Shadowproof

S&P Is a Terrible Predictor of Sovereign Debt Defaults

Asian and European markets fell very slightly today, as the collapse that would supposedly be associated with the failure to agree to a plan several days from default has not yet materialized. The US markets are down, but again, not radically so. Nevertheless, Wall Street is now making arrangements for a possible US debt downgrade:

Wall Street’s top concern is no longer that the United States will fail to increase the federal limit on borrowing by Aug. 2 but that political leaders will fall short in their negotiations over an ambitious plan for taming the nation’s debt, according to financial analysts.

If President Obama and Congress are unable to reach such an agreement for reducing the debt, credit-rating firms — in particular, Standard & Poor’s — could cut the top-notch U.S. debt rating, sending a shock across U.S. financial markets.

S&P has said that raising the $14.3 trillion debt ceiling by the deadline, and thus avoiding a potential default, is not enough to avoid a downgrade. In any case, analysts say, many on Wall Street remain confident that Washington will cut a last-minute deal to raise the debt limit before the government runs short of money to pay all government bills and interest on existing debt.

But there’s not as much confidence about efforts to reach an agreement on debt reduction.

This is just absolutely nuts, for so many reasons. First of all, this is not the first time this year that Standard and Poor’s, at least, has threatened a credit downgrade. They did so right at the beginning of the budget debate, when the White House was stil calling for a clean debt limit bill. And even at that time, they were basing it on whether or not Congress would agree on a plan to cut the budget deficit. This completely oversteps the boundaries of what a credit rating agency should look at with respect to sovereign debt, putting S&P in the position of guessing about the US political system and demanding specific dollar amounts of deficit reduction. It’s a very aggressive move, turning S&P into a miniature version of the IMF, using the shock doctrine to force countries into austerity, which is favorable to bondholders (which indirectly pay for the rating agencies’ existence).

Second, S&P is making this decision on behalf of investors, when investors are simply not showing the same concern about US debt. Ten-year Treasuries are still in an historically low position, and if the debt limit situation were out of the way they’d probably be lower. S&P, by contrast, is saying that a small debt limit deal wouldn’t be good enough. According to whom?

The simple fact is that the markets have not linked the short-run debt ceiling debate to America’s long-term fiscal imbalances. The markets have not yet judged the U.S. and found it wanting. Ezra shouldn’t say that financial markets have done these two things when they have not.

Keep in mind that these rating agencies failed utterly during the housing bubble, and have a serious conflict of interest with the US government, who is deciding the fate of the rating agencies based on studies mandated by the Dodd-Frank financial reform law.

It’s also the case that the rating agencies have a horrible track record when it comes to sovereign debt:

And what’s more important, the ratings agencies own internal analysis shows that they are terrible at rating government debt. Their ratings are all off, as government, especially those with a printing press for their own currency, simply don’t behave like the corporate world they were designed to analyze. And rather than just being wrong, they are wrong in that they are always overestimating the likelihood that governments will default.

Mike Konczal provides a fact sheet backing up the claim. The rating agencies keep publishing studies that public bonds default far less than corporate bonds, and they keep rating public bonds relatively low compared to those corporate bonds. As Paul Krugman writes, “The point is that when S&P or Moody’s speaks, that’s not the voice of ‘the market’. It’s just some guys with an agenda, and a very poor track record. And we have no idea how much effect their actions will have.”

S&P’s explanation for all this is that the US political system is “more focused on debt consolidation” now, so they have to find a solution. As Kevin Drum notes, this means that anytime Republicans start screaming about the deficit, the rating agencies will respond by threatening a downgrade. It’s a neat little two-step.

To the extent that their actions have any effect, it will be to force austerity. That’s what happened when S&P threatened a debt downgrade to Britain. They reacted with an austerity program that has ripped through their economy and caused massive unemployment and a double dip recession. But if kept some bondholders happy.

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