So, my caution as to whether the US debt deal would be enough to stave off a downgrade proved well founded. On Friday, Standard & Poor's (S&P) announced that it was downgrading the long-term US debt rating to AA+: the coveted AAA rating is no more. To rub salt into the wound, S&P said that the outlook on the new long-term rating is negative, signaling the possibility of further downgrades. (Moody's still has the US at AAA, albeit with a negative outlook.)
S&P cited two main reasons for the action. First: '...our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics.'
And second: '...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 to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.'
Since (1) is largely a consequence of (2), I think it's fair to interpret the downgrade as a product of the current US political situation, with its disastrous consequences for the quality of US policymaking.
Some initial thoughts:
- The US remains critical to the global economy. US financial markets dominate their global counterparts – the GFC itself is testimony to that importance, showing how US financial market disruption could trigger the largest and most synchronized global downturn since the 1930s. As a recent IMF report on spillovers from the US economy highlights, US markets are central to global asset pricing. The US accounts for about one-third of global stock and bond market capitalisation, a significantly greater share of market turnover, and US asset prices serve as bellwethers for global prices. Changes in US bond yields and share prices have major spillover effects on financial markets in other countries.
- This downgrade, then, will be a powerful test of the importance of ratings in moving markets. More specifically, the dysfunctional state of US politics that has triggered the downgrade is hardly a surprise, and to this extent, theoretically Friday's rating change should (as usual) be a lagging indicator of credit risk. So while the initial market reaction is inevitably going to be negative as uncertainty increases and risk premia are marked up, the longer term implications are harder to judge. For example, the potentially adverse consequences of higher US borrowing costs may be limited by the fact that credit-worthy alternatives are currently in very short supply (the Eurozone is in even worse shape than the US right now). Note also that immediately pre-downgrade, and for all the talk of US debt problems, the threat of a renewed recession had been pushing US bond yields down, not up. There is also a large amount of uncertainty as to the possible size of any forced sales resulting from the ratings downgrade, with the Fed already working hard on limiting this risk.
- Regardless of the market implications, it's hard to dispute that the downgrade makes for an historic moment. The US economy stands at the centre of the global financial system as currently constituted. The US dollar is the closest thing we have to a global reserve currency; the US Fed the closest approximation to a global central bank; and until now the yield on US treasuries has been synonymous with the risk-free rate. The loss of AAA status is of great symbolic importance.
- In particular, this represents a blow to US prestige. For one potent example of this, take a look at Beijing's response as channeled by Xinhua, the official Chinese news agency: 'The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone.' This is the kind of stern and somewhat self-righteous lecture that once upon a time would have been delivered by rich-world governments to profligate developing countries. Now the scolding is being directed at the world's largest economy.
- The current focus on the ratings agencies is only going to increase. Indeed, even the announcement of the downgrade turns out to have been damaging not just for US credibility, but also for S&P's, as the US Treasury was able to highlight a US$ 2 trillion mistake in the agency's calculations. Whoops.