Credit Downgrade Consequences

The Nobel-winning economist Paul Krugman cites Mike Konczal for the proposition that the ratings agencies are really bad at rating government debt.  The context for this is that S&P is now claiming that it's ready to downgrade the US's debt if Congress passes a clean debt ceiling hike without a budget plan.  Moody's is taking the opposite tack, saying that the US should get rid of the debt ceiling (a proposition I agree with-- it's redundant and really serves no purpose but to create gridlock).

I actually agree with Konczal.  Really, it's hard not to.  The ratings agencies have been pretty terrible at their job, especially in recent years.  But Krugman extrapolates that to mean that it doesn't matter if the US gets downgraded.  And I have a harder time agreeing with that.  Krugman's argument isn't illogical-- he points us to Japan, which was downgraded by S&P and Moody's in 2002, but whose interest rates have hardly changed since.  This, Krugman argues, means ratings don't matter.

Now, Paul Krugman is way, way smarter and way, way more knowledgeable about these issues than I am.  But one thing I'd like to see him address is this.  First, Japanese bonds are held by different investors than US Treasuries.  As I understand it, Japanese bonds are held largely by Japanese citizens, who are big savers.  Americans, on the other hand, have long been big dissavers.  Our bonds are held by foreign governments (China especially), all kinds of investors seeking an investment as safe as cash, but yielding something rather than nothing, and institutional investors like pension funds and university endowments.  Second, and this is related, Japan was downgraded from AA to AA- by S&P, and from AA3 to A2 by Moody's.  The US, on the other hand, is rated AAA.  And that's significant.  Third, the US has a lot more outstanding debt than Japan does.  Japan's economy is about a third the size of the US's, and it has less outstanding debt as a result.

I'm not entirely positive of the mechanics of this rule, but I know that there are plenty of institutional investors that are only allowed to hold AAA-rated bonds.  And the safest of the AAA investments has long been US Treasuries.  Now, institutional investors alone aren't enough to generate the demand that has driven the massive quantity of Treasuries in the market down to the interest rates that Treasuries pay out today.  Investors have genuine faith in the creditworthiness of the US government.  But these investors dumping US Treasuries if the US got downgraded almost certainly WOULD drive up the US's borrowing costs.  And that would be a big deal, as our future budgets would have to pay significantly more toward servicing the debt.  And every dollar we spend servicing the debt is a dollar that isn't spent on education, health care, infrastructure, or any number of worthwhile uses.

And if that's the case, then we SHOULD be worried about a US debt default, contrary to what Krugman tells us.  Not because we should trust Moody's and S&P's opinions, but because of the cascade effect that those opinions could have on institutional investors.