Harvard Business Review

Does S&P Deserve a Downgrade?


Posted on Harvard Business Review: August 9, 2011 7:40AM

By Jeff Stibel

Those who live outside Los Angeles may or may not have heard of "Carmageddon." Carmageddon was the temporary closure of a 10-mile stretch of freeway running through the heart of Los Angeles, a closure that was expected to create an artery blockage on the scale of a massive heart attack. In the end however, traffic was so light that a drive through Los Angeles during Carmageddon was more heaven than Armageddon.

The current reaction to Standard & Poor’s decision to downgrade the U.S. nation’s credit rating has the same tone. Prognosticators are outdoing one another in either attaching great significance to the downgrade or in treating S&P like it’s the oracle of economic truth beyond criticism or reproach.

Both views are wrong.

Ratings are great when there is misinformation or uncertain information, but that is not the case here. There is nothing Standard & Poor’s knows about the U.S economy that is not known to any economics student, newspaper columnist, or anyone else who cares to familiarize him or herself with widely known facts. We all have access to the same statistics: the gross debt stands at $14.5 trillion, unemployment is 9.1%, and we’re spending far more than we are taking in. This is all cause for serious concern. More than a month ago, I published an article stating that the U.S. was headed back into recession and very little has changed since then. But the U.S. still remains the largest economy within a single national border (the EU is about the same size but includes 27 States) with a GDP that is 200% larger than that of China.

In fairness to S&P, the downgrade was to a level which hardly indicates risk. An "AA+" rating is defined by S&P as follows: "An obligation rated ‘AA’ differs from the highest-rated obligations only to a small degree. The obligor’s capacity to meet its financial commitment on the obligation is very strong." And all ratings agencies tell their constituents that their ratings are a guide, a compass, not a hard and fast rule. Most institutions won’t even act on a single rating until another agency (such as Moody’s or Fitch) backs that rating, which has not been done.

Even if the S&P downgrade did provide a new data point, ratings agencies in general do not have strong track records at forecasting based on large-scale data and tend to be more reactive than proactive. The analysts at Standard &Poor’s—like most of us—are far from infallible. This is the same ratings agency that waited seven days before Enron went bankrupt before issuing its first downgrade; the same agency that gave its highest rating to the very mortgage-backed securities that helped precipitate the great recession; the same agency that made a $2 trillion mathematical error—according to the Obama administration’s math—in its most recent report downgrading the nation’s credit rating.

Standard & Poor’s downgrade sheds no new light on this situation and takes little account of the softer, regenerative aspects of our economy. We are embroiled in politics, not economics. But ratings agencies should not play politics. By its own admission, Standard & Poor’s decision to downgrade our rating is as much based upon our politics as it is on our economics. They wrote, "The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed." Well said. Most of the country believes our rating for effective policymaking is somewhere between a D and an F. But that is not the point of a credit ratings agency.

We must separate the risk of politicians acting childishly (extremely high) from the risk of the United States actually defaulting on its debt (extremely low).

Ironically, the political gridlock that caused the downgrade may actually help to reduce our debt. David Leonhardt remarked in the New York Times that if Congress remains deadlocked and cannot agree on a new tax policy, then the Bush tax cuts will automatically expire across all tax brackets on January 1, 2013. According to Bloomberg, this "amounts to a $3.6 trillion tax increase over 10 years," roughly four times more than the debt deal negotiated between Democrats and Republicans. In other words, the political gridlock that Standard & Poor’s considers a major factor in our downgrade might be a major factor in righting our ship.

Fortunately, not everyone believes in this "Carmageddon" downgrade. Warren Buffett says we should have a "quadruple A" rating; Tim Geithner accused the S&P of "terrible judgment." Saturday’s New York Times led with a story saying "many analysts say it’s not so clear that it will deliver any immediate shock to financial markets or to consumers." This proved to be overly optimistic—the markets reacted negatively as they opened across the world on Monday. Not surprisingly, the VIX (known as the "fear index") jumped to its highest level in over a year. This is to be expected. After all, it’s the first downgrade on U.S. debt, ever.

We should remember that previous downgrades of other major economies have coincided with boosts in the stock market and bond rates after a short period. When Moody’s downgraded Japan in 1998, the Tokyo stock market climbed 25% in just 12 months. Ten year Canadian bonds jumped from 7.6% to 8.1% following Canada’s downgrade in 1993. I’m not suggesting that the recent downgrade is a good thing. What I am saying is that predictions are really hard, even for experts, so it should not surprise us if US debt rallies in the coming months as well. In the meantime, we’d do well to keep calm, avoid panic and focus our energies on job creation and sound economic policymaking.

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