The downgrading, from AAA to AA+, of the Standard & Poor’s rating of long-term U.S. government debt has produced both a week of extreme volatility in financial markets and a fair degree of puzzlement among observers of those markets. How was it possible, many wondered, that bonds that had just suffered a historically unprecedented downgrade should be in demand at a real interest rate close to zero? Even more strikingly, how could a downgrade lead an asset to appreciate in value (the price at which bonds are traded moves inversely with the interest rate)?
The natural, if naïve, belief that the rating reflected some kind of expert and objective judgment was quickly knocked down. First, there is no question of expertise here. Having failed spectacularly with ratings of firms like Enron and Worldcom during the dotcom bubbles and assigned AAA ratings to thousands of worthless mortgage-backed securities in the leading up to the global financial crisis, Standard & Poor has completed the trifecta with a $2 trillion error, pointed out by the U.S. Treasury on the eve of the downgrade.
Moreover, while the debt-ceiling debate certainly displayed the dysfunctionality of the American political system in an extreme form, it also made it evident that a “technical” default on U.S. debt is more unlikely than many observers (including this one) had previously supposed. The Fourteenth Amendment, which came to prominence during the debate, provoked different interpretations, but all agreed that default was unconstitutional. Rather then stop payments on debt, the president would be obliged either to declare the debt ceiling unconstitutional or to cease payment on legal obligations such as Social Security—not to mention “discretionary” payments like the wages of the armed forces.
The downgrade made no sense, then, if it was interpreted as an expert judgment on the likelihood of a default on U.S. government debt. Rather, the actions of S&P must be interpreted as a political intervention, and in this context the downgrade seems both rational and effective.
The direct interests of S&P as a ratings agency are well served by the current financial system, and most importantly by the success of the agencies in maintaining their claim that their ratings are merely opinions, protected by the First Amendment, and not professional advice subject to potential legal action for negligence or lack of expertise. Both because they are headquartered in the United States and because they depend critically on U.S. law, the ratings agencies are inevitably political actors within the American system.
More broadly, the ratings agencies are representatives of the interests of bondholders, which differ in important ways from those of the United States as a whole, or even those of U.S. owners of capital. Bondholders as a class are indifferent to whether the economy grows strongly or slowly, or even contracts. High levels of unemployment are beneficial in holding down wages growth unless they provoke dangerous political reactions. The only risks that affect the interests of bondholders are those of default, taxes and inflation.
Default is straightforward. If a government or corporation defaults on its debt, bondholders miss out on the interest they are entitled to, and, in part or whole, on the return of their principal. The threat of default may be used to induce creditors to restructure debt, for example by agreeing to slower repayment, but this is just another kind of default and is treated as such by ratings agencies.
For a corporation, therefore, the only choices are to pay up or to default, a course that normally implies bankruptcy. While strategic use of bankruptcy has now become commonplace among corporations, this course still has high costs.
Provided they act before their position becomes unsustainable, governments can avoid default through “austerity measures” such as expenditure cuts or higher taxation. Such policies will typically produce an economic contraction, but that is of no concern to external bondholders unless it is so severe as to offset the improvement in the government’s fiscal balance caused by the original measures. For domestic bondholders, however, there is the risk that, if tax increases are focused on capital income or, more broadly, on upper-income earners, they will lose on the roundabouts all that they gained on the swings.
Finally, if governments have issued debt denominated in their own currency, there is the option of inflation. Inflation is the great enemy of creditors of all kinds, but particularly of bondholders. The destruction of the rentier class by the inflation that followed World War I is the archetypal example, still vivid enough in memory to dominate the debate over monetary policy in countries like Germany.
Hyperinflation, or even a return to the double-digit rates that prevailed in the 1970s and 1980s, is not in prospect. But a wide range of economists, from Keynesians like Paul Krugman to centrists like IMF chief Olivier Blanchard to conservatives like Ken Rogoff, agree that current targets of 2 to 3 percent inflation are too low, especially when, as in the United States, actual core inflation rates are below that range.
An inflation rate of 4 percent would make for more flexibility in real prices and interest rates. It would also claw back from bondholders, as a class, some of the gains they made when the financial system (that is, the unsound investments made by that system) was bailed out by taxpayers during the financial crisis.
The core of the U.S. political establishment, most notably the Treasury, is strong in its opposition to such a course of action and in its support for the only feasible alternative, that of rigorous austerity policies. The fact that, rather than facing down the Republicans over their debt-ceiling blackmail, Obama sought to enlist their support for a “grand bargain” reflects his commitment to the “Treasury View.”
On the other hand, the failure of the grand bargain reflects the challenges faced by the establishment, both from the Tea Party on the right and from Obama’s increasingly disillusioned Democratic base.
The purpose of the downgrade is to lock in bipartisan commitment. In this context the criticism of the Republican Party makes perfect sense, even though that party is in general sympathetic to bondholder interests. The deal on offer from the Obama administration involves massive cuts in expenditure, combined with a much smaller contribution from “revenue enhancements.”
More importantly, the proposed revenue enhancements do not involve any increase in tax rates. Rather, revenue enhancement, if it happens, will involve the removal of concessions and tax expenditures. Some businesses and households will end up paying more taxes as a result. But bondholders, as a class, will have nothing to fear.
Judging by movements on financial markets since the downgrade was announced, the intervention by S&P has been highly successful. Bond yields have remained at historically low levels, generating substantial gains for existing holders of long-term bonds (since these bonds were issued at higher rates in the past, they now trade at a substantial premium to their face value). Meanwhile stock markets have fluctuated wildly around levels well below the peaks of the 1990s.
The lesson was hammered home by the announcement of the Federal Reserve that it planned to maintain short-term interest rates at extremely low levels through 2012 and 2013. The implication is that the economy will remain depressed at least for the next several years.
What the U.S. economy actually needs is a renewal of fiscal stimulus in the short run, accompanied by credible policies for a long-term return to surplus. The achievement of this goal was unlikely in the aftermath of the debt-ceiling fiasco. Standard & Poor has done its best to make it impossible.