Editor’s note:  Standard & Poor’s downgrade to the US AAA
sovereign debt rating last Friday rocked markets. Although some investors have
said the rating cut has been partly discounted by investors, not all agree, and
some say it was a poor move. Bill Miller, chief investment officer, Legg Mason
Capital Management, says the downgrade was “precipitous, wrong and dangerous”.

At best, S&P showed a stunning ignorance and complete
disregard for the potential consequences of its actions on a fragile global
financial system. S&P chose to take this action after the worst week in US
equity markets since 2008, a week which not only saw stocks fall sharply, but
which also witnessed a dangerous escalation in the ongoing European debt crisis
with spreads widening to post-Euro records in systemically-important countries
such as Italy and Spain amid general political paralysis. The action was wholly
unnecessary and the timing could not have been worse. Compounding this, the
reasoning was poor, and consequences both short and long term for the global
financial system are completely unpredictable.  

It is totally unacceptable that privately-owned, for-profit
companies should have special, legally sanctioned status at the heart of
financial system to function as quasi-regulatory authorities whose opinions can
determine what securities financial institutions can hold, how much capital
they need, what the borrowing costs of every member of the system will be, all
based on secret deliberations without any accountability. The disastrously
flawed ratings of these agencies were at the heart of the financial crisis of
2008, and this unilateral action by S&P threatens to create mayhem yet
again in the system by creating uncertainty about the ability of the United States
to function in its unique and critical role in the global financial system.

Precipitous

There was no need for S&P to rush to judgment just days
after a bruising political battle had secured a bipartisan agreement to raise
the debt ceiling through the next election cycle and which initiated a process
to begin to cut spending and address the nation’s long term fiscal imbalances.
Neither Fitch nor Moody’s saw any need to do so, and Moody’s indicated that
contrary to S&P they saw the agreement as “a turning point in fiscal
policy” and declared that a downgrade would be “premature.” It is unclear what
benefit S&P saw in taking action when it did. It is perfectly clear they
either did not consider or didn’t care what the consequences of this hasty and
rash decision might be.

Wrong

In addition to being precipitous and ill timed, it is also
wrong. Warren Buffett as usual was right in his analysis, saying S&P was
wrong to downgrade and that the US
should be “quadruple A.” There are at least three reasons why S&P was wrong
to downgrade. First, it is incredible that S&P should think the US is less
creditworthy on a short or long term basis now than it was two weeks ago, when
an agreement to raise the debt ceiling had not been reached, both parties
appeared intransigent, and contingency plans were being considered including
prioritizing payments or even declaring the debt ceiling null and void under
Section 4 or the 14th Amendment.

In any event, an agreement was reached, passed by
comfortable majorities in both Houses, and it completely assures our ability to
fund the country’s operations through the next election. It also initiated a
process whose objective is to tackle the nation’s long standing fiscal
imbalances, something that did not exist prior to this agreement.

The contentious debate surrounding the debt ceiling
succeeded in doing something important that had not been done before. It
concentrated the public’s attention on our deep fiscal imbalances, and changed
the governing priorities to include measures to address the unsustainable
trajectory of government spending. There is now no serious debate about needing
to reform and curb entitlement spending. Both parties agree on this. The debate
is now centered on if any, or how much, revenue enhancement is needed. This is
progress and should have counted for, not against, the US’s AAA
rating, as Moody’s correctly opined.

Second, S&P apparently gave little or no weight, or
certainly insufficient weight, to the unique role the US plays in the
global economy. The US
is the largest, most productive economy in the world and the dollar remains the
global reserve currency. There simply is no alternative to the dollar as the
global reserve currency and as the instrument of global trade. The only other
possible alternative, the euro, is structurally flawed and is in what may turn
out to be an existential crisis. Issuing our own currency means we can always
settle our debts by printing more money if need be, so there is absolutely no
question of our ability to pay.

Our military spending exceeds 40 per cent of the global
total and is more than six times larger than China, the second largest spender.
This spending provides a global security blanket for other countries such as Canada and Australia, both rated AAA, and as such
represents a subsidy to other developed world economies.

Our status as the dominant global economy, sponsor of the
world’s reserve currency and as the only military superpower in the world makes
us sui generis economically. That alone should be worth a rating at least one
notch higher than anyone else, and probably accounts for Mr Buffett’s comment
about the US being “quadruple A.”

Third, the market says S&P is wrong. The US enjoys among
the lowest interest rates in its history coincident with the highest deficits
and a daunting long term fiscal outlook. Yet when investors in a highly
uncertain world are looking for safe assets, they invest in US Treasuries. We
are borrowing at lower long term rates than we did when we were running a
budget surplus and public officials began to wonder if we were headed for a
shortage of US Treasury securities to buy. During the financial crisis in 2008,
the worst financial crisis in history, investors flocked to Treasuries and the
US dollar because they sought the safest, most creditworthy assets in the
world. S&P seems not to have noticed this.

Dangerous

Perhaps most worrisome, S&P’s actions pose unpredictable
and dangerous risks to the global economy. Markets are complex adaptive systems
whose behavior emerges as a result of the actions of its participants, each of
whom is making local decisions but which aggregate to global consequences. Bubbles
and crashes are endemic to the system and are due in part to information
cascades and diversity breakdowns as everyone moves at once in the same
direction due to new information, fear, or greed.

As Warren Buffett has noted, fear is contagious and spreads
quickly; confidence is fragile and only returns gradually and over time.
S&P’s actions can only undermine an already weak level of confidence and
raise uncertainty. At this point S&P has managed to create what Keynes
called irreducible uncertainty: we just have no idea what the consequences may
be of S&P deciding that the risk-free assets issued by the country that
occupies a unique place in the global economy may not be risk free after all.

S&P said they believed their downgrade was already in
the markets as they had first flagged the potential for it to happen months
ago, and again in July raised the prospect of a downgrade. Former Treasury
Secretary Paulson said the same thing about Lehman brothers, pointing out he
repeatedly said taxpayer money would not be used to rescue Lehman’s creditors.
He believed that was in the market as well. He was wrong. Last week the
Treasury’s Borrowing Advisory Council, which consists of senior people at the
largest bond shops in the country, met and the minutes of the meeting indicated
none of them thought a downgrade was imminent. Late last week, online
prediction market Intrade listed the odds of a S&P downgrade by 2013 at
50 per cent. So much for being in the market.

One can only hope the market sees S&P’s precipitous and
wrong downgrade as idiosyncratic, absorbs it without too much turmoil, and
moves on, realizing the US at long last is about to tackle its fiscal
imbalances while remaining the best credit in the world.

The future, though, is obscured by clouds of uncertainty. No
one can predict the consequences of S&P’s action. Perhaps there will be
none. But complex systems can exhibit non-linear behaviors dramatically
different from what the change in circumstance might seem to warrant. No one could
have foreseen that a single Tunisian
street vendor’s suicide would topple that
government, the government of Egypt,
dramatically raise oil prices, ignite civil war in Libya
and unleash massive unrest in Syria.

The consequences, if any, of S&P’s precipitous, wrong,
and potentially dangerous decision will unfold in the next days and weeks. One
consequence we can all hope for is that Congress ends the oligopoly of
Nationally Recognized Statistical Ratings Agencies (NRSRO) before they
contribute to or ignite another financial crisis. Even S&P agrees, stating
to its credit that that regulatory reliance on ratings by NRSROs should end. By
all means let’s have S&P and Moody’s and Fitch opine all they want about
creditworthiness, but let’s have them do it in a free competitive market and
not via a legally-sanctioned oligopoly who effectively regulate without
oversight or consequence.