What Does Moody's Mean If It Downgrades U.S. Debt?

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Friday, 14 September 2012 04:52

The NYT tells us that Moody's, the bond-rating agency that thought all those subprime mortgage backed securities were Aaa, is threatening to downgrade U.S. government debt if Congress doesn't meet its conditions. While the markets will probably ignore a downgrade from Moody's, just as they did the downgrade from Standard and Poor's last year (the price of U.S. Treasury bonds soared in the period immediately following the downgrade), it still would be worth asking what Moody's might mean by a downgrade.

In principle, Moody's is rating the risk of default. U.S. government debt is issued in dollars. The U.S. government prints dollars. Does Moody's believe that there is a growing probability that the United States will forget how to print dollars?

There is the issue that the Fed has control of the money supply and the Fed is distinct from the Treasury. As an anti-inflation policy, the Fed may limit its issuance of money even as interest rates on U.S. government debt soared. However in a crisis can anyone believe that the Fed would actually let the country default rather than buy up government debt?

Furthermore, at the end of the day the Fed is answerable to Congress. If a particular group of Fed governors and bank presidents was prepared to let the government default rather than buy up bonds, does anyone think Congress would just let this happen rather than replace the individuals or restructure the Fed altogether? That seems highly unlikely, but is this what Moody's now thinks could happen?

There is another story sometimes told that Moody's is simply indicating that it believes that there is an increased risk of future inflation if deficits are not brought under control. That is an interesting proposition, but it means that Moody's is making an inflation prediction, not assessing the risk of default.

 

If Moody's is simply warning of a risk that higher inflation will erode the value of U.S. government debt then it should extend this concern to all dollar denominated assets regardless of the issuer. The point would be that anyone holding a bond denominated in dollars risks seeing its value eroded due to higher inflation in the future, therefore all bonds denominated in dollars should be downgraded if U.S. government debt is downgraded.

There is also the issue that Moody's does not seem to have been in the business of issuing inflation warnings in prior years. It did not downgrade U.S. government debt in the 70s even as inflation rose into the double digits. In those years bond holders really did see a substantial erosion of the value of the debt due to inflation yet the alarm bells never went off at Moody's or Standard and Poor's.

So if a risk of inflation is now the basis for a downgrade, this is a new policy. It would be worth asking when the bond rating agencies changed their approