The S&P Downgrade: Is the Sky Falling?

Paul Krugman on the S&P downgrade:

S&P and the USA, by Paul Krugman: OK, so Standard and Poors has gone ahead with the threatened downgrade. It’s a strange situation.

On one hand, there is a case to be made that the madness of the right has made America a fundamentally unsound nation. And yes, it is the madness of the right: if not for the extremism of anti-tax Republicans, we would have no trouble reaching an agreement that would ensure long-run solvency.

On the other hand, it’s hard to think of anyone less qualified to pass judgment on America than the rating agencies. The people who rated subprime-backed securities are now declaring that they are the judges of fiscal policy? Really?

Just to make it perfect, it turns out that S&P got the math wrong by $2 trillion, and after much discussion conceded the point — then went ahead with the downgrade.

More than that, everything I’ve heard about S&P’s demands suggests that it’s talking nonsense about the US fiscal situation. … In short, S&P is just making stuff up — and after the mortgage debacle, they really don’t have that right.

So this is an outrage — not because America is A-OK, but because these people are in no position to pass judgment.

S&P may also be covering itself after doing so poorly prior to the financial meltdown. If S&P leaves the outlook at AAA and problems emerge down the road, it’s credibility will be even more shot than it is already and likely irreparable. Missing another big problem is essentially a death sentence. But if it downgrades the debt and nothing happens, it can claim its warnings and the downgrade were key factors in persuading people in both the public and private sectors to take steps to avoid disaster. It’s Chicken Little claiming that his warnings stopped the sky from falling.

The point I’m making is that because of its damaged reputation, the risks S&P faces are not symmetric, and the lack of symmetry will bias the ratings it issues toward ensuring it doesn’t miss another problem. The upshot is that false positives, as I believe this is, will be much more likely.

About Mark Thoma 243 Articles

Affiliation: University of Oregon

Mark Thoma is a member of the Economics Department at the University of Oregon. He joined the UO faculty in 1987 and served as head of the Economics Department for five years. His research examines the effects that changes in monetary policy have on inflation, output, unemployment, interest rates and other macroeconomic variables with a focus on asymmetries in the response of these variables to policy changes, and on changes in the relationship between policy and the economy over time. He has also conducted research in other areas such as the relationship between the political party in power, and macroeconomic outcomes and using macroeconomic tools to predict transportation flows. He received his doctorate from Washington State University.

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