The Treasury Department and the Federal Reserve have already revealed what their strategy toward Standard & Poor's will be now that the agency has stripped the U.S. government of its AAA rating: to destroy S&P's credibility.
They can make a pretty good case. It’s not just that S&P revealed its ratings process to be corrupt and deeply flawed during the subprime mortgage bubble, as it gave inflated AAA ratings to bad securities in order to satisfy its investment banking clients, according to the Financial Crisis Inquiry Commission report. It's also that the ratings agency appeared to go well beyond its ambit this time by taking it upon itself to assess, as it said in its report Friday, the "effectiveness, stability, and predictability of American policymaking and political institutions."
Rep. Brad Sherman, D-Calif., a leading voice on Capitol Hill for ratings agency reform, seconded the Obama administration's approach in an interview with National Journal on Sunday. "They did this on the theory that Washington might deliberately refuse to pay its debt because of a political impasse. But I don't know what makes them experts at this. They don't have anybody over there who has ever sat on the floor of the House," said Sherman. "S&P's main job is rating private issuers, and they have some expertise in that, although obviously they got it pretty wrong in mortgage-backed securities. But in this case you need to be a political scientist and not an MBA. And I don’t know if they’ve got any political scientists over there."
The problem with this line of attack is that S&P is not the first ratings agency to downgrade U.S. debt. It was preceded by a much smaller but arguably more credible agency, Egan-Jones Ratings Co., which on July 16 also reduced the U.S. credit rating to AA+, although it did not include a "negative” outlook. In an interview on Sunday, the managing director of Egan-Jones, Sean Egan, said that his own decision was driven by the worrisome size of America's debt to GDP ratio, nearly 100 percent by his estimate, and by the inability of policy-makers in Washington to come to any kind of intellectual understanding about the economic causes of America's debt crisis.
Egan said he would like to see some kind of common ground, which currently doesn't exist, between the "neo-Keynesians" in the Democratic camp, who believe in more government stimulus, and the "neo-Libertarians" on the Republican side who simply want to reduce the size of government. "I don’t think the political leaders have a handle on what country is faced with. They still don't understand the underlying factors," Egan said. "The economics comes first, and then the politics."
Congress and the Obama administration, he said, must arrive at some kind of "new framework" for "what will make America more competitive, such as enhancing the quality of the education system, double-checking the wisdom of spending $3 trillion on three undeclared wars, and determining whether or not sufficient checks and balances exist so the credit crisis won't recur. Of the $14 trillion or so in U.S. debt, $3 trillion was the result of the three wars, and $2 trillion was because of the credit crisis."
Egan leaves himself open to the same kind of criticism being directed at S&P, of course, which is that a rating agency is supposed to be analyzing securities, not national politics. At the same time, there is little doubt that the impasse over two fundamentally different economic philosophies is partly what underlies the political gridlock in Washington, as National Journal reported in May.
Egan-Jones, while a relatively tiny firm, earned plaudits in the run-up to the financial crisis by "warning investors about poor credit quality long before the Big Three ratings agencies," according to Fortune magazine. Sean Egan has long been a critic of those agencies, S&P, Moody's and Fitch, because their revenues derive from the fees they receive from the investment banks whose securities they rate. That creates a potential conflict of interest, in that the agencies can succumb to temptation—and often did during the credit bubble—to deliver whatever ratings their clients pay for, even if they aren't justified. Egan-Jones, by contrast, earns its revenues from investors who subscribe to its service.
The U.S. Treasury in recent days has called the S&P downgrade fundamentally flawed, attacked its math, and has sought to discredit the agency by citing its poor performance during the credit bubble. The Fed, meanwhile, has directed the banks under its supervision to effectively ignore the S&P analysis.