Should Political Concerns Guide Debt Downgrade Decisions

A particularly stark stand out in the S&P statement on why it downgraded the U.S. is the political tone. The decision was essentially based on an analysis of the politics in Washington and less on direct financial reasons America may not be able to pay its debt in the future. This is also reflected in that the downgrade was just from AAA to AA+, the difference between “highest quality” and “high quality”. As investors pointed out yesterday by continuing to buy Treasury debt, pushing yields down even further from their historic lows, America is going to pay its debt in 10 and 30 years. So is S&P wrong? And should politics guide downgrade decisions?

The partisan hacks just blaming the GOP or White House for this are not clearly defining by what criteria S&P would be considered correct or incorrect in their assessment of American debt. Rather, the political bickering and finger pointing basically has proven the S&P point. The good news is that many people are seeing the irony.

S&P is right in noting the brokenness of the political system. Though the brokenness—a somewhat trite and loaded phrase—is not because of a lack of compromise, but because rhetoric carries the day instead of cold factual analysis of the impact policy decisions carry.

For instance, when we talk about housing, we talk about the American Dream. We talk about how great housing is. And why the middle class are gods among men to be served. This translates into support for Fannie Mae and Freddie Mac, it means no action on addressing the housing market for fear of upsetting the “fragile” recovery. And it means ignoring the historical reality about housing—it barely grows in value adjusted for inflation, it often times sticks families with unsustainable debt, it immobilizes households that want to move for work but can’t sell their home, and it treats renters like an untouchable class. Looking at the data and ignoring the rhetoric would mean putting Fannie and Freddie on a path to being phased out. It would mean accepting falling housing prices as a good thing to get us back on track with historical norms and as a means of making housing more affordable to clear out our supply.

But that won’t happen in Washington in this climate.

In what ways is the S&P statement different from any other pessimistic conversation about the state of American political affairs. How could we argue that the political system is in top notch, AAA form?

Then again, the ratings agencies traditionally haven’t rated the political system of sovereign nations. Their business is to rate countries and companies based on creditworthiness. And American has shown it will pay its debts. Like the debt ceiling deal or not, something passed and lenders go their money back. It remains to be seen what the Joint Select Committee will come up with in terms of long-term debt issues, so perhaps S&P should have waited until November to make this call. After all, they stated themselves that near-term ability to repay debt is not a problem for America since the debt ceiling deal was passed.

In criticizing S&P it is fair to point out their failures to downgrade Enron until just days before the company went under, its failure to see the housing bubble or the true nature of toxic debt in mortgage-backed securities, and overall coziness it has with the financial system because of its NRSRO oligopoly standing. So why should we trust their political analysis? We don’t have to, but since many Americans feel in their gut the same way S&P seems to about political dysfunction, it appears that many are.

S&P would have made a stronger case if they had included financial reasons for their decision. In their first draft they did include some language with deficit and debt math, but their interpretation of the CBO baseline was about $2 trillion off, so they ultimately removed that section.

This created a few problems: first, it undermined part of their report because separately they argue for ending the Bush tax cuts. This would mean between $900 billion and $2.8 trillion in revenues over the next 10 years (depending on who you ask). Both of those numbers are reasonably close to S&P’s $2 trillion error. Furthermore, S&P argued that the debt ceiling deal should have shaved $4 trillion off the long-term debt scenario. So why did the $2 trillion correction not adjust S&P’s findings? Reducing the deficit projection by $2 trillion is roughly the same as the $1.6 to $1.9 trillion S&P wanted to see in the debt ceiling deal. And it is more or less what S&P sees as the positive revenue collection coming from ending the Bush tax cuts.

What gives? Not the political system.

And that is ultimately where this decision was based. So call this an unorthodox ratings decision. Which is arguably fitting given all the unorthodox monetary policy we’ve seen over the past three years. So whether S&P are wrong depends on what you think they should be rating. And ultimately it is their decision to determine what they want to rate and how. The funny thing is, that even if they were going off just the numbers—as Moody’s and Fitch seem to be doing—I’d argue they’d still be correct in downgrading. We need a lot more than a $4 trillion slow down in the expansion of government. We need real reductions in federal spending. We need real reform for Medicare and Social Security. And we need a budget that sticks to just the revenue that we bring in. All of that will mean a lot more than $4 trillion.