JONATHAN CHAIT AUGUST 10, 2011
[Guest post by Alex Klein.]
In the past week, the media and government have justifiably exhausted all possible ways of beating up on S&P. Although juicy, as I’ve argued before, these criticisms are coming a year too late. But for what it’s worth, here’s a list of other investments that S&P consider safer than American debt, and rate AAA:
Finland, The Isle of Man, The Islamic Development Bank, Johnson and Johnson, Microsoft, Exxon Mobil, ADP, and finally… The City Center Trust, a portfolio of 13 full-service hotels.
Even though S&P is getting savaged, the agency has a few unlikely defenders. Ezra Klein, Felix Salmon, and Jonathan Chait claim that, in downgrading US credit, S&P came to the right decision for the wrong reasons — that they stumbled upon an uncomfortable truth, and thus, we shouldn’t shoot the messenger. I disagree. The recent debt ceiling circus does not imply that the US could ever go into default for an extended period of time. The President is right. Warren Buffet is right. And most importantly, even after the downgrade, the market has staked hundreds of billions of dollars on the creditworthiness of the US government. Even on Monday, the Treasury was able to sell $32 billion worth of bonds at a record low interest-rate.
Amid macroeconomic turmoil, we’re seeing a flight to quality to US debt, historically and currently considered the safest and most boring place to invest. And it’s not just the three-year notes. Short-term loans are at bargain-basement interest rates of 0.03 percent, while one, five, ten, and even thirty-year treasury bonds are close to their lowest yields in seven months. If S&P’s downgrade reflected some kind of inconvenient truth about the riskiness of American debt, investors would have picked up on it a long time ago and fled for safer shores. But today, American debt is the safer shore. Even failure to raise the debt ceiling in the future doesn’t mean default. The treasury would cut back on government expenditures, but the bondholders would be fine. If S&P’s downgrade were legitimate, treasury bonds wouldn’t be seeing record high demand.
S&P, Chait/Salmon/Klein, and myself are actually all in agreement on one thing: A radical wing of the Republican party has created and exploited a hostage situation, one that has likely decreased market confidence in the ability of government to stimulate the economy. Here’s where I differ: I don’t think that this political analysis, albeit correct, implies that a hypothetical, extended American insolvency is even a remote possibility. The gridlock could result in some very ugly things, but a bond market default is not one of them.
In fact, a couple weeks ago, S&P itself was on my side. In the midst of the debt crisis, two weeks before the August 2nd deadline, I spoke to both S&P and Moody’s about the threat of default. Nikola Swann, chief S&P sovereign debt analyst, was testy. “It's basically the difficulty the US has, as a country, in making up its mind which is the driver here,” he told me. But he was still adamant that default was a remote possibility. “The likelihood of an actual of default — a nonpayment of market debt — is quite low. Remember that the rating is still AAA.” Back then, CDS spreads — insurance against American default — were implying a 6-in-10,000 chance of American default within the year. I floated Swann this number, and got this response: “That seems within the right ballpark.” S&P was telling me the chances of American default were 0.06% even during the debt crisis. After having heard this from the horse’s mouth, their post-deal downgrade struck me as even more absurd and opportunistic.
We’re all guilty here of using armchair political psychology to entertain hypotheticals: thankfully, when S&P did it, the bond market didn’t listen. But while Salmon, Klein, and Chait are right to point out the shreds of accuracy in S&P’s cobbled-together justification, the agency’s downgrade doesn’t reflect market reality, and doesn’t deserve an endorsement.