Tuesday, April 19, 2011

S&P Delicately Downgrades our Debt. Duh!

Yesterday Standard and Poor's changed the outlook on their rating of US sovereign debt from "stable" to "negative". This caused a spike in the number of visitors to my blog, so there seems to be some concern out there. Yes, bondholders should be worried about the government's long-term ability to keep its payment promises, but the move by S&P yesterday was a pathetically small gesture. In fact, Standard and Poor's have not downgraded America's top AAA credit rating; they're only saying that there's a one-in-three chance that they will downgrade us from AAA to AA+ some time in the next two years.

In addition to being only a possibility, the downgrade wouldn't mean much even if it happened. The following table from Wikipedia puts this possible downgrade in perspective:
As you can see, even if they downgraded us to AA+ there's still a long way to go before they start warning that economic conditions could threaten future bond payments.

There are two reasons to be skeptical of either a AAA or AA+ Treasury bond rating. First, unlike every other dollar borrower on the planet, the U.S. government has the power to create dollars out of thin air through the Federal Reserve Bank, which reduces the value of each dollar. In effect, the government can borrow money and then re-define what money is before paying it back. It's a lot like government-sanctioned counterfeiting. This may not fit the technical definition of defaulting, but it is effectively defaulting, and it's already happening. By this measure our credit rating should already be "D".
D: An obligor has failed to pay one or more of its financial obligations when it became due.
The second reason not to trust the bond ratings comes from recent history. The ratings agencies played a major role in the real estate bubble of the last decade and subsequent financial collapse. Back in the early 2000's, Freddie Mac and Fannie Mae were grouping together risky mortgages (sub-prime) into single investment packages known as mortgage-backed securities, and Standard and Poor's and Moody's were giving many of these securities AAA ratings. How far off were the ratings? According to Paul Krugman of the New York Times, 93% of these sub-prime AAA securities have defaulted as of 2010.

In other words, it's pointless for S&P to try to rate U.S. government debt on the same scale as private borrowers who can't print money, especially when a "AAA" rating still leaves open the possibility that a large category of bonds can default en masse.

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