The question on the minds of most investors? What to make of the S&P downgrade of US debt?
There are many opinions and plenty of finger pointing. Step back. Take a deep breath. Follow along with me as we consider this from three different perspectives -- public policy, political, and market.
It is important to consider all three perspectives. Many observers are confusing these.
The US Policymaking Process-- Background
Policymaking in the US reflects the concept of pluralism. The process empowers many different groups who often can veto or block changes. The resulting decisions reflect a centrist policy. It has worked pretty well for over 200 years.
Market pundits do not like this. They want to see a clean and efficient solution -- and one that agrees with their own personal choices!
Any process that does not deliver this outcome is wrong. Let us apply this to the debt ceiling debate.
For starters, this should not have been on the agenda. Those in Congress who want to challenge the budget deficit should do so via the appropriations process, the taxation process, or the budget process. Doing it at a time when it can raise apparent questions about US creditworthiness was irresponsible.
Our political process allows people to behave in irresponsible ways. This was not the first time, nor will it be the last. Once the issue is in play, what should we expect?
- The Tea Party took one extreme, unwilling to vote for any increase in the debt limit without various impossible conditions.
- The liberal wing of the Democratic party took another extreme, unwilling to compromise on any program including cuts to favored spending programs.
- Moderates in both parties found a central ground and the debt extension was passed -- something that was completely predictable, as I repeatedly noted.
So the pundits, led by the dimwits at the S&P rating group, don't like this process. They think that it raises the possibility of a future default.
This is completely wrong. It demonstrates the lack of understanding by the S&P and by many pundits.
We have a political process that permits extreme viewpoints to have a voice.
If you don't like this, take it up with James Madison!
Let us be clear about the issues. Addressing the deficit means deciding things like the following:
- Entitlement spending
- The age of retirement and eligibility for Medicare
- Defense spending
- The level of taxation -- and who should pay
- How fast should we address the problem?
- Should we cut spending and related jobs with the economy on shaky ground?
And many more...
Who should make these decisions? Should it be done by our elected officials? Should it be something using the checks and balances from our Constitution?
No matter what you think about the questions, you should have an opinion about who should decide. Should it be the S&P rating committee? Who elected them?
The obvious policy implication is for the US to strip some official authority from the ratings agencies. They might be needed to help investors assess muni bonds, but they are not needed for US sovereign debt.
The value of these agencies was already in doubt after the blunders of Enron, Worldcom, and the AAA ratings accorded to various synthetic mortgage obligations. S&P seems to be on a suicide mission here -- a race to be as irrelevant as possible.
The S&P decision seems to reflect a verdict on our governmental process as well as the decision. It is a poorly-timed, tone deaf verdict, rendered despite their acknowledged error in calculating the long-term debt ratio.
Not the least of the embarrassments is the empowerment of the Chinese. While I do not expect the Chinese to sell US debt, the S&P has empowered them to recommend a cut in our defense budget!
This will be a huge sideshow. I am writing this before the morning talk shows where each party will blame the other. One of the biggest challenges for investors is to put aside the political commentary (despite our own strongly-held opinions) and think only about investments.
My early line is that the GOP will score by blaming Obama for presiding over a downgrade. I get commentary from friends of all persuasions. The liberals think that Obama sold out. If he had done what they wanted, we would have had a downgrade from all three agencies. My conservative friends can't believe that we don't have a balanced budget amendment.
Everyone wants to know what this will do to the market. My own estimate (check out what I predicted last week) is that the effect will be modest. Here are the reasons:
- No one buying US Treasuries depends on these ratings.
- There are three agencies. The other two are smarter than the S&P.
- Those who have covenants requiring a AAA rating often base it on two agencies. Those that do not have this provision will soon change the requirements.
- The biggest effect will come from psychology -- not from actual bond trading.
Monday trading will be complicated, since the Europe story will compete with the S&P downgrade.
A Final Thought
My final verdict is that this decision is more relevant for the S&P ratings group than for the US. It is a bad decision that will diminish respect for the agency. They took an extreme viewpoint. They indulged in politics. They poured gasoline on a fragile market.