Standard and Poor’s downgrade of United States debt came after repeated warnings of such action: as policymakers argued over whether, and with which conditions attached, to raise the U.S. debt ceiling, the agency warned that a downgrade was possible.
While the consequences of the downgrade – the first time in over seventy years that U.S. debt will not have a risk-free, AAA rating – remain to be seen, the event offers a window into financial market-government relations. To what extent have the Great Recession and the European debt crisis led to a change in how markets evaluate sovereign borrowers? And what might these changes mean for governments’ capacity to act autonomously from financial markets?
First, the downgrade – perhaps more a comment from S&P’s on the current state of U.S. fiscal policymaking, rather than change in assessment of “willingness and ability to pay” – could be motivated by S&P’s desire to demonstrate its capacity to render difficult decisions. Certainly, the ratings agencies have been guilty of rating assets “risk free” – mortgage-backed securities, for instance – when they clearly were not. Demonstrating that every rated asset is open for reassessment is useful for the agencies, as they struggle to maintain relevance vis-à-vis regulators and investors. And, indeed, many other sovereigns have been subject to ratings downgrades; Spain’s rating is now AA, Ireland’s is BBB+, and Greece’s has fallen all the way to CC.
Second, the S&P action reminds us that a specific assumption long held by markets – that the bonds issued by governments of wealthy countries are free from default risk – may be changing. In the early 2000s, I argued that governments of wealthy democracies have a good deal of policymaking autonomy vis-à-vis capital markets. As long as governments do well in terms of macro-outcomes, such as low inflation and small fiscal deficits, markets were content to charge them relatively low interest rates. Investors paid little attention to the finer details of government policies – how they allocated spending across categories, or whether left or right-leaning governments were in office. This was in marked contrast to the broader pressures that markets placed on governments of developing countries. In such places, a concern with default risk led to a greater set of pressures from private investors.
But now, as it has become clear that membership in EMU does not lead necessarily to stable fiscal policies, and as some developed countries have deficit and debt levels that rival or exceed those of economies in Latin America, southeast Asia and sub-Saharan Africa, this easy shortcut – “developed country sovereign debt is safe” — may no longer apply. So some governments may find themselves more exposed to financial market pressures than in the past. And these governments could find that political events – including wrangling over a debt ceiling – provoke a greater market response than they once did. Whether this is a short-term pattern or a longer-term change remains to be seen.
Third, the U.S. may not be as exceptional as it once was. Yes, U.S. Treasuries are likely to remain a favored risk-free asset for investors (see below). But the special benefits that have accrued to the US as a result of the dollar’s global role and the Treasury note’s reputation may eventually come to an end. Indeed, with a debt to GDP ratio approaching 100 percent (see IMF data), the US has a level of indebtedness that exceeds Ireland’s and approaches Italy and Belgium’s. And – reflecting the fact that credit rationing historically has bitten much sooner for developing than for advanced economies – most emerging markets have debt to GDP ratios that are significantly lower than the U.S. Put differently, on the basis of just its fiscal statistics, the U.S. would have been under pressure to accept an IMF program long ago. Of course, there are many differences between the US and the typical IMF borrower; the broader point is that the US can’t necessarily expect its “special” status vis-à-vis markets to persist indefinitely.
Fourth, when we think about the effects of changes in investors’ assessments on governments’ capacity to borrow, and their more general ability to select policies, we must consider not only the interest rate premium, but also the maturity structure of government debt. It’s not just about what it may cost the U.S. government to borrow going forward. It’s also about how frequently the U.S. is required to “face the markets” – to roll over a portion of its outstanding debt. Governments with short debt maturity profiles face market-based pressures sooner and more frequently. The Economist noted last year that the average maturity of U.S. debt as 4.8 years, compared with 13.7 years in the UK, and 5.8 in Germany. Although political scientists have paid little attention to explaining the choices governments make regarding debt management (e.g. borrowing short at lower rates versus borrowing long at slightly higher rates), these may well have important consequences.
Returning to the immediate consequences of the downgrade, these may be less severe than some have suggested. Certainly, were the downgrade followed by an increase in the risk premium on U.S. government securities, the increase in interest rates could cascade through the economy – to state and municipal borrowers, as well as to firms and consumers.
But it’s important to put the downgrade in context: neither of the other two major ratings agencies has followed suit. And, more importantly, the markets may not follow Standard and Poor’s. We know from academic analyses that, while ratings agency actions sometimes move markets, they just as often follow markets: the agencies affirm what markets already thought. Witness, for instance, downgrades of southeast Asian banks and sovereigns after the 1997 crisis had unfolded.
In the U.S. case, the fact remains that Treasury securities are a favored “flight to safety” instrument for investors worldwide. When risk acceptance and global liquidity is high, investors look for high-risk, high-return assets – equity offerings in emerging or frontier markets, for instance. But when risk aversion is high, investors seek out safe havens. Treasury bonds have long been such a haven, both for domestic and foreign investors. Many holders of U.S. government securities are official entities (such as foreign central banks), while others are private investors.
What other options do these safety-seeking investors have? There’s the Swiss franc. And there’s gold. Both have experienced surges in prices that come from the search for safe investments. But where else might investors go? Certainly not into euro-denominated instruments, given the continuing crisis in the euro-zone. And probably not into renminbi-denominated instruments; for all of the speculation that the dollar’s “exorbitant privilege” is reaching its end, don’t expect it just yet.
Yes, the downgrade reminds us that the U.S. is not as exceptional as it might like to think. Perhaps a certain amount of financial market pressure would be useful in convincing policymakers to take seriously the longer-term questions of revenues, expenditures and debt. But, at the same time, a U.S. bond will still be (relatively) safe bet for investors and banks, both at home and abroad.