Typical isn’t it? Go away for a few days and in your absence, the world’s biggest economy has its credit rating dubbed ‘negative’ by one of the biggest agencies, Standard & Poor’s. The language used by ratings agencies can appear a little obscure, but suffice it to say that AAA is good. AAA Stable is OK, AAA Positive is better, but AAA Negative means flashing warning signs. Ratings decline along a scale punctuated by fewer ‘A’s, more ‘B’s until they reach junk status.
The news triggered a sharp fall in share markets, stunned by S&P’s announcement and the likely impact of the report. The agency cited as the causes of its outlook warning the following factors: very large budget deficits and rising government debt in comparison to its AAA peers (see chart at following link); and an unclear path to addressing these twin ‘problems’. The US deficit stands at around $1.4tn and its public debt is around $14 tn.
This all sounds fairly alarming, explaining why politicians, analysts and economists with an interest in unsettling the public have found it so easy to do so. Big numbers cause people to fret about big consequences. And yet nominal readings need to be seen in their context and, in the case of deficits and debts, the framework used is that of comparisons to GDP. Only by comparing data to the overall value of a country’s output or wealth can they really be seen as meaningful.
US debt to GDP stood at 58.9% in 2010, putting the US 37th in the list of the most highly indebted nations. It’s interesting to note that the UK is in 23rd spot in the chart and the paragon of fiscal responsibility, Germany, is in 19th place. Why the big panic? S&P’s downgrade occurred a week after the IMF warned of instability in financial markets resulting from high US deficits. The ‘negative’ outlook means that S&P thinks there is a one-in-three chance of a full debt downgrade within two years.
It’s fair to say that the market didn’t believe S&P’s gloomy prognosis. Logic might suggest that two consequences might flow from the downgrade warning: government bonds would fall in price, making their yield rise; and the US dollar would fall. In the event neither of these events occurred. Both bond prices and the dollar rose in reaction to the announcement. It seems that there might be more to S&P’s sabre-rattling than meets the eye.
Firstly, as many analysts noted, S&P’s warning is ironic given that it was the agency’s rating of mortgage-backed securities as AAA standard investments that increased massively the debts of US and other sovereign governments following the financial crisis of 2007 onwards. Those securities are now virtually worthless. The roots of the near-meltdown in financial markets have been traced many times before. Here’s a good summary of these events. What remains is in the words of one observer, ‘the tailor who sold the emperor the non-existent suit, pointing fingers’.
Secondly, as a result of their alleged ‘incompetence’, S&P’s ratings not only played a key role in creating the fiscal problems they now threaten to act against, they also have led many observers to call for civil and criminal prosecutions against the ratings agencies themselves. This downgrade to ‘negative’ might be part of a ‘death dance’ between the US authorities and the ratings agencies. If the US retains its AAA status, perhaps no action will be taken against the likes of S&P for its ‘culpability’ in the inaccuracy of its ratings in the run-up to the financial crisis.
S&P’s owners McGraw-Hill would be keen to counter such accusations, of course. Moody’s and S&P’s are clearly, though, in a kind of symbiotic relationship with the financial organisations and governments whose credit they rate. Whether agencies should appear able to wield such influence when rating sovereign government debts, is another thing, though. It will also form the basis of tomorrow’s blog entry.