U.S. credit downgraded, Europe turmoil spreading

In case you missed the news out from the U.S. on late Friday, we have the shocking news about the U.S.'s credit rating being downgraded by S&P. The downgrade is controversial on many levels but the most unfortunate thing is that the downgrade was arrived at based on contentious & possibly flawed arithmetic. Clusterstock has a good write-up on this (here). To wit:

S&P has said their decision to downgrade the U.S. was based in part on the fact that the Budget Control Act, which will reduce projected deficits by more than $2 trillion over the next 10 years, fell short of their $4 trillion expectation for deficit reduction. Clearly, in that context, S&P considers a $2 trillion change to projected deficits to be very significant. Yet, although S&P's math error understated the deficit reduction in the Budget Control Act by $2 trillion, they found this same sum insignificant in this instance.

In fact, S&P’s $2 trillion mistake led to a very misleading picture of debt sustainability – the foundation for their initial judgment. This mistake undermined the economic justification for S&P’s credit rating decision. Yet after acknowledging their mistake, S&P simply removed a prominent discussion of the economic justification from their document.

In their initial, incorrect estimates, S&P projected that the debt as a share of GDP would rise rapidly through the middle of the decade, and they cited this as a primary reason for a downgrade.

In S&P’s corrected estimates – which lowered S&P's projection of future deficits by $2 trillion over 10 years and lowered S&P's estimate of debt as a share of GDP in 2021 by 8 percentage points - public debt is much more stable.

In a separate article, Clusterstock presented S&P's counter-argument on the downgrade (here). To wit:

S&P sovereign ratings head David Beers called it "a complete misrepresentation of what happened," in an interview on Fox News Sunday.

Talking to reporters on Saturday, Beers said “fiscal policy, like other government policy, is fundamentally a political process.”

The S&P downgrade statement affirmed that, noting political leaders' unwillingness to tackle tax and entitlement reforms.

"Our opinion is that elected officials remain wary of tackling the structural issues required to effectively address the rising U.S. public debt burden in a manner consistent with a 'AAA' rating and with 'AAA' rated sovereign peers," the report said.

In my opinion, S&P's 'error' has significantly diluted its message & compromised its decision to downgrade U.S.'s credit rating. However one could also argue that the counter-argument by the Treasury is nothing by news spin. If the other rating agencies- Moody & Fitch- were to follow in the footsteps of S&P, there would be no argument on this subject.

Notwithstanding the above issue, I believe we have entered in the preliminary stage of another round of financial crisis, not on the U.S. front but in Europe (here). The simmering turmoil in Europe, which afflicted peripheral small countries like Greece, Portugal & Ireland, is now moving to bigger countries like Italy & Spain. This pattern of contagion reminds me of how the U.S. sub-prime crisis morphed & progressively grew bigger until it became the Banking Crisis. We could be seeing a run-up to another September to remember.

Note: On the argument given by S&P with regards to the U.S. credit rating downgrade, I like to add that in my banking days, we looked at a borrower's ability to repay the loan and his/her willingness to repay the loan. There are borrowers who have the ability to repay but they choose not to repay. These are the real rascals and S&P argues that the U.S. government, which comprises the Executive branch & the Legislative branch, could fail to carry out the necessary fiscal policies or programs to meet its debt obligation on a timely basis. One good example is the recent Congressional fight to raise the Debt Ceiling. Another would be the 1995-1996 government shutdown also due to failure to pass the Budget. This line of thinking is well-argued by Paul Brodsky of QB Partners, as posted in the Big Picture (here).