Last Updated Aug 17, 2011 4:05 PM EDT
The overwrought reaction to Standard & Poor's downgrade of Treasury debt says less about the state of America's public finances than the state of mind of the American public. After a dreadful week in the financial markets, some commentators responded to the S&P downgrade by predicting an acceleration of the decline in stocks and a run on the dollar and Treasury bonds. But while stocks did sell off that Monday morning after the downgrade, there are good reasons to expect stability to be restored across the markets soon. Here's why:
S&P had assigned Treasury debt a negative outlook already, meaning that a 50-50 shot of a downgrade in a matter of months existed. Being shocked by the downgrade is like being shocked that a coin flip came up tails. Being shocked by the downgrade after the unwholesome debt ceiling negotiations and the meager spending cuts that came out of them (posts on the debt ceiling are here and here) is like being shocked that the flip of a coin with tails on both sides came up tails.
Much concern centers on the prospect of a domino effect as downgrades spread to insurance companies, municipalities and others whose own debt is backed by Treasuries, or else on the possibility of forced selling by investment funds that have to hold AAA paper. But the two other principal credit agencies, Moody's Investors Service and Fitch Ratings, reaffirmed the Treasury's AAA rating, so why would Treasury debt no longer broadly be considered AAA? Why is it that only S&P's rating matters?
An entry in a Wall Street Journal blog on the reaction to the downgrade points out that S&P assigned AAA ratings to mortgage securities that blew up in 2008, leading to the financial crisis that led to the recession that led to the high fiscal deficits that led to the S&P Treasury downgrade. A piece on Fortune's website notes that rating agencies generally have a poor record of identifying companies - Bear Stearns, WorldCom, Enron - that are about to default, so why take this move so seriously?
Click to the next page for more reasons that the downgrade matters less than many seem to think.