Criticism of Standard & Poor’s decision to downgrade the United States’ credit rating from AAA to AA+ has generally gone like this: S&P is full of halfwits with a horrific track record of risk analysis, and they have no right to judge the country’s fiscal situation. You should ignore S&P. But if you don’t, you should note that the ratings agency is completely wrong about the country’s probability of default.
This analysis strikes me as mostly correct, and the markets seem to agree. Since Friday, investors have blithely shrugged off S&P’s suggestion that U.S. Treasuries are getting riskier. Indeed, demand for them has risen: Spooked by the sovereign debt crises in Europe and the specter of declining corporate profits stateside, traders are fleeing stocks for the warm safety of American bonds. The United States is borrowing for the cheapest rates since the 1960s, downgrade be damned.
But this interpretation also seems to be missing the point. Standard & Poor’s knocked the United States’ rating from AAA to AA+ not because of economic risk but because of political risk. All of S&P’s other judgments aside, that call seems to be completely correct.
In its note, the ratings agency does raise questions about the United States’ long-term fiscal stability. In a world in which one party refuses to raise taxes—any taxes at all—balancing the budget in a reasonable timeframe becomes very, very difficult. It means enormous cuts to defense and safety-net programs and to investment in infrastructure, education, and research. That does not mean good things for growth.
But S&P does not dwell on the numbers much (a good thing, given that they got them hugely, embarrassingly wrong at first). Instead, it focuses on the country’s politics and governance. The math problem is hard enough. It only gets harder given the gleeful abuse of the filibuster, lack of bipartisan compromise, and complete absence of rational economic policymaking on the Hill. Thus, the “downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges,” the note concludes.
Pundits have challenged this analysis. Warren Buffett, speaking on CNBC, argued that, “Our currency is not AAA, and in recent months the performance of our government has not been AAA, but our debt is AAA.” Political blogger Kevin Drum concurred: “S&P shouldn’t be in the business of commenting on a country’s political spats unless they’ve been going on so long that they’re likely to have a real, concrete impact on the safety of a country’s bonds.”
But Washington threatened a debtpocalypse, if not a default, for 11 excruciating weeks. Despite clear signs that the debt-ceiling impasse was hurting the economy, policymakers insisted on drawing the fight out until the very last minute. When it was all over, Senate Minority Leader Mitch McConnell promised to do it again the next time we need to raise the debt ceiling, and the time after that, and the time after that. We might be able to pay our debts, but it is far from clear that we will always be willing to pay them. Given all that, it hardly seems wrong for S&P to take our daft political climate into serious consideration.
Sovereign-debt downgrades often have more to do with politics than with economics—or, more precisely, with a political inability to tackle a looming economic problem. Consider the recent downgrade of Japan’s debt. The country is in worse fiscal shape than the United States, to be sure, with debts twice the size of its annual GDP. But Japan is wealthy and stable. It controls its own currency and monetary policy. The chance of an actual default seems small.
Yet S&P downgraded it in January to AA- from AA+. Why? Because of the political impasse on raising taxes to help solve the country’s long-term fiscal problems. “In our opinion, the Democratic Party of Japan-led government lacks a coherent strategy to address these negative aspects of the country’s debt dynamics,” S&P said, slapping the country with its first downgrade since 2002.
A similar dymamic is at play in the United States: a ratings agency, no matter how discredited due to its past performance, believes that the political system is an economic risk. The world’s investors might not be worried about default in the United States. They might not have any reason to, right now. But it is hard to see Congress as an ideal institution for managing our fiscal policy going forward.