S&P AIMS TO WHIP CONGRESS INTO DEBT ACTION / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

S&P aims to whip Congress into debt action


By Brad DeLong

Published: April 19 2011 09:17

A spokesperson for Standard & Poor’s said on Monday that there was an “at least a one-in-three likelihood” that the rating agency “could lower” its long-term view on the US within two years. US equities quickly dropped by more than 1.5 per cent. Importantly, however, the dollar did not weaken and US Treasury interest rates did not rise. The reason for this unexpected pattern is simple: the markets think this move is important not because it signals something fundamental about the economy, but because of the political impact it will have in Washington.


So what is going on? A sovereign-debt downgrade is supposed to mean that a government’s finances have become shakier. This means that the likelihood of internal price inflation is higher, the future value of the nominal exchange rate is likely to be lower, and the possibility that creditors might not get their money back in the form and at the time they had contracted for had gone up.


But if this were true the value of the dollar should have fallen on Monday. At the same time nominal interest rates on US debt should also have risen. The value of equities, meanwhile, could have gone either way: macroeconomic chaos would diminish future profits, but stocks have always been and remain a hedge against inflation.


But that is not what happened here. Instead equities fell, the dollar rose, and nominal Treasury interest rates were unchanged. Given this, there are two things to bear in mind. First, you can go insane trying to over-interpret short-term market movements. Second, news comes in flavours: new news, old news, no news, and political news. And it is important to understand which type this was.


If S&P’s announcement were genuine “new news” to the market, we would have expected to see the standard pattern: equities down, dollar down, rates up.


Meanwhile, if the announcement were old news, we would have expected to see no price movements at all – the smart money would already have taken up their positions. Equally, if it were no news – if the market as a whole simply thought that S&P was irrelevant – then we would have expected to see no price movements at all. But this did not happen: we did see price movements, both in equities, and in the dollar.


Instead what we saw just what might have been expected to see if SP’s announcement is seen not as a piece of information produced by a financial analyst studying the situation, but instead as a move by a political actor trying to nudge a government toward its preferred policies.


Why? On Monday we saw confidence in the US, and the dollar as a safe haven, strengthen. This means that some who were previously leery of keeping their money in dollars, out of fear of future depreciation, are now less leery. This means some in the markets expect the S&P announcement to be successful as a political intervention. In short, the market thinks the S&P has just increased the chance of a long-term budget deal.

Monday’s pattern makes sense, therefore, if S&P’s announcement is seen as a political move. The market reaction sees Congress like a mule: it only moves when hit with a whip. Normally the whip to get a deficit-reduction deal is fear of the bond market’s producing a spike in interest rates and borrowing costs, but perhaps a fear of a ratings downgrade will do instead. Over the next few months we will see if the market is right.


The writer is professor of economics at the University of California, Berkeley

Copyright The Financial Times Limited 2011