Politics & Policy

Down on the Downgrade?

John Berlau, Chris Chocola, Burton Folsom, and others talk about the S&P.

Is Standard & Poor’s downgrade fair? Whose fault it is? What can be done about it? National Review Online collects expert reaction.

John Berlau

The downgrade itself was fair. However, S&P’s timing and “partisan gridlock” rationale were questionable, as is its implicit advocacy of higher taxes. Nothing really changed for the worse since before the debt-ceiling fight, so S&P should not have waited to issue its new rating until after the issue was resolved. And it’s beyond laughable that after the U.S. was downgraded, many countries mired in the Eurozone crisis still are rated AAA.

S&P was actually a Johnny-come-lately at marking down U.S. debt, as two upstart credit-rating agencies, Egan-Jones Rating Co. and Weiss Ratings, had already done so. Unlike S&P, these firms made clear that their ratings were about long-term prospects, rather than the debt-ceiling fight, and emphasized spending over taxes.

When Egan-Jones, widely respected for its early downgrades of Bear Stearns and Lehman Brothers, changed its rating of U.S debt from AAA to AA+ on July 16, it explained: “The major factor driving credit quality is the relatively high level of debt and the difficulty in significantly cutting spending. We are taking a negative action not based on the delay in raising the debt ceiling but rather our concern about the high level of debt to GDP.”

Similarly, Weiss, which lowered its rating in April from C to C-, offered this explanation: “Our downgrade today is not contingent on the outcome of the debt-ceiling debate.”

In a truly free market for credit ratings, S&P’s fairness shouldn’t matter nearly as much. S&P and Moody’s would be to securities what Zagat is to restaurants, a rating influential because of its reputation but without undue power over a restaurant and its customers.

But that’s not how it works today with the government-protected cartel of credit-rating firms. As Kevin D. Williamson recently pointed out in “Downgrade Nation” in the pages of National Review, “The judgment of the Big Three agencies is taken as gospel by practically no serious investor; their ratings are largely of technical and legal concern.”

In 1975, the Securities and Exchange Commission (SEC) created the designation of “nationally recognized statistical rating organization” (NRSRO) for credit-rating firms. Regulatory agencies soon began requiring that banks, brokerage firms, pensions, and insurance companies carry mandated levels of securities rated AAA from an SEC-approved NRSRO.

From the 1990s until 2003, only the “Big Three” of S&P, Moody’s, and Fitch had been approved by the SEC to be NRSROs. And when these firms would rate a new security as AAA, financial firms would rush to buy it to satisfy their regulatory capital requirements. This is what helped created the bubble in AAA-rated mortgage-backed securities.

We are slowly moving away from this government-backed cartel. Prodded to increase competition by the bipartisan Credit Rating Agency Reform Act of 2006, there are now ten firms approved by the SEC to be NRSROs, including Egan-Jones. And over the weekend, financial regulators prudently waived the NRSRO requirement so that financial firms holding U.S Treasuries would not have to substitute “safer” bonds of AAA-rated countries such as France to satisfy their regulatory capital requirements.

But we still have to go further. The situation today with the credit ratings embedded in our financial regulatory system is analogous to one in which zoning authorities would give permits only to restaurants with top ratings in Zagat, whether or not customers wished to patronize them.

— John Berlau is director of the Center for Investors and Entrepreneurs at the Competitive Enterprise Institute. He blogs at OpenMarket.org. CEI research associate Matthew Melchiorre contributed to this article.

 Chris Chocola 

People can argue over the fairness or accuracy of the S&P downgrade until they’re blue in the face, but what no one disputes is the size and scope of a massive debt burden that really does threaten to destabilize America’s ability to make good on its obligations. The Club for Growth supported the “Cut, Cap, and Balance” legislation because it was the only plan proposed that actually balanced the budget and forced Congress to live within its means. The plan passed by Congress is typical — it puts the hard work off until later, something that Congress has done time and time again.

During the debt debate, I was often reminded of the old 1980s TV commercial for the Fram Oil Filter. The auto mechanic selling the filter would look into the camera and say, “You can pay me now, or you can pay me later,” and paying later is always more expensive and more painful. We’re at the same moment now: We can either do the hard work today of cutting spending and implementing pro-growth policies, putting America on a sustainable fiscal path, or we can put it off until it becomes even more expensive and more painful. Most folks don’t need Standard & Poor’s to explain that.

— Chris Chocola is president of the Club for Growth.


