Saturday, August 6, 2011
Credit ratings agencies, the debt ceiling, and AA+
S&P pointed out that political volatility in the U.S. played a huge (if not the major) role in the downgrade. There is plenty of academic research that illustrates the importance of political volatility on capital investment - the more uncertain investors are of a state's political stability, the less likely they are to invest in it. This has generally been used to show why democracies have higher FDI flows than non-democracies, even though non-democracies can use coercion to be more business-friendly. The issue is investors may not be certain these regimes won't be toppled from internal strife. So, it's interesting to see the volatility point being raised about a democracy, particularly the (at least at one point in recent history) global economic leader and unipolar power, the United States. While the calculations appear to be off by a lot, and it seems S&P accounted for domestic politics a lot more than economics, it does show that there are real consequences to the game some far-right Republicans were willing to play over the debt ceiling.
It also points out that some view our democracy as dangerously volatile. This is a real problem moving forward, and might signal the biggest impact of the Tea Party: their lack of interest in any compromise and extremist political views make governing very difficult. Not to say I'm in favor of much of what the Democrats or moderate Republicans are selling, either, but those two groups were much more cognizant of the importance to not turn the debt ceiling debate into a game of brinksmanship it ultimately became. Republicans have to appeal to the far-right for their own political survival as well, so that means any policy debate, particularly one on economics, will be badly damaged by the bitter political divide in this country right now. It's not just that partisan bickering is bad and makes Congress look like a bunch of children - it's that it makes it much harder for us to implement sound policies at a time when we really need them, and now might affect foreign investment and our credit.
This is all true, of course, and something we need to be cognizant about. But...in addition, we should keep in mind who these credit agencies really are. For one, we were downgraded by S&P, but not the other two, Moody's and Fitch. The three of them are frequently referred to as the Big Three. So that might suggest the situation isn't quite as grim as we would think. More importantly...what's the track record of these agencies? Like...in the last economic crisis? Remember the subprime mortgage crisis of just a few years ago? Recall that the Big Three credit rating agencies were accused of enabling the crisis. These are the same people who told us that bundled mortgage securities (that were full of insanely high risk loans) were of the safest nature, even though it was fairly obvious they weren't.
As a result of these securities getting AAA ratings instead of much lower ones, investors bought them like hot cakes. The banks could not have played the horrible games they did with the economy without the high demand for these securities the massively inflated ratings created. The ratings agencies made lots of money from their evaluations of these securities, and were competing against each other in some ways over them, leading to a huge downgrade in the ratings standards. Not surprisingly, when the cat was finally out of the bag, the securities were downgraded and the economy was in ruins. So, there should be no doubt, the Big Three credit ratings agencies bear a lot of responsibility over the economy tanking as a result of the subprime mortgage crisis.
So, it bears to ask: how independent are these agencies? They are publicly traded, meaning they look for profits to their investors...does this alter their rating system? Should we view them as credible anymore, given the role they played just a few years ago? If the answers to these questions are not all positive (they're not), we should be wary about anything any of these agencies say (we should). As such, it seems odd that, despite the real issues I raised earlier, the S&P downgrade might have a big impact on the markets. I'd be suspicious of a thief managing a bank. In the same way, I'd be cautious about trusting a credit rating agency until they clearly demonstrated that they had fixed the problems from last time...even if there was some validity to their concerns.