Monday, August 08, 2011

David Levey on the Ratings Downgrade

David Levey (Managing Director, Sovereign Ratings, Moody's Investors Service, 1985-2004) sent out the following statement yesterday to a number of publications, including the New York Times, Wall Street Journal, Financial Times, and Bloomberg. Since I haven't seen it published anywhere and he has granted permission to freely reproduce it, I'm posting it here (I thank Sam Bowles for forwarding the statement to me):
The recent S&P downgrade of the credit rating of US Treasury bonds is unwarranted for the following reasons: 
  1. The US dollar remains the dominant global currency and no viable competitor is on the horizon. The euro is heading into dangerous and uncharted waters while deep and difficult political, economic and financial reforms will be required before the renminbi could become fully convertible for capital flows and Chinese government bonds a safe reserve asset. 
  2. US Treasury bills and bonds, along with government-guaranteed bonds and highly-rated corporates, will for the foreseeable future remain the assets of choice for global investors seeking a "safe haven", due to the unparalleled institutional strength, depth and liquidity of the market. Although there are several advanced Aaa-rated OECD countries with lower debt ratios and better fiscal outlooks than the US, their markets are generally too small to play that role. Since ratings are intended to function as a market signal, it makes little sense to implicitly suggest to investors seeking "risk-free" reserve assets that they reallocate their portfolios toward these relatively illiquid markets. 
  3. Despite the above positive factors for the US, it is certainly the case that the US long-term debt outlook is deteriorating under the pressure of rising entitlement costs and an inefficient, distortionary tax system. Failure to reverse that trajectory would eventually make a downgrade unavoidable. But the recent discussions signal to me that -- finally -- public awareness of the fiscal crisis is growing and beginning to influence Washington. There is still a window of time -- perhaps as much as a decade -- within which structural reforms to spending programs and the tax system could reverse the negative debt trajectory.
  4. The bottom line is that the global role of the dollar and the central position of US bond markets make somewhat elevated debt ratios more compatible with a Aaa rating than is the case for other countries, another version of the US's "exorbitant privilege". But that extra leeway is finite and serious reforms to entitlement programs, particularly Medicare, must be made in a reasonable time horizon. If not, global investors will eventually conclude that our political system is incapable of making the needed changes and turn away from US assets, regardless of the institutional strengths of US markets.
This is consistent with Warren Buffet's view of the downgrade.

Even more interesting than Levey's statement was his preamble, in which he states that he has "no connection with Moody's nor any non-public knowledge of what its analysts think about the rating or what they intend to do" and then adds the following: 
As I see our current situation, the Federal Reserve, with its too-tight monetary stance since the summer of 2008, has allowed nominal GDP to fall far below trend, causing a collapse of output and employment -- as described by the monetary bloggers Scott Sumner, David Beckworth, Bill Woolsey, and David Glasner. Had the Fed acted properly (by, for example, setting a nominal GDP level target) the recession would have been much shallower and fiscal stimulus might not have been undertaken. As it was, the collapse of nominal GDP drove the "fiscal multiplier" to zero, leaving us with more debt and nothing to show for it.
Whether or not the Fed had the capacity and the commitment to have substantially mitigated the recession in the absence of fiscal policy, I'm not qualified to judge. But I remain skeptical that the rating agencies have the ability to evaluate credit risk with greater accuracy than the market itself would do in their absence. Were it not for the fact that capital requirements for financial institutions are set on the basis of their ratings, I doubt that there would be much of a market for their services, or that they would have such visibility and influence. And as far as sovereign debt is concerned, I'm not sure that they provide us with any useful information or guidance.


  1. But the exorbitant privilege has been partly the ability of the US to inflate its debt away. Political gridlock will increase the temptation to do that, but international investors are openly warning that they may not put up with it, making US govt debt likely to be less liquid and thus increasing the risk of holding on to it.

    S&P is merely stating the obvious that such risk has increased--there is gridlock in Washington, and the Chinese government is clearly angry about the devaluation of its dollar denominated assets through QE.

    On top of that the debt to GDP ratio has risen dramatically. How could US debt not have become riskier? It seems that we Americans can't face up to the fact that we are becoming an ordinary power.

  2. Lakshmi, thanks for your comment. My point was not that there has been no change in the risk of holding Treasuries, but rather that there's no new information in the downgrade. More generally, the rating agencies have typically lagged market signals of credit risk, or have been completely off the mark. My earlier post on this makes these points more explicitly.

  3. There is indeed new information about the risk of a default or the monetization of the debt to avoid technical default. And the whole world saw the evidence--the Republican Party, including all its Presidential hopefuls (save Huntsman), is willing to have the country default in order to make no new taxes of any kind are imposed.
    This is a downgrade that the US richly deserves.

  4. Lakshmi, the information to which you refer was available before the downgrade, so the downgrade itself is not informative. Given this, I'm not sure what purpose it serves. Frankly I don't care if they downgrade further, the rating is just meaningless given that it conveys no new information.