Of Clouds and Silver Linings

I didn’t post anything about the manufactured debt-ceiling crisis because I thought the whole thing was political theater and that the best way to make our politicians stop this sort of nonsense would be to ignore them entirely.

But there is at least a bit of a silver lining: S&P has downgraded American sovereign debt to below AAA for the first time in, to all intents and purposes, forever.

Since the manifest culpability of the ratings agencies in the financial crisis obviously hasn’t done enough to dent their credibility, perhaps this ludicrous decision will be the straw that finally breaks the camel’s back.

Why ludicrous? Because the United States has the strongest credit in the world, as evidenced by the extraordinarily low rates of interest demanded for our debt and by the fact that when there is a financial crisis – even one caused by purported fears of an American default! – investors flee to the safety of . . . American government debt.

You say, apropos of the recent game of chicken between the GOP and the Democrats, that American political institutions have proven themselves to be significantly flawed, unable to deal with serious fiscal challenges. What, praytell, do you think of the vastly more significant game of chicken playing out across the pond between Germany and the more economically troubled members of the Euro zone (particularly Italy)? Why should Germany still be rated AAA when it doesn’t even borrow in its own currency, and faces the potential collapse of its entire banking system if an adequate solution to the Euro crisis is not found?

(Note that I don’t expect any such thing to happen. But I also don’t expect the United States ever to default on its debts. My point is that if I had to compare the likelihood of the collapse of the Euro versus the likelihood of an American default, why on earth – even in the wake of the recent absurdity – would I rate American default more likely?)

The practical consequences of the downgrade by a single agency are minimal, but should Moody’s follow suit we might see an additional silver lining: the collapse of the Basel II/III capital rules. These rules are organized around credit ratings: AAA-rated debt requires virtually no capital to hold. Since, as we learned in the financial crisis, AAA ratings can be manufactured, and since the ratings agencies have proven willing to let themselves be gamed in the manufacture of said ratings, a system like this creates an enormous incentive to pursue such games, and hide risk in the apparently risk-free portion of a bank’s portfolio (which is precisely how the major American banks nearly went under in 2008-2009). But if Treasuries do not get the most favorable capital treatment, then the whole system is obviously absurd. So, hopefully, purportedly risk-free instruments that are not backed by the full faith and credit of the United States government will, in the future, have a more substantial capital charge associated with them, which will reduce the incentive to hide risk in this fashion.

Finally, since nobody else is going to agree with me that the loss of our S&P AAA is a good thing because it discredits the AAA as such, this action by S&P is going to serve as a considerable constraint on future legislative action to increase the deficit (whether by extending tax cuts or enacting new spending programs), for fear that such action would lead to further downgrades. As such, since we are plainly headed towards a double-dip recession, we’re about to get a test of the monetary-policy-_uber-alles_ theories that have been floating around. Because a renewed recession will unquestionably balloon the deficit further. And if the central bank doesn’t take action in the face of both a renewed recession and the prospect of a sovereign downgrade, I think we can safely say that, whatever Chairman Bernanke may have written in his academic work, he doesn’t actually believe he can engineer a nominal GDP recovery.