Don’t shoot the messenger whose August 5 downgrade of U.S. debt set off the turmoil that rocked world markets this week. Standard & Poor’s had ample reason to lower its rating of long-term U.S. Treasury bonds from their top AAA rating to AA+, says Wharton finance professor Richard J. Herring.
The S&P downgrade was in some ways a no-brainer, according to Herring. “After the political spectacle [in Congress] over raising the debt limit, it is hard to argue that the U.S. is in a stronger position to repay its debt than it was a year earlier,” he says. “S&P had very clearly stated its concerns and the amount of fiscal reduction it felt necessary to maintain the AAA rating, and the last-minute deal simply didn’t make the mark.”
Indeed, S&P focused on Washington’s dysfunctional politics in the agency’s downgrade report. “The political brinkmanship of recent months,” said the agency, “highlights what we see as America’s governance and policymaking becoming less stable, less effective and less predictable than what we previously believed.”
Among other key points with regard to the historic downgrade:
S&P could soon have company. While S&P is currently the only major credit agency to downgrade U.S. debt, that may change before long. “It’s not obvious that Moody’s or Fitch will maintain the AAA rating,” says Herring. “Both are reconsidering their current rating.” A smaller agency called Egan-Jones lowered its own rating of U.S. debt from AAA to AA+ in July.
The three major rating agencies have credibility when rating government debt. S&P, Moody’s and Fitch have been much better at evaluating government debt than their failure to spot the risk of subprime mortgages during the housing bubble might indicate. “In that case, the rating agencies got it wrong for a huge, important class of securities,” notes Herring. “That’s not true with regard to sovereign debt,” he says of bonds issued by national governments. Agency ratings of such debt “have been relatively good — though far from perfect,” he adds.
S&P’s $2 trillion error was hardly material. The agency initially underestimated the projected long-term impact of the Congressional debt-cutting deal by $2 trillion. “But $2 trillion in terms of the grand scheme of things is a small number,” says Wharton emeritus finance professor Marshall E. Blume. For example, the Congressional Budget Office estimated in January that if current spending laws remained in place, federal debt would grow from 70% of this year’s $14.5 trillion Gross Domestic Product to 190% of the GDP in 2035. Looked at another way, the present value of the federal government’s funding shortfall for Medicare, Medicaid and other programs now exceeds $100 trillion, notes Wharton business and public policy professor Kent Smetters. (Present value estimates what the sum of a future stream of money would be worth today.)
U.S. Treasury bonds have been higher since the downgrade. The price of 10-year Treasuries has climbed and yields on the bonds, which fall when prices rise, hit near-record lows before gaining a bit on Thursday. Treasury debt “still looks good relative to other assets,” says Herring. None of the remaining countries with AAA ratings “have a sufficient quantity of debt outstanding to provide an adequate substitute for large holders of dollars.”
The impact of the downgrade could have been much worse. In a prescient move, regulators did not require financial institutions to adjust their books to reflect the downgrade. This would have clobbered bank balance sheets by forcing them to put up more capital against their vast holdings of Treasury securities, experts say.
Overall, the downgrade serves as a wakeup call to Washington. “S&P is predicting that there is now a non-zero chance that the U.S. could default on its debt in 10 or 20 years,” says Blume. S&P further warned that the agency could lower its rating to AA within the next two years if there is less debt reduction than Congress agreed to.
Any default would be a matter of choice rather than necessity, since the U.S. could always print more money to meet its obligations. “It’s very easy for the U.S. to avoid a default,” says Blume. But Washington might not accept “the inflationary pressures that would go along with the printing of money.”
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