The Trillion Dollar Mistake

On 5th August 2011 the United States was stripped of its AAA credit rating for the first time in 94 years, following an official downgrade of its treasury debt by rating agency Standard & Poor’s (S&P). The decision came after a recently brokered deal in Congress to trim the deficit was not believed to assuage concerns regarding America’s ability to re-pay its debts.

Grid-lock in Congress has made raising the federal debt ceiling, a usually routine process, tumultuous. On 2nd August, less than 24 hours before the existing deal was due to expire – which would render the US government unable to pay its short-term obligations and effectively in a temporary shut-down – Congress passed a bill raising the borrowing limit by $2.4tn in exchange for spending cuts equalling $2.1tn over the next 10 years. S&P said Congress had only achieved “relatively modest savings” which fell “well short” of the $4tn believed necessary to stabilise the government’s medium-term debt dynamics and avoid a downgrade.

Totalling $14.3tn, US government debt has reached record highs, and the deal passed in Congress neither reigns in profligate spending nor strengthens revenue streams through higher taxes. However, the US is having no trouble borrowing in the financial markets to cover its current deficit. Even after the downgrade the yield on the US 10 year note is hovering around 2%. Furthermore, the government’s medium-term budget arithmetic shows that modest reformation of public health-care schemes such as Medicare and closing loopholes in the tax code can go a long way in reigning in the deficit – if political roadblocks can be overcome.

With unemployment at 9.1% alongside the creation of no new jobs, fears of a double-dip recession are real and grave. Therefore, at a time when governments and central banks are undertaking all means necessary to restore confidence in the economy, S&P’s downgrade of American debt was at best unnecessary and at worst foolish. In the following weeks the S&P 500 fell 280 points (20%) and the FTSE 100 fell 800 points (13.5%).

Furthermore, the recent track-record of rating agencies has been nothing short of lamentable. In the words of Paul Krugman, S&P’s decision to downgrade US debt is analogous to the story of “[a] young man who kills his parents, then pleads for mercy because he’s an orphan.” America’s deficit is largely a result of stimulating an economy that crashed following the financial crisis of 2008. S&P, along with its sister agencies played a large role in assigning AAA credit-ratings to collateralised debt obligations (CDOs) and other mortgage backed securities, which have subsequently turned into toxic-waste. S&P also gave Lehman Brothers an A-rating right until the month it filed for chapter-11, and perhaps worse still US treasury officials spotted a $2tn mistake in S&P’s calculations, which the rating agency acknowledged, but proceeded to complete the downgrade anyway.

While it is true that many countries risking default (including Greece and Ireland) have been downgraded, this is normally after the markets have turned on them and sent borrowing costs soaring. In the events where a downgrade has tried to pre-empt the markets, rating agencies have consistently got it wrong. Nine years after being downgraded by S&P in 2002, Japanese 10 year notes are still trading at close to 1%.

Even setting aside the question of its credibility and mathematical accuracy, S&P’s fundamental mistake is one of regarding a political problem as an economic one. Within an economic framework, America’s ability to tackle its budget deficit is solid. The real question is whether its political one will allow it to do so.