S&P downgrade of long-term US debt divides experts

August 8, 2011 - 4:15 PM

WASHINGTON (AP) — Standard & Poor's decision to downgrade the credit rating of long-term U.S. debt has unleashed a flood of responses from critics and defenders.

Many critics said S&P had no business downgrading U.S. Treasurys, which remain the safest and most easily tradable investment of choice around the world. And in fact investors offered backing for that argument Monday, when they continued to pour money into U.S. Treasurys.

Supporters of S&P's move countered that Congress had shown itself incapable of making the tough decisions needed to reduce U.S. deficits over the long run. Over time, they say, the United States cannot borrow at the same pace without a credible plan to shrink its budget deficits.

Here is how each side lines up:

THE CRITICS:

Many analysts noted S&P's dismal record in rating securities before the 2008 financial crisis. The firm gave triple-A ratings to many securities cobbled together from high-risk subprime mortgage loans. When millions of homeowners couldn't repay those loans, the securities collapsed in value and triggered the 2008 financial crisis.

"We don't care what S&P thinks, about Treasuries or anything else," Ian Shepherdson, chief U.S. economist at High Frequency Economics, wrote in a note to clients. "And we are completely baffled that anyone else would take it remotely seriously, either. Its appalling record over the last few years ... speaks volumes."

The S&P didn't help itself by acknowledging that it made a $2 trillion error in its initial calculations of the future U.S. debt burden. The agency went ahead with its downgrade after acknowledging the mistake.

"You did have the tiny error of $2 trillion," said billionaire investor Wilbur Ross in an interview on CNBC. "It's almost as though they had made their mind up independently of the math."

And investors continued to buy Treasurys on Monday, seemingly defying S&P's analysis.

"With investors willing to hold trillions of dollars in long-term U.S. debt at interest rates well below 3 percent, the financial markets certainly do not seem to share S&P's concern," said Dean Baker, an economist at the Center for Economic and Policy Research, in an email.

Many also questioned the timing of the downgrade. Just a week ago, Republican leaders in Congress and President Barack Obama agreed to cuts that reduced future deficits by $2.1 trillion to $2.4 trillion over 10 years. That agreement was part of a deal to increase the government's borrowing limit. Without such a deal, the government risked defaulting on its debts.

Standard & Poor's said the political wrangling that preceded the deal showed that the U.S. political system has become "less stable, less effective, and less predictable."

But democracy is inherently messy, several critics said, and the process shouldn't be a reason for the downgrade.

"It really does feel that what they downgraded was democracy, rather than anything else," Ross said.

THE DEFENDERS:

S&P's supporters argued that the credit rating agency was correct to take the political process into account in its assessment of Treasury debt.

Neel Kashkari, a managing director at PIMCO, said the recent budget deal made none of the hard choices that will be needed to bring the government's budget closer to balance. Kashkari is the former manager of the government's $700 billion bank bailout fund.

"Until Republicans and Democrats show an ounce of backbone and do what's in the interest of the American people, rather than what's in their own immediate political interest, I can't argue with S&P's conclusion," he said in an interview on CNBC.

Ethan Harris, an economist at Bank of America Merrill Lynch, agreed with S&P's consideration of the political dynamic in Washington.

"A sensible process is where everything is on the table, most of the negotiation is done in private and each side gives a little," he wrote in a note Monday. "Instead, there was a game of brinkmanship, including a threatened shutdown and/or default."

Other economists argued that the S&P's decision reflects a fundamental reality: The U.S. debt is huge and growing. Even the deal reached to raise the borrowing limit only slows its growth, rather than cutting it.

"S&P simply took into account the 800-pound fiscal gorilla in the room that many market participants have been studiously trying to ignore for many years," said Joshua Shapiro, chief U.S. economist at MFR Inc., in a note to clients. The fact that the firm may have made mistakes in the past "doesn't change this basic fact," he said.

Kenneth Rogoff, an economist at Harvard University, said that while the markets might ignore the downgrade now, S&P's move could have an effect in the future, particularly once the U.S. economy improves. An improving economy will push up demand for loans and could lead to higher rates.

"It will affect our interest rates, as well it should, maybe 5 to 10 years from now," Rogoff said in an interview on CNBC.