The S&P Downgrade: Is the Sky Falling?

Last Updated Aug 17, 2011 3:53 PM EDT

This post was updated on August 17, 2011.
After the S&P downgraded US long-term debt from AAA to AA+, many people pointed out that the ability of the US to pay off the debt is not in question. The downgrade is about the willingness to pay.

An analogy might help. A household facing a large debt burden might be able to pay off its debts if mom and dad get two jobs, the kids work after school and on weekends, and they sell the family heirlooms to the pawn shop. But if the household isn't willing to go to those extremes, it may decide the better option is to default (declare bankruptcy). Thus, default -- even for governments -- is often about the willingness rather than the ability to pay. For example, if the citizens of a country are willing to pay more in taxes, which means working harder for less, then it may be possible to pay the debt. But if too many extra hours of work are needed to raise the necessary taxes, the willingness may not be there -- the citizens would revolt under such a large tax burden -- and the government will default.

S&P is not worried about ability to pay, it is worried that the US political system does not have the necessary willingness. The worry is that we must cut spending and raise taxes to get the debt under control, both will be needed, but as the recent negotiations over the debt ceiling made clear, one party is unwilling to allow the necessary tax increases.

I believe this is a misreading of the circumstances. People won't revolt at the spending and tax changes that are needed to fix the problem (though they might object to a solution that involves inflating away the debt). We will find a way to do what is needed.

S&P may also be covering itself after doing so poorly prior to the financial meltdown. If S&P leaves the outlook at AAA and problems emerge down the road, its credibility will be even more shot than it is already and likely irreparable. Missing another big problem is essentially a death sentence. But if it downgrades the debt and nothing happens, it can claim its warnings and the downgrade were key factors in persuading people in both the public and private sectors to take steps to avoid disaster. It's Chicken Little claiming that his warnings stopped the sky from falling.

The point I'm making is that because of its damaged reputation, the risks S&P faces are not symmetric, and the lack of symmetry will bias the ratings it issues toward ensuring it doesn't miss another problem. The upshot is that false positives, as I believe this is, will be much more likely.