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By Adam Ozimek

First I want to let S&P speak for themselves at some length, since their report lays out pretty clearly what it is they are worried about:

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. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options. In addition, 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.

Our opinion is that elected officials remain wary of tackling the structural issues required to effectively address the rising U.S. public debt burden in a manner consistent with a ‘AAA’ rating and with ‘AAA’ rated sovereign peers (see Sovereign Government Rating Methodology and Assumptions, June 30, 2011, especially Paragraphs 36-41). In our view, the difficulty in framing a consensus on fiscal policy weakens the government’s ability to manage public finances and diverts attention from the debate over how to achieve more balanced and dynamic economic growth in an era of fiscal stringency and private-sector deleveraging. A new political consensus might (or might not) emerge after the 2012 elections, but we believe that by then, the government debt burden will likely be higher, the needed medium-term fiscal adjustment potentially greater, and the inflection point on the U.S. population’s demographics and other age-related spending drivers closer at hand.

I don’t see a whole lot unreasonable in there. If you read S&P’s document Sovereign Government Rating Methodology and Assumptions, you can get a better look at the criteria they’re using. They use five main ratings factors:

  • Political score: Institutional effectiveness and political risk
  • Economic score: Economic structure and growth prospects
  • External Score: External liquidity and investment position
  • Fiscal score: Fiscal flexibility and fiscal performance, combined with debt burden
  • Monetary score: Monetary flexibility
Despite some indignant protestations, it’s hard to argue that the bottom 4 criteria are all that matters in assessing sovereign risk and that institutional effectiveness and political risk should be ignored when assessing sovereign risk. The S&P document goes on:

The political score assesses how a government’s institutions and policymaking affect a sovereign’s credit fundamentals by delivering sustainable public finances, promoting balanced economic growth, and responding to economic or political shocks… The primary factor for determining the political score is the effectiveness, stability, and predictability of the sovereign’s policymaking and political institutions.

Again, it’s hard to argue that the recent debt ceiling debate did not represent a decrease in the effectiveness, stability, and predictability of our policymaking. Aren’t those complaining most about S&P the same ones who were making these same criticisms of the Tea Party recently?

I want to disagree with Kevin Drum in particular who argues that we were never going to default on our debt. He says:

…even if a deal hadn’t been cut by August 2nd, we wouldn’t have defaulted on our debt. A bunch of government services would have been temporarily put on hold, but bondholders would have been completely unaffected. This is a really important point. It’s true that a temporary government shutdown would have been bad, but this has happened before. It’s ugly and stupid and unnecessary, but it’s politics. America’s debt, however, was never at any risk.

That’s Kevin’s perception. When it comes to markets and financial panics perception is everything and beliefs can be self-fulfilling. If market players agreed with Kevin, then he’d probably be right. I doubt that this is the case however. I side with Lawrence White:

”…if the federal government delays payment to anyone, then certainly in a common-sense sense, the government has defaulted on its obligations….I believe that the financial markets would not be copacetic [if bondholders were repaid but other creditors weren’t]….They would realize that the government was stiffing one set of claimants who are creditors, and the markets would worry that they might be next”

and Neil Buchanan:

“Foreign holders of Treasuries will understand that it is politically untenable to pay foreigners but not Americans…Can you imagine the firestorm if Americans were told that we cannot afford to pay Social Security recipients, because we have to pay foreign banks and governments first? …No matter how strong the argument that doing so is necessary to protect our credit rating, the bottom line is that the government would be favoring foreigners over Americans. Any foreign investor would know that this is not politically sustainable. They would have every reason to dump our bonds, or at least to require much higher rates of return.”

S&P, and I believe Fitch, also said they would have considered any payment prioritization in-and-of itself a “selective default”. I have a hard time believing that these are not risky outcomes.

Source: Delving Into the Downgrade