The stock market was in free fall Tuesday afternoon and investors were panicking. Many were seeing their savings dissolve as the Big Board flashed red. The market seemed to be reacting to Standard & Poor’s downgrading of the credit rating of the United States from AAA to AA+.
The lowered credit rating may have caused the record sell-off or it may have been the catalyst that kindled the smoldering fire of general insecurity, high unemployment in a sagging economy and the European debt situation (which is worse than ours). As investors flee from risk, they convert their investments to gold or — you guessed it — U.S. Treasury bonds, the very instruments that were downgraded. Despite S&P’s negative valuation, Treasuries are still considered the safest haven when everything else collapses.
When S&P made its announcement last Friday after the American markets closed, howls of protest screeched out of Washington. The U.S. Treasury pointed out a $2 trillion error in the credit-rating agency’s calculations. Democrats tried to discredit S&P for being unreliable. Republicans blamed President Obama either for making the wrong policy decisions or for not doing anything.
S&P said it had based the downgrade on two factors, one economic and one political. The financial reasoning was undermined by the $2 trillion error, and S&P revised its numbers accordingly. Using the CBO’s estimate of the GDP in 2021 combined with an extra trillion in debt, Paul Krugman calculates that based on 30-year bonds “an extra trillion in borrowing adds something like 0.07% of GDP in future debt service costs. Yes, that zero belongs there. The $4 trillion S&P said it needed to see clocks in at less than 0.3% of GDP.” Krugman concludes that the math doesn’t support S&P’s position.
The agency gave more weight to its assessment of the American political climate when it announced the credit downgrade. In its report, S&P cites the weakening of “the effectiveness, stability, and predictability of American policymaking and political institutions.” They are “pessimistic” about the ability of the two political parties to “bridge the gulf” that separates them to reduce the deficit by cutting back on entitlements and raising revenue. This reasoning is indisputable, but it’s not new. Why is it suddenly relevant now? We’ve known for some time that Congress is dysfunctional.
Though the United States has never defaulted, S&P’s downgraded rating has placed the creditworthiness of the United States on a par with Italy’s and lower than that of most European countries.
Democrats are assailing S&P’s credibility, citing its failure to accurately assess the condition of companies like Lehman Bros. S&P affirmed the investment bank’s AAA rating three days before the company collapsed, precipitating a global panic. The financial crisis of 2008 was due in large part to S&P and the other agencies that bestowed a AAA rating on subprime-mortgage-backed securities. Those securities became the toxic assets that would have submerged even the largest banks, had they not been subsequently bailed out by the government (adding to the deficit). It should be noted that the credit-rating agencies are paid by the entities they grade. Does that reek of conflict of interest? A favorable rating redounds to the profit of both parties.
The “Tea Party Downgrade,” said Sen. John Kerry (D-Mass.), is attributable to the intransigence of some Republicans and especially the Tea Party. The protracted debt-ceiling debacle, in which some members of Congress held the debt ceiling hostage to their intractable demands, coupled with their willingness to allow the United States to default made the unthinkable thinkable. A U.S. default suddenly became possible, and reaching consensus on fiscal policy much less likely.
It was primarily the unbridgeable gulf between the two parties that determined S&P’s action. The current ability of the United States to meet its obligations is not in question. The United States has a more favorable debt-to-GDP ratio than some AAA countries, like Great Britain and France.
But the focus on the deficit is misplaced. Our greatest problem by far is unemployment. Right now, corporations are being hounded for not creating jobs, but they aren’t spending because there is no demand. Yet most of the spending cuts will come from defense and other discretionary spending. The Defense Department is not only a huge employer, but it also provides jobs indirectly through its contracts with its suppliers. Trimming back the Defense Department , as well as most of the other cuts in the discretionary budget, will result in job losses as agencies are closed and staff is cut. People who are out of work don’t create demand. People who have lost their homes or are facing foreclosure don’t create demand. The insistence on spending cuts will only worsen the dismal jobs situation.
The other barometer of the economy, the stock market, rallied Tuesday morning, but wiped out its gains in the afternoon after the Fed announced its intention to hold interest rates “exceptionally low” for the next two years. But in the last hour of trading, the Dow Jones Industrial Average spiked, closing at 11,239.77, up 429.92 points, or nearly 4 percent. Stability may remain elusive for a while.