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Why S&P’s Downgrade is No Joke Why S&P’s Downgrade is No Joke

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Economy / ANALYSIS

Why S&P’s Downgrade is No Joke

The real impact of S&P’s downgrade is political, not economic.

 (Andrew Burton/Getty Images)

photo of Edmund L. Andrews
August 6, 2011

It’s tempting to dismiss Standard & Poor’s downgrade of U.S. long-term Treasury bonds as no big deal in the real world. It’s also tempting to describe it as a broad criticism of the whole political system, a pox-on-both-your-houses curse at the intransigence of both Republicans and Democrats.

Both of those conclusions would be mistakes.  

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It’s probably true that S&P’s first-ever downgrade of  U.S. Treasuries from AAA to AA+  will have little impact on interest rates.   Credit ratings, though hugely important, are only one of many factors affecting the cost of borrowing.  The more important factors are broad forces of supply and demand for Treasuries, and the outlook for inflation and growth.  That’s why Japan has been downgraded three different times in the past decade (it’s currently AA-) yet its long-term rates are lower than those on U.S. Treasuries.

(TEXT: S&P’s Statement Announcing Downgrade)

It’s also true that S&P is hardly some kind of Delphic Oracle.  It and the other rating agencies were almost criminally negligent about the risks of subprime mortgages during the housing bubble.  And it’s not as if S&P told investors anything about U.S. fiscal problems on Friday that they didn’t already know.

So what’s new?

The big new element on Friday was an official outside recognition that U.S. creditworthiness is being undermined by a new factor: political insanity. S&P didn’t base its downgrade on a change in the U.S. fiscal and economic outlook. It based it on the political game of chicken over the debt ceiling, a game that Republicans initiated and pushed to the limit, and on a growing gloom about the partisan deadlock.   Part of S&P’s gloom, moreover, stemmed explicitly from what a new assessment of the GOP’s ability to block any and all tax increases.

S&P was remarkably blunt that its downgrade was mostly about heightened political risks:  “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,” it said.

(TEXT: Politicians React to Downgrade)

“The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently.”

To be sure, S&P didn’t specifically single out Republicans. It criticized the overall $2.4 trillion deal as too limited, and it implicitly criticized both political parties for refusing to tackle their sacred cows – entitlements, in the case of Democrats; tax increases in the case of Republicans. 

But it’s hard to read the S&P analysis as anything other than a blast at Republicans.  In denouncing the threat of default as a “bargaining chip,” the agency was saying that the GOP strategy had shaken its confidence.  Though S&P didn’t mention it, the agency must have been unnerved by the number of Republicans who insisted that it would be fine to blow through the debt ceiling and provoke a default.

As many other analysts have noted, the deficit-reduction deal wouldn’t stop debt from climbing faster than the nation’s GDP over the next decade.   It warned that the government’s publicly-held debt would climb from 74 percent of GDP at the end of this year to 79 percent by the end of 2011.  

 But one reason S&P said it had become more gloomy was that it had revised its assumptions about the most likely course of fiscal policy. In previous projections, it said, its “base case scenario” had assumed that Bush tax cuts for the wealthy would expire at the end of 2012, while tax cuts for families earning less than $250,000 a year would be extended.  That, it said, would have reduced deficits about $950 billion over ten years.

But the new S&P base case assumes that Congress extends all the Bush tax cuts.   “We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act,” S&P said.

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Republican leaders didn’t lose a moment’s sleep over any of this, immediately blaming Democrats for the downgrade.

“This decision by S&P is the latest consequence of the out-of-control spending that has taken place in Washington for decades," House Speaker John Boehner declared in a statement Friday night.  “The spending binge has resulted in job-destroying economic uncertainty and now threatens to send destructive ripple effects across our credit markets.”

Treasury officials, infuriated that S&P had gone ahead with the downgrade, complained that the rating agency had made a $2 trillion error in its deficit calculations as late as Friday evening.  S&P, they said, delayed its announcement and revised its numbers – but stuck to the same conclusion.

But that was a sideshow, because the real thrust of the ratings downgrade wasn’t about the specific numbers so much as the political outlook for making headway on the deficit.

“S&P's judgment was not that the U.S. could not repay, but rather, given the political process, that it might choose not to repay,” said Vincent Reinhart, a senior fellow at the American Enterprise Institute and a former director of monetary affairs at the Federal Reserve.  “That is in part a fall-out from Washington partisanship.”

In the short term, the downgrade may have little or no concrete impact.  For the time being, global investors don’t have enough other places to park their money – particularly in times of great uncertainty, like now.  Like them or hate them, but the market for U.S. Treasury securities is bigger, more liquid and in many ways still safer than any other markets in the world.

But over the longer term, it may well mark a watershed moment—the beginning of the end of what the late French president Charles De Gaulle called the “exorbitant privilege’’ of the dollar’s role as the world’s reserve currency.  Even if the fiscal and inflationary risks of the United States are still tolerable to global investors, the political risks may not be.   That can make a difference.

The potential costs may not be just be in the form of higher borrowing costs.  Shortly after S&P made its announcement Friday night, China’s official news agency declared that the United States would have to use “common sense” to “cure its addiction to debts” but cutting military and social spending. 

“China, the largest creditor of the world's sole superpower, has every right now to demand the United States address its structural debt problems and ensure the safety of China's dollar assets," Xinhua said.

That’s bluster, and not for the first time, and it has not stopped China from continuing to acquire mountains of Treasury debt.  It’s the only way it can keep its currency from soaring in value against the dollar and making Chinese exports more expensive.

But it’s worth remembering that the United States and many other countries are pushing China hard for reforms on a host of fronts—letting its currency float at market rates; focusing more on domestic growth; opening up its financial system.   

U.S. officials have always argued that those reforms are a matter of good government and would help reduce the massive global trade imbalances that played their own role in the last financial crisis. 

But if U.S. creditworthiness is being knocked down because of its gridlock, gamesmanship and procrastination, its ability to make those good-government arguments is likely to be diminished.

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