S&P has received some deserved criticism for the timing and nature of its decision to downgrade the long-term sovereign credit rating of the US on Friday. (See for example these excellent critiques by Clive Crook and Paul Krugman.)
Although S&P’s strictures on the path for US debt and the dysfunctional nature of Washington’s recent political games seem valid, what can the ratings agencies actually tell us about the creditworthiness of the US that we do not already know? Very little. And why did they pick the most volatile day in financial markets since the Lehman crisis to deliver their opinions on a debt problem which, by their own reckoning, will play out over at least a decade?
In their haste to release their downgrade, S&P suggested that the $2,4000bn package of cuts agreed by Congress last week falls well short of the total needed to stabilise the debt total in the long term. By most estimates, it falls about $2,000bn short of the amount needed. Yet S&P initially made an error amounting to $2,000bn in their own estimation of the debt ratio in 2021. When they realised this, they proceeded with the downgrade anyway. Either $2,000bn of cuts does matter or doesn’t matter. Which is it?
We need to keep a level head about all this. Yes, the US does have an indisputable medium-term debt problem. And, no, the recent deal in Congress did not solve it. But the US cannot be forced to default on debt which is denominated in its own currency while it has huge untapped taxable capacity and a sovereign central bank to boot. It would only default because of the existence of a debt ceiling voluntarily imposed by Congress. After last week’s near debacle, surely this problem cannot rear its ugly head again.
The whole point about the debt crisis in the eurozone is that countries like Italy and Spain might one day be forced to default because they do not have their own sovereign central banks, and because they have limited untapped taxable capacity. Perhaps S&P should concentrate on pointing this out, instead of raising red herrings about the close-to-impossible contingency of a US default.
Still, the deed is now done. What will be the market consequences? Those who have studied the legal consequences of this downgrade suggest that the impact should, in logic, be rather small.
Few, if any, investing institutions will be forced to unload their holdings of Treasuries because of a small change in the ratings from a single agency. The Fed has said that the standing of Treasuries used as collateral in bank borrowings from the Fed will not change. The same should be broadly true of the collateral used in private market transactions, though there could be some deleveraging as investors are forced to reduce their holdings of risk assets now that Treasuries are haircut more than before. As I say, in logic, the effects should not be large. But the markets did not seem in much of a mood for logic on Friday.
Taking a longer-term view, it is not impossible that the US could suffer from a crisis of confidence in its debt which is focused not on default risk, but on inflation risk. That has happened before, notably in the early 1970s. If it happened again, it would be the worst economic outcome conceivable. Treasury yields would rise while the dollar collapsed. Both unemployment and inflation might rise at the same time.
Perhaps this, rather than outright default, is what is worrying S&P. But if so, it should have added that there is no sign whatsoever of this happening now. Investors continue to flood into Treasuries because they believe that inflation has peaked for the current mini-cycle, and because they think that the risk of a double-dip recession is rising markedly. Those are the dominant forces at work.
The US economy is in bad shape and its recent policy-making has clearly not been triple A. But, now that the debt ceiling has been raised, a default on its sovereign debt is fairly low down on its lengthy list of worries. The downgrade by S&P needs to be seen in that context.
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