacle.”
That’s about the right reaction to have. As James Fallows points out, S&P is basically making a guess, no more informed or uninformed than any observer of politics. No modeling went into this threatened downgrade. “They’re saying they have an opinion on the state of Congressional-White house dealings on the budget,” writes Fallows. “Fine. Go on a talk show or start a blog.”
In addition, as long as debt is issued in US dollars, and as long as the US prints its own currency, the government has a pretty good shot at paying off debt. To the extent that there’s a problem with this, it comes when borrowing rates get too high, but of course, the price of borrowing on this news FELL yesterday. “As long as there is diesel fuel to power up the back-up generators that run the government’s computers, they will have the money to back their own bonds,” Galbraith concluded.
This all begs two questions: 1) why did this get such notoriety yesterday, and 2) why did S&P even bother? I think the first can be made clear by the overlooked fact that this is nothing new. Moody’s threatened a credit downgrade in March 2010. It just so happened the political world was busy at that time waiting to see if Congress would pass the health care bill. Moody’s actually continued to make these threats for the better part of a year. So chalk up the interest in S&P to a) a slow news day, and b) a newfound concern with deficits in Washington. After all, the President just made a speech about it!
Then you have the second question, why did S&P bother with this? Dean Baker has an answer.
S&P and the other bond rating agencies had their lobbyists working overtime in the financial reform debate. The Senate had approved an amendment by Senator Franken, which would have taken away the power of the issuer to select the agency that rated its bonds. Under the Franken amendment this power would instead be given to the Securities and Exchange Commission.
This amendment removed an obvious source of corruption. If the company issuing debt gets to pick the agency that rates the debt, then the bond-rating agency has an obvious incentive to give the debt a positive rating. Otherwise they will lose business. This likely explains how hundreds of billions of subprime mortgage backed securities got investment grade ratings.
However, the Franken amendment never took effect. In the conference committee, Representative Barney Frank, who was then head of the House Financial Services Committee, got language that delayed the implementation for at least two years. In the mean time, the current system, in which the issuer picks the rating agency, remains in place.
This should raise the obvious question: does S&P hope to influence the final resolution of the Franken amendment with its negative outlook on U.S. debt? It’s a terrible thing that we have to ask if the umpire is taking payoffs, but we do have to ask.
I don’t think you can discount this possibility. Ratings are big business: the Levin report revealed that an agency can get up to $750,000 to rate a particular security. That’s a gravy train they have an interest in moving down the track. And if their paymasters want to force some resolution on the deficit, they have the wherewithal to make this nonsensical downgrade threat, which was just as nonsensically taken seriously.