This clip above and the article below really helped my understanding of the issue.
What’s Next After the S&P Downgrade
by Jagadeesh Gokhale
Jagadeesh Gokhale is a senior fellow at the Cato Institute, member of the Social Security Advisory Board, and author of Social Security: A Fresh Look at Policy Options University of Chicago Press (2010).
Added to cato.org on August 8, 2011
This article appeared on The Huffington Post on August 8, 2011
What now, in the wake of Standard & Poor’s downgrade of U.S. debt?
Well, the real answer is: nothing much.
Though the agency’s downgrade is being reported apocalyptically by news media — and had a corresponding effect on markets early Monday — the fact is that the S&P rating should be treated as but one datum in a vast sea of information about the financial sector and the overall economy.
Jagadeesh Gokhale is a senior fellow at the Cato Institute, member of the Social Security Advisory Board, and author of Social Security: A Fresh Look at Policy Options University of Chicago Press (2010).
S&P is only one of three major agencies whose credit ratings are widely used by individual and institutional investors to set their asset portfolios. Despite S&P’s downgrade, the other two major ratings agencies — Moody’s and Fitch — affirmed their AAA rating of U.S. Treasury bonds.
S&P’s own suggested interpretation is that ratings are “one of several tools that investors can use when making decisions about purchasing bonds and other fixed income investments.” Indeed, S&P’s language here hints at a double standard: it issues the ratings, but then describes them as not very useful — suggesting a desire on the part of S&P to evade accountability when their ratings turn out to be misleading, as happened with mortgage-backed securities during the recent recession.
S&P’s ratings measure “relative risk,” informing investors about whether one financial asset is more (or less) likely to default compared to another. Thus, with the recent downgrade, U.S. Treasuries are now more risky than the sovereign debt of several other countries: Australia, Sweden, Canada and six others. However, none of those countries is large enough, with capital markets sufficiently deep or liquid, to replace U.S. Treasuries as the destination of choice for investors wishing to shield their capital from risks.
Moreover, because accruing federal revenues are considerably larger than federal debt service costs, the likelihood of an outright default on U.S. public debt remains remote. The only other way to default on U.S. Treasuries is through higher inflation — to erode the real value of federal debt, most of which is denoted in nominal (rather than inflation-adjusted) terms. The potential for rising inflation in the long-term remains high with banks, non-bank financial intermediaries, and regular private sector firms sitting on large hoards of liquid reserves. But the likelihood of an inflationary spiral in a sluggish economy with a high rate of unemployment appears to be very low. Therefore, a broad-based exit from U.S. Treasuries appears unlikely.
S&P says that its ratings do not amount to investment advice — to purchase, sell or hold particular financial instruments. They are simply one of many factors — such as companies’ business models, their revenue potentials, input costs, sector outlook, technologies in development, and so on — that should be considered when selecting financial investments. Indeed, this view was strongly emphasized by S&P and other ratings agencies after the financial sector collapse from exposure to sub-prime mortgages. Those loans were financially engineered to construct derivative financial assets — mortgage-backed securities, collateralized debt obligations — that were rated AAA, but which later failed spectacularly and still toxically infest many financial institutions’ portfolios.
That episode has cast considerable doubt upon the ability and reliability of ratings agencies’ risk evaluation methods. By S&P’s own admission, establishing ratings is not a science. Well, then: it must be an art at which the agencies have proved particularly inept. The $2 trillion error in S&P’s projections of U.S. federal debt — an error S&P admitted — is clear evidence that these agencies are unworthy of worship on a pedestal.
Finally, the ratings downgrade provides no new information about the fiscal condition of the U.S. federal government. Our aging population — increasing longevity, and the retirement of 76 million baby boomers — will boost government spending on entitlement benefits unless those programs are reformed to cut costs. Politicians’ unwillingness to reform them is well known. And it just happened again, as Congress and President Obama settled on a small budget deal that’s likely to leave the government’s finances in a deeper hole by the end of the decade. Investors and others knew it as soon as the budget deal was announced, as indicated by the almost universally negative market commentary on the adequacy of the deal. The recent market decline must be interpreted as a clear response to the disappointing outcome.
The S&P ratings downgrade only rubber-stamps the negative outlook on the federal government’s finances that markets have already expressed. This ratings downgrade, by itself, is unlikely to make much additional difference to market outcomes in the short term; markets had clearly decided on their own not to rely too much on S&P’s rating of U.S. Treasuries.
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