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Political games, rating charades and the U.S. debt

Steve Tadelis, professor of business, economics and public policy | August 8, 2011

Last Friday Standard and Poors (S&P) was gracious enough to offer their formal view on the trustworthiness of Uncle Sam: S&P downgraded US debt from AAA to AA-plus for the first time, citing the size of government debt and the political gridlock as the two most concerning issues. In particular, they state that the government’s current plan “falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.”

What were the motives of S&P to release information that is not informative? Is it their duty as gatekeepers of true value and their dedication to this duty that prompted the downgrade, or is there an ulterior motive? Going back three years and recalling their ratings of the infamous mortgage-backed securities makes me doubt this noble motive, and possibly even S&P’s competence. Indeed, all the rating agencies need several years of reputation building before I am willing to even suggest that they can be trusted to offer accurate and unbiased ratings. We may indeed not be in the dire straits we are now if the rating agencies did their job adequately three to five years ago.

Putting S&P’s motives aside, let’s try to evaluate the aftermath of their announcement. The verdict was that US debt is not as safe as it was previously conceived to be. What effect should this have on the market? To answer this question, consider a simple analogy. Imagine that you and others enjoy diversity in food consumption and as such, choose to eat two kids of food: doughnuts and apples. There is a market for both, and current prices reflect the balance between supply and demand. Now imagine that a study from the University of California in San Francisco, a highly regarded medical research institution, suggests that doughnuts are not as healthy as we thought they were. Because most of us are concerned with our health, we will consume fewer doughnuts and more apples to sustain our needs. The increased demand for apples will cause the prices of apples to rise, and the decreased demand for doughnuts will cause the price of doughnuts to drop. This is the beauty of the market: prices reflect both desirability and scarcity.

Now back to US debt. Using the food analogy, the S&P rating was akin to saying that US debt is not as healthy as we thought. In response, we should demand less US treasury bonds at current prices and instead buy alternative assets, causing the price of US treasury bonds to drop, or alternatively, the yield (return) on bonds to increase. However, the market’s reaction today laughs at this suggestion. In fact, the prices of US Treasury Bonds rose instead of falling! (The yield of 30-year Treasury bonds dropped from 3.85 percent on Friday to 3.68 percent today. Shorter term bonds also saw a drop in yields.) On the other hand, it seems that enough people reacted to S&P’s announcement with the expected psychological impact — a serious drop in confidence — causing anticipated changes in two other markets: stock prices plummeted and gold prices rose (the ultimate safe haven).

So what really went on? We know that the debt-ceiling fiasco was the main reason behind S&P’s downgrade of US debt. However, did anyone really believe that Congress would allow our country to default on its financial obligations? It is safe to say that people who pay attention and think through the issues were confident that a deal would be cut at the end. The back and forth between Republicans and Democrats was a tantalizing display of a game of brinkmanship, in which one of the parties would have to back down from their demands. The Republicans won this pathetic game after speaker Boehner credibly demonstrated his strength. There are more than enough crazy Tea-Party freshman, and other conservatives who need to defend against Tea-Party rivals in the coming primaries, who will actually prefer the country to default over increasing taxes. Once this was made clear, the Democrats had to fold. There was never of issue of whether a deal will be reached, but just how long it will take one party to convince the other that its position will triumph.

Back to our original question: why did S&P join the political games with their own game of rating charades? My best guess is a desperate attempt to try and regain some of the lost reputation they and the other rating agencies suffered following the mortgage-backed securities mess. I think it is safe to say that the market’s reaction suggests that S&P will not only fall short of regaining its reputation, but their irresponsible announcement caused further harm to an already weak and fragile economy. Bond markets are generally run by large institutional buyers, and the drop in yields suggests that S&P’s announcement was largely ignored by these more savvy investors. On the other hand, stock prices, which are more sensitive to the mood of the small less rational investor, plummeted (the S&P-500 lost 6.6 percent). And now that so many small investors saw a drop in their stock market wealth, their propensity to consume will most likely fall further, almost surely causing a negative self-fulfilling effect on the economy.

At least for now it seems that Moody’s and Fitch, the other two rating agencies, are behaving in a more responsible way. As Moody’s listed on their website earlier today, “The US retains its AAA because of the diversity and size of the US economy, a long record of solid economic growth, and the global role of the dollar and the unmatched access to financing it provides”. This is based more on economic fundamentals than S&P’s sloppy statement about medium-term debt dynamics. And in line with the belief that government default was never a real option, Fitch’s website stated earlier today that “as it expected, agreement was reached on an increase in the United States’ debt ceiling and, commensurate with its ‘AAA’ rating, the risk of sovereign default remains extremely low.” One can only hope that in the next few days these more sensible statements help the market regain its sanity.