Burton Folsom

The S&P downgrade is fair. The Bush and Obama administrations both share blame for expanding entitlements, adding new spending programs, and doing little to suppress the debt. The Bush tax-rate cuts did encourage investment and expanded federal revenue — a plus for his presidency. And Bush did try to privatize part of Social Security. But as FDR accurately said almost 75 years ago, “Those [Social Security] taxes were never a problem of economics. They are politics all the way through.” And as long as politicians are allowed to seek votes by handing out federal cash, the national debt will sharply increase. S&P is sending a message to the U.S., and we can restore our credit with better fiscal policy.

Is that likely? Maybe. We have a precedent with the federal-spending restraints after World War I. From 1916 to 1920, because of that war, the U.S. national debt increased almost 20-fold, from $1.2 billion to $24.3 billion. During the1920s, however, Andrew Mellon, secretary of the Treasury under Presidents Harding and Coolidge, helped cut federal spending to the point that the U.S. had federal-budget surpluses every year of the 1920s. Therefore, the U.S. negotiated the war debt on terms of low interest rates. The U.S. was such a good credit risk that it survived a 20-fold jump in the national debt with steady low interest rates on the debt intact.

The European debt and the downgrades on that continent have been a wake-up call to the U.S. With fiscal restraint, possibly a balanced-budget amendment, and more politicians who care about their country more than about buying votes, the U.S. can restore its AAA rating by 2013.

— Burton Folsom blogs at BurtFolsom.com and is a professor of history at Hillsdale College. His latest book is New Deal or Raw Deal?

Nicole Gelinas

For more than three years after the U.S. government rescued Bear Stearns in March 2008, Washington used its own AAA rating to bring the credit of big financial firms up. Now, Washington’s failure to discipline itself — and to allow free markets to govern the financial world — is bringing the credit of the United States and of the financial firms that depend on it down.

S&P’s fiscal and political analyses, on the merits, are pedestrian. The company is saying what we already know. Debt has gone up — and is going up — and American politics can be, well, alarmingly robust. And S&P made a $2 trillion error in its original analysis, to boot — corrected only after the Treasury sent over a last-minute correction.

But, the Obama administration can’t really complain about S&P’s mediocrity. The White House has helped maintain S&P’s power by protecting the failed financial institutions that pay for ratings and thus pay S&P’s bills. (S&P rates the U.S. government for free, which may explain the downgrade.)

The S&P downgrade is bad enough. But the downgrades that have happened since last Friday night are significant, too. On Monday, S&P downgraded Fannie Mae, Freddie Mac, and the Army, Navy, and Air Force Exchange Services (which sell goods and services to military personnel) — plus 83 other entities that either depend on government guarantees or invest heavily in government securities.

“The downgrades of Fannie Mae and Freddie Mac reflect their direct reliance on the U.S. government,” S&P noted. The same is true for the rest of the bunch.

It’s these follow-on downgrades that are the most important signals to Big Finance and Big Politics alike. The conventional wisdom of Wall Street and Washington, for which S&P is a coat-holder, is starting to take notice of a crucial fact: The fiscal and political capacity of America’s government to protect Wall Street from free-market forces is finite.

Bondholders of large financial institutions such as Fannie, Freddie, Bank of America, Citigroup, and Goldman Sachs have got to think: Seven to ten years from now, with the U.S. government finally making choices on the entitlements issues that Standard & Poor’s is most worried about, is Washington really going to put such a priority on bailing out sophisticated investors of large financial institutions, as has happened since 2008?

When abstractions really become concrete — when it really comes down to it — will the U.S. choose Goldman bondholders again over American soldiers and retirees?


The government cannot protect everyone. And institutions and people are learning that they had better figure out where they rank in the pecking order. This explains why big banks’ stocks did so poorly on Monday, outpacing the broader market’s steep declines.

The same is true for Europe — and Germany, for one, should take heed. Since Greece began foundering more than a year ago, markets have expected that Germany would use its own credit to bring Greece up.

But now that Portugal, Italy, Ireland, and Spain have added themselves to the supplicant side, the risk has become more acute that instead of bringing the others up, credit-wise, Germany will allow the others to bring its own credit down, all in the service of protecting European banks’ creditors and stockholders from their own bad decisions.

It’s sad that it had to come to this. Because Western governments have not allowed free markets to discipline bad borrowers and bad lenders alike — by forcing them to accept losses for bad business decisions — free markets now must attack the sovereign credits of these Western governments.

Political leaders should understand: While governments won the first few battles against free-market discipline, starting back in 2008, markets will win the larger war, not governments. Hedge-fund guru George Soros proved this maxim nearly two decades ago, when he bet against the British pound’s artificial value until the British government finally, inevitably, caved in.

A nation that sacrifices essential free-market principles to obtain a little temporary growth will get neither.

— Nicole Gelinas is a contributing editor to the Manhattan Institute’s City Journal.

