Moody's Threat to Downgrade U.S. Debt - Meaningful or Much To Do About Nothing?

In early September, Moody’s, one of the “Big Three” credit rating agencies in the United States, threatened to downgrade U.S. debt if no solution to the Fiscal Cliff crisis is found before year’s end. This comes a year after one of Moody’s competitors, Standard & Poor’s (S&P), downgraded U.S. creditworthiness after the protracted stalemate over raising the nation’s debt ceiling. Like S&P, Moody’s placed a greater emphasis for their decision upon the current political dysfunction endemic in Washington D.C. than upon the ever increasing national debt. In the statement accompanying their decision Moody’s said, “If those negotiations lead to specific policies that produce a stabilization and then downward trend in the ratio of federal debt to G.D.P. over the medium term, the rating will likely be affirmed and the outlook returned to stable. If those negotiations fail to produce such policies, however, Moody’s would expect to lower the rating.” The negotiations Moody’s is referencing regard the now infamous “Fiscal Cliff”, which is a set of automatic tax hikes and spending cuts due to begin on January 1^st unless some alternate deal is reached. The concern over a failure to come to an agreement is absolutely legitimate as virtually every economist whose opinion has been referenced on the matter has said essentially the same thing: the impact of such tax hikes and spending cuts upon our national economy would be catastrophic and would almost certainly result in another recession. Opinions on the necessity and timing of Moody’s statement, however, are mixed, as some view it as a politically motivated announcement, one designed to pressure the current president on the eve of a national election, while others applaud the willingness of the credit rating’s giant to pragmatically analyze and address a pressing issue.

Shortly after Moody’s decision was released a number of scathing articles criticizing the apparent associated political motivations of the announcement were written. The gist of these was as follows: of all the sovereign bonds in the world a United States Treasury bond has the lowest risk of default. There are several reasons why this is true, not least of which is that even with the ongoing stagnant economic recovery that has followed the worst economic recession in eighty years, the United States still possesses the largest and most powerful economy in the world. The United States has its own central bank, the Federal Reserve, which enables it to simply print money to pay back its bondholders if necessary. This gives it a distinct advantage over other countries, such as those currently struggling with sovereign debt issues of their own in Europe, who have to deal with the European Central Bank (ECB), an entity that is not domestically based and can be at times harsh in its dealings with eurozone member countries, as the current mess in Greece attests. Finally, the U.S. has an advantage that no other country can count upon as the dollar is the world’s primary currency, comprising more than 60% of all central bank reserves. This final attribute is one of the biggest reasons that most of the world’s transactions involve dollars. These factors, say the critics of Moody’s, make the credit rating agency’s decision meaningless in an economic context as, from the perspective of risk, there isn’t a financial asset that can be purchased anywhere that is preferred over U.S. Treasuries. This is a cogent point, as is the oft cited failures of the U.S. credit rating agency sector that were among the biggest contributing factors to the credit crisis of 2008. Companies who rated sub-prime mortgages AAA, mortgages that later turned out to be worthless, say the critics, are either incompetent, corrupt or both. Regardless of perspective, it is hard for anyone to refute the positive assertions regarding our sovereign bonds or the legitimate criticisms of the credit rating agencies.

Not everyone was critical of Moody’s decision, however, as support was issued from some surprising places. The liberal columnist Ezra Klein wrote an interesting piece in the Washington Post, that noted that, given the mind-numbing political gridlock that has been part and parcel of Washington D.C. throughout the current presidential administration, Moody’s is, if anything, being overly cautious and should have issued a credit watch on U.S. debt a long time ago. Mr. Klein argues quite persuasively that given the dysfunctional nature of the American political system it is only logical to take into account the inability to accomplish necessary goals, like resolving the Fiscal Cliff crisis, when calculating the price of our national debt. He closes his article with the following quote: “…my worry isn’t that they’re being overly pessimistic. It’s that they still don’t understand how bad things have gotten.” As a long time respected political insider, it is as hard to undercut Mr. Klein’s position as it is the opposition’s opinion. Perhaps the truth, as it so often does, lies somewhere in the middle; yes there are political motivations behind the statement, but rational logic is clearly present as well.

Whether ulterior motives are present or not, the remaining open question is this: what affect will such a credit downgrade have on domestic interest rate levels? S&P’s decision last year to downgrade U.S. debt for the first time in history was loudly lamented as a harbinger of doom as predictions of massive spikes in interest rates swirled about from nearly every quarter. A year later, the exact opposite has proven to be true as it has become difficult to keep track of how many times U.S. bonds and notes of various maturities set new historical lows for yields. The S&P decision had so little effect, that if Moody’s hadn’t announced it would follow in its competitor’s footsteps, most people would be hard pressed to remember it.

The summation is this: if this country goes over the Fiscal Cliff, our economy will find itself in dire circumstances. What rating is assigned to our debt as a result of the failure of our elected officials to avert this disaster will be irrelevant. Given recent reports out of Washington D.C. that a deal on the Fiscal Cliff is potentially in the offing, thankfully it appears that the politicians have realized this as well.