Standard & Poor’s decision to downgrade America’s credit rating on Friday is momentous, but not, I suspect, for the reasons most people will cite. Many worried that interest rates would skyrocket and the markets sell off. This seems unlikely. The news won’t be a surprise and S&P was kind enough to dampen any impact by waiting until after the markets closed. There are very few investors who will be compelled to sell Treasury debt because it’s rated AA+ instead of AAA. Banks will not have to hold more capital against their Treasury holdings, regulators confirmed.
Another popular interpretation is that this is a wake-up call about our runaway debt. And indeed, S&P, in its decision, did cite the inadequacy of the debt deal agreed to by Congress and Barack Obama this past week:
[T}he fiscal consolidation plan that Congress and the Administration agreed to this week falls short of the amount that we believe is necessary to stabilize the general government debt burden by the middle of the decade.
Not surprisingly, Republicans seized on this as evidence that their strategy and views have been vindicated. The office of John Boehner, speaker of the House of Representatives, called it the “latest consequence of the out-of-control spending that has taken place in Washington for decades.”
But this interpretation is incomplete and misleading. As S&P’s announcement makes clear, the inadequacy of the deal was only one motivation. As important (to me, even more important) was the the reckless and divisive battle that preceded it:
The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy … [This] weakens the government’s ability to manage public finances …
This is crucial. Sovereigns aren’t like companies. They can’t go bankrupt, and creditors can’t seize their assets. Their creditworthiness depends as much on their willingness as their ability to pay. As Felix Salmon presciently noted before the announcement was made, it’s not our ability to pay that’s in doubt:
America’s ability to pay is neither here nor there: the problem is its willingness to pay. And there’s a serious constituency of powerful people in Congress who are perfectly willing and even eager to drive the US into default. The Tea Party is fully cognizant that it has been given a bazooka, and it’s just itching to pull the trigger. There’s no good reason to believe that won’t happen at some point.
Absent the toxic politics that infected the debate, we could have hammered out a deal that stabilized the debt without squeezing the economy too much in the near term. After all, Britain, Germany and even Italy seem able to do so, and we have in the past, too.
Investors largely tuned out the debt-ceiling debate until its final days out of a belief based on long experience that for all the antics and rhetoric of the Tea Party, the people who actually run Capitol Hill would never compromise the country’s credit worthiness. After all, it was Mr Boehner who reminded his freshmen colleagues that on the debt ceiling they’d have to act like “adults.”
That is not what happened. As the fight dragged on, the leadership moved closer to the Tea Party, not the other way around. And they seem happy with the results. Why else would Mitch McConnell have promised on August 1st to do exactly the same the next time the debt ceiling must be raised?
It is striking that the proponents of this strategy seem so oblivious to its impact. Our economy is lubricated by a sophisticated and stable credit market whose most vital component is also the most ephemeral: trust. As the crisis amply demonstrated, when trust erodes, the system freezes up. America has built a reputation for responsible and credible management of its finances over the centuries, and that reputation has been reduced to a political football, like a federal judgeship. Henceforth a foreign pension fund or central bank that once mindlessly ploughed his spare cash into Treasurys will have to think twice.
I never had much sympathy for the view that America’s economy was about to be eclipsed by China’s, and the main reason was our political institutions. Those checks, balances and laws provide an orderly means to change course in response to new challenges. China’s authoritarianism deprives the government of a feedback mechanism to tell it when it is meeting the needs and aspirations of its people. That makes its system intrinsically fragile.
Events of the last few weeks have forced me to reconsider. While the crash of a high-speed train highlighted many of China’s ongoing weaknesses, it also revealed, in the vigorous reporting and commentary that followed in print and online, a nascent apparatus of accountability. Conversely, America’s ostensible success in avoiding default in fact highlighted the growing dysfunction of its political institutions.If these events are portents of things to come, then the day when China displaces America as the world’s economic superpower is closer than I thought.
My more optimistic take is that the behavior of the markets and record disapproval ratings will force Congress to acknowledge the idiocy oftheir recent behavior and to adapt by substituting compromise for brinkmanship. Investors won't learn much new from S&P's announcement. Politicians should.