Samuel Gregg

There are many reasons to be cynical about ratings agencies. These are, after all, the same outfits that assured us collateralized-debt-obligation markets were doing fine just before they started imploding in 2007–2008. Their slowness in warning about the fading creditworthiness of corrupt entities such as Enron and government-sponsored enterprises such as Fannie Mae and Freddie Mac is a matter of record.

That said, Standard & Poor’s decision to downgrade America’s creditworthiness shouldn’t surprise us. It simply states in a pseudo-official kind of way what everyone — citizens, investors, politicians, and maybe even Paul Krugman — already knows: The failure of Washington’s neo-Keynesian policies combined with the long-term projections for entitlement-spending have lowered confidence in the U.S.’s ability to meet its fiscal obligations.

In terms of who’s responsible, the list is long. It embraces not only the Obama administration but fiscal progressives of all parties who have sat in the Congress and Oval Office over the past 70 years. Those economists who have long downplayed the significance of high debt in the name of demand-side policies are also culpable.

Blaming politicians and economists, however, is easy. A more uncomfortable reckoning would note that many Americans now expect high levels of government welfare spending. Soft despotism, to use a Tocquevillian phrase, is alive and well in America.

Another difficult-to-hear truth is that there is no simple way out of this mess. By “simple,” I don’t mean that we don’t know how to restore economic prosperity and reduce public debt. As Adam Smith wrote, “Little else is required to carry a state to the highest degree of affluence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice.” In our present circumstances, that translates into reforming our Byzantine tax system but above all dramatically diminishing our dysfunctional welfare state.

The hard part is persuading enough Americans that we cannot go on this way. And that requires major downward adjustments in people’s expectations about government’s role in the economy. For, as long as many Americans are reluctant to accept that entitlement spending must be reduced in real terms, few politicians will have the moral courage to do what must be done. Policy change matters. Attitudinal change, however, matters even more.

— Samuel Gregg is research director at the Acton Institute. He has authored several books including On Ordered Liberty, his prize-winning The Commercial Society, and Wilhelm Röpke’s Political Economy.

Aparna Mathur 

The widely anticipated downgrade of long-term U.S. debt finally happened on Friday night. S&P lowered the U.S. credit rating from AAA to AA+ amidst concerns about the government’s budget and the rising debt burden. This further fueled the decline in the Dow Jones and the NASDAQ as nervous investors realized that the debt deal did not go far enough toward resolving the U.S.’s economic uncertainties. The administration reacted as one might expect, blaming the ratings agencies rather than acknowledging that there was a real problem to be handled. Gene Sperling, head of the National Economic Council, slammed S&P for a $2 trillion mistake in its debt calculations.

Statistical errors aside, there is no getting away from the fact that the U.S. today has a debt-to-GDP ratio of approximately 100 percent, and it is projected to go much higher. Many countries with debt to GDP ratios of less than that have defaulted in the past. Future spending projections make it clear that debt and spending are out of control.

Also, it is not as if the debt number is a sole dark spot in an otherwise bright scenario. There is little to suggest that the U.S. has ever fully recovered from the economic recession that began in December 2007. GDP growth rates have been weak, averaging 0.4–1.3 percent, annualized, for the first two quarters of this year. There are still 6.8 million fewer nonfarm jobs than there were at the start of the recession. Many institutions still hold bad mortgage debt, and with the S&P/Case-Shiller home-price index declining again, the less said about the housing market the better. The outlook for the economy is decidedly weak.

Does this mean the United States is on the verge of default?

S&P has the reputation of being influenced by subjective economic and political conditions, rather than purely objective data. Also, its track record is not the best when it comes to predicting the likelihood of sovereign default. For example, it has been criticized for not downgrading Ireland’s debt rating until 2009 — long after the financial problems had become obvious. It is quite possible that S&P’s calculations have no predictive ability relating to the chance of U.S. default. The upward movement in ten-year Treasury prices Monday morning seems to indicate little market concern for the specter of default. But the S&P rating serves another purpose. It is a clear expression of unease at the state of the United States economy, and on that count it is right on target.

Many analysts fear that the U.S. may be heading for a double-dip recession. The downgrade therefore fit perceptions about the country’s troubled economic scenario. Rather than attacking the rating agencies for doing their job, the best response would be for the administration to do its job by cutting long-term spending and providing a less-uncertain future for the markets’ jittery participants.     

— Aparna Mathur is a resident fellow at the American Enterprise Institute.

John D. Mueller

To ask “Is the S&P downgrade fair? Whose fault it is? What can be done about it?” is like posing those questions about a thermometer that reads 99 when the temperature in Washington, D.C., is actually 90 degrees in early August. The thermometer is inaccurate, possibly due to malfeasance on the part of the manufacturer. But it’s still August in Washington.

Who deserves blame for that? God? The thermometer’s manufacturer? Global warming? Or Thomas Jefferson and Alexander Hamilton, for having solved America’s first debt crisis by sitting our nation’s capital in a tropical swamp, to get the votes of Virginians that Hamilton needed to get Congress to pass his plan for the federal government’s assumption and payment of the debts of the feckless Continental Congress and colonial governments? (Which his strategy did, by the mid-1830s.)

Like all commercial rating agencies, Standard & Poor’s has the same hand-in-pocket relationships as members of the U.S. Congress have with the partisan factions they represent. S&P was negligent in certifying low-grade junk as high-grade before the 2008 crash. But that didn’t cause the crash. And the folks at S&P bootlegged their own clueless and partisan comments about taxes into the downgrade, while making huge careless mathematical errors. But as James Madison and Alexander Hamilton explained in the Federalist, this is the way a workable political system behaves, because it is peopled by human beings, not angels.

The main reason the stock market has been falling is not S&P’s downgrade or even the fecklessness of Congress. As I explained in a paper published in October 1997, “The tremendous rise of the stock market since 1980 is due primarily to the relative rise in the number of Baby Boomers saving for retirement. This has bid up stock prices to the benefit of their parents’ generation, which bought stocks while prices were relatively low.” But, “the same factors imply that the stock market’s total return will peak relative to the economy before the year 2000, and decline sharply thereafter.”

I wrote the paper to explain why it was fatuous to believe that privatizing Social Security could solve its long-term financial problems, because markets are affected by exactly the same demographic bust caused by Roe v. Wade. It’s also the main factor in the long-run budget deficits.

But both the stock market’s latest decline and Congress’s inability to balance the budget are related to a different problem: Congress having abandoned Hamilton’s first principle of American political economy: Don’t issue money to fund the federal deficit.

I predict that the next successful president will hire another Hamilton to restore the gold standard, and end the dollar’s role as the chief official reserve currency of the world by repaying outstanding dollar reserves.

If you think I’m crazy, I’ll simply remind you that I participated in several initiatives, including the tax reforms of 1981 and 1986, that were pronounced ridiculous, crazy, impossible — right up to the day they were signed into law. And lawmakers jostled to be in the Rose Garden and take home a pen that the president used to sign the bill.

— John D. Mueller is the Lehrman Institute Fellow in economics at the Ethics and Public Policy Center and president of the financial market forecasting firm LBMC LLC, both in Washington, D.C.

Veronique de Rugy

We can debate whether or not Standard & Poor’s should have downgraded the credit rating of the United States, but one thing is sure: The rating agency’s decision seems consistent with its July 14 warning on the matter. At the time, S&P laid out clear criteria for avoiding a downgrade: Agree to a credible plan to reduce the debt-to-GDP ratio within three months and guarantee this new-found fiscal discipline will actually stick.

What does it mean? Anyone who has looked at a Congressional Budget Office or Office of Management and Budget baseline understands that the debt problem in the United States will not go away as long as we don’t reform the major sources of the spending explosion — Social Security, Medicare, and Medicaid — which will blow apart any possibility of an equilibrium between revenue (no matter how high marginal rates get) and expenditures.

Unfortunately, the debt-limit deal failed to even fake a solution. The debt ceiling was raised. We got downgraded.

Who’s to blame? While S&P take notes of the Republicans’ unwillingness to raise revenue, it also explains that “the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability.” Basically, it would have been key to show signs of willingness to cut these autopilot programs. That didn’t happen, since many lawmakers in Congress (Democrats mainly, though not exclusively) refuse to talk about reductions in entitlement spending. It makes it hard to argue that Republicans are the only ones to blame for the downgrade.

Now, by maintaining a negative outlook on the U.S. credit rating, S&P is warning us that further downgrades are likely if lawmakers fail to adopt real reforms to reduce the debt-to-GDP ratio. Thankfully, we are not the first nation to struggle with a dangerous debt-to-GDP ratio, and we can learn from others’ mistakes and successes.

Recently, Harvard’s Alberto Alesina and Silvia Ardagna looked at 107 efforts to reduce debt in 21 OECD nations between 1970 and 2007. Their results suggest that spending cuts are a more effective way than tax hikes to reduce debt-to-GDP ratios. American Enterprise Institute economists Andrew Biggs, Kevin Hassett, and Matthew Jensen find similar results: The unsuccessful fiscal consolidations they studied consisted of 53 percent tax increases and 47 percent spending cuts, while successful fiscal consolidation consisted of 85 percent spending cuts.

In other words, historically, the more “balanced” approach (a mix of revenue increases and spending cuts) widely advocated these days in Washington leads to failure to reduce the debt-to-GDP ratio. The United States cannot afford to follow this pattern.

— Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.

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