The Benefits of a Downgrade

by John Berlau

The AAA rating played a key role in the mortgage bubble. And of late, it was playing a similarly dangerous role in a bubble in United States Treasury securities. Standard & Poor’s downgrade Friday night of U.S. debt from AAA to AA+ will help pop this bubble. This is an action that will have some costs, but also benefits, for the U.S. economy as a whole.

As we saw this week, what is good for the U.S. Treasury market is not necessarily good for U.S. markets in general. As a result of the Euro crisis and the resolution of the debt-ceiling dispute, foreign and domestic investors flooded into Treasuries in a supposed “flight to safety.” But this in turn precipitated a crash in the European market, which hit the U.S. markets, as well.

Conversely, an action such as this downgrade that hits the value of U.S. Treasuries — though, given that the Euro debt is the only real alternative, it won’t affect the value that much — may channel more investment into U.S. corporate debt. This could in turn help fund the business expansion and job creation the economy so desperately needs.

The AAA rating for U.S. and other government securities has given sovereign debt an advantage over private debt. Given the profligate behavior of many of the world’s governments, this advantage was often undeserved. A more honest reflection of the risks of investing in the debt of the U.S. and other governments means a more even playing field for entrepreneurs to raise capital. And that is never a bad thing.

To reduce so-called systemic risk of a downgrade, the U.S. government should move with all deliberate speed to get rid of the embedding of the AAA rating in regulations. U.S. regulations have given credit-rating agencies undue power by forcing banks and brokerage firms to carry securities with AAA ratings in regulatory capital requirements. One of the very few redeeming features of Dodd-Frank is that it encourages regulatory agencies to get rid of this embedding and put more reliance on old-fashioned due diligence of the investment a financial institution holds. U.S. regulators should move on this — yesterday!

— John Berlau is director of the Center for Investors and Entrepreneurs at the Competitive Enterprise Institute. He blogs at E-mail him at [email protected].

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