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Posted at 11:55 AM ET, 08/09/2011

A little perspective on S&P’s downgrade


It's true that Standard & Poor's downgrading of U.S. Treasury debt is more about politics than economics -- but not in the usual way.

The Obama administration seems to have decided that the downgrade, the first in U.S. history, is both a personal affront and a political disaster. It's gone on the warpath against S&P, with the president, Treasury Secretary Timothy Geithner and other top officials denouncing the rating agency as ill-informed, inept and irresponsible. The fact that the Dow Jones industrial average plunged 5.5 percent on Monday, with the downgrade as a proximate cause, surely deepened the White House's outrage.

Can we get a little perspective here?

First, although the downgrade is a possible explanation, it's not the only cause — and maybe not the main cause — of Monday's market sell-off. Remember, stocks had been dropping since late July. On July 21, the Dow closed at 12,724. On Monday, it closed at 10,810, a 15 percent decline. Most of that preceded the S&P action.

Possible explanations for the two-week slide include: fears of a much sharper economic slowdown than had been expected, hurting corporate profits; disillusion over the partisan struggle to raise the federal debt ceiling; the release on July 29 of revised figures on gross domestic product, showing that economic growth had been overestimated in the first quarter of 2011 and also in 2008 and 2009; more debt problems in Europe, especially last week when Italian and Spanish bonds encountered heavy selling.

Next, let's try to understand S&P's $2 trillion "error" that's received so much publicity. What did S&P do wrong? Well, the Budget Control Act — the legislation with the budget deal that raised the debt ceiling — specified that one category of spending (“domestic discretionary spending”) would grow at the rate of inflation over the next decade. By contrast, S&P's analysts assumed incorrectly that this spending would grow at the rate of the economy (gross domestic product). GDP almost always grows faster than inflation, and the difference — when compounded over a decade — came to $2 trillion.

That's a lot of money, even in Washington. This is a serious mistake, and once the Treasury pointed it out, S&P might have paused to see if its rating conclusion warranted rethinking. S&P didn't pause, but it does have a rejoinder. Despite the revised spending, prospective budget deficits — the annual gaps between spending and tax revenues — remain so large that government's debt burden keeps rising. It goes from 74 percent of GDP in 2011 to 85 percent of GDP in 2021. The basic trends, S&P argues, don't change. (Under the original assumption, the debt-to-GDP ratio in 2021 would have been 93 percent.)

People can argue whether S&P exercised good judgment in making its downgrade. My own view is that it was influenced by its disastrous performance in the housing bubble. Overly optimistic ratings of mortgage-backed securities fed the real estate boom and seriously tarnished the reputations of all rating agencies. With its Treasury downgrade, S&P was trying to refurbish its reputation by showing it could stand up to the world's biggest borrower. This institutional impulse is what I meant, in part, when I argued above that the rating was more about politics than economics.

There is another sense in which this downgrade is mostly about politics — a sense in which S&P is undoubtedly right. Five years ago, no one imagined that the U.S. government might default on its debts or its obligations. It was a non-issue. People didn't dismiss it; they didn't think about it. It was inconceivable. Now, it is conceivable, even if (as Warren Buffett and others argue) the possibility seems so remote as to border on the impossible. Logically, that's true; the United States has the economic capacity to service and repay outstanding debts. But logic isn't the only thing at play. Politics has intruded, and it's fickle. However certain it was five years ago that the United States would always repay on time, it's a little less certain today.

The message: Even if Standard & Poor's had kept the AAA rating (as two other major rating agencies have), that label no longer conveys the absolute predictability that it once did.

By Robert Samuelson  |  11:55 AM ET, 08/09/2011

 
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