The debt ceiling as a negotiating tactic

The efficiency of financial markets depends, at least in part, on a high level of transparency as to the credit quality of market participants; and credit rating agencies have an important role to play in that regard. At the moment I’m not sure the crop of credit rating agencies in the US are doing such a great job, specifically with regard to their assessments as to the credit quality of the US government. I feel like I’m sort of rooting against the home team, and that’s discomfiting; but the distinction between long-run and short-run considerations is critical to my thinking.

Consider the following thought exercise: Suppose you want to assess the credit quality of some company, and that company has announced a change in the composition of its board. The newcomers have taken issue with the company’s direction under the preceding board. Nothing has really changed yet, but the new board has announced that it’s considering implementing a policy whereby payments to the company’s current vendors and suppliers for work either contracted for or completed would be contingent on renegotiating contracts pertaining to future purchases. Clearly, any counterparty to this company would have to view it as being a less reliable trading partner under the new regime. I think you can probably see where I’m going with this…

Essentially, this is the posture of congressional Republicans who are threatening to block raising the debt ceiling. Unquestionably, the likelihood of default has become much higher with the reconfiguration of Congress after the midterm elections; and from where I sit, the increased plausibility of not raising the debt ceiling is real and should itself justify lowering the government’s credit rating. Why are credit rating agencies turning a blind eye to this very consequential change in circumstances?

The three major private credit rating agencies are Standard & Poor’s, Moody’s Investor Services, and Fitch Ratings. Moody’s and Fitch have bestowed their highest rating for US government bonds, while S&P rates the government at AA+ — one level down from their highest rating. The S&P AA+ designation was made in August of 2011 about four months after finding that the outlook had become “negative.”

The rationale for the downgrade was the following: ”… the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.” I don’t think it’s hyperbole to say that things have only gotten considerably worse relative to how things stood in 2011; but despite this deteriorating situation, none of these rating agencies have revised their ratings downward.

I’m wondering how these agencies have managed to ignore the Republican’s stated willingness to shut the government down as a means to achieve their fiscal objectives. Are these agencies waiting for an actual default to occur before adjusting their marks? If so, they’re doing all of us a disservice.

In the near term, downgrading the government’s credit rating would inevitably impose some immediate, higher costs for the government due to the higher interest rates that the market would demand; but if those higher costs cause the recalcitrant Republicans to reconsider their posture about the debt limit, we could be saved from much sharper interest rate increases as well as interruptions in the delivery of government services and support payments critical to the health and wellbeing of myriad households.

Whatever the disagreement between Republicans and Democrats may be in terms of the scope and scale of government expenditures, the willingness to shut down the government to achieve a desired objective more than irresponsible. It’s dangerous. Downgrading the credit rating of the government is, indeed, a drastic action; but in the face of the Republican’s willingness to play chicken with the debt ceiling, drastic actions is justified. Revising these various credit ratings in advance of the deadline to raise the debt ceiling could very well serve as the catalyst that saves us from far more dire outcomes.