Why, oh why, do we take the credit rating agencies so damn seriously? By “we,” I mostly mean government leaders who would rather be photographed wearing a pink G-string on the beach than endure a downgrade of their country’s debt.
A triple-A rating by the Big Three agencies—Standard & Poor’s, Moody’s and Fitch—is the global good-financial-housekeeping seal of approval. It means a country essentially has zero chance of defaulting on its debt, and that its premiers and finance ministers are crackerjack economic and financial stewards. That, in turn, translates into votes at home and international prestige and clout.
Just ask French president Nicolas Sarkozy, who faces re-election in the spring. He reportedly said he would be “dead” if France were to lose its top rating. Oops! In fact France did, in January, when S&P hammered euro zone countries with a mass downgrade. Having made a big deal about the golden value of a triple-A rating, Sarkozy has now made himself an easy target for opposition politicians who want his job. “J’accuse...”
It’s a wonder that anyone bestows so much power on the rating agencies, given their history of bad calls, arrogance and the potential for conflicts—the biggest being that they are paid by debt issuers. Those conflicts became embarrassingly apparent in 2007 and 2008. Remember the mountains of structured products—including mortgage-backed securities and collateralized debt obligations—that received the highest ratings? When the U.S. housing bubble burst, many of these securities turned to dust and the global financial system nearly collapsed. Four years later, many banks and economies are still paying for the sins of the rating shops.
But never mind; debt has to be rated. After the credit crunch, the agencies’ attention quickly turned to another burgeoning market: sovereign debt.
A rating agency’s job is to provide an “opinion on the general creditworthiness of an obligator” (that wording from S&P). Pretty simple, really. One implication is that soaring national debt loads are trouble. If debt keeps mounting, there obviously is some chance the country will become insolvent, meaning debt payments would go missing, triggering either a default or a bailout to prevent one (Greece, Ireland and Portugal all asked for bailouts in 2010 and 2011).
The problem is that not all debt loads are created equal. Take Japan. During the “lost decade” of the 1990s, the government started running large deficits. It’s still running them, and Japan is now saddled with a debt-to-GDP ratio of more than 200%, about double that of some of the hardest-hit euro zone countries. Yet despite downgrades by the rating agencies, Japanese bonds are still considered among the safest debt instruments anywhere.
How can this be? Japan’s debt has a lot of support. The country has an international current-account surplus and cash-rich households. The threat of deflation means that yields on its 10-year bonds, at 1% or less, are still attractive. Plus Japan, unlike the euro zone countries, can raise or lower its own interest rates and print money. It’s almost impossible for a country with its own currency to go bust. To suggest that every country with a high debt load is also a high default risk is ridiculous.
On the other hand, a relatively modest debt load may not help all that much in a credit crisis. Look what happened to Spain and Ireland, which have debt-to-GDP ratios less than half that of Japan.
The bigger problem is the government leaders who worship at the altar of the rating agencies, under the apparent assumption that the faceless gnomes at S&P and their rivals (Quick: Name a credit agency CEO) can make or break economies. They can, perversely, by threatening downgrades unless governments pile austerity upon austerity.
Many politicians then do exactly that. They hike taxes, sack civil servants by the trainload, and slash spending on health, education and infrastructure. The economy then duly stays mired in recession and deficits remain intact, so the agencies demand more medieval torture in the form of ramped-up austerity. The teachings of Keynes are apparently absent from their bookshelves.
Poor Mario Monti. The man who replaced bunga-bunga boy Silvio Berlusconi as Italy’s prime minister in November got whacked by a double S&P sovereign downgrade in January, in spite of a credible economic austerity and reform program that was praised by Germany, the euro zone’s paymaster. Shouldn’t S&P, at worst, have kept Italy’s credit rating intact as a reward for good behaviour?
Here’s a suggestion to leaders who are slaves to the rating agencies: Treat them like investors treat them—that is, pretty much ignore them. When the United States lost its triple-A status last year, Treasuries gained value. Ditto Italian bonds when Italy was downgraded this year. Every market needs a good lagging indicator to confirm that the worst is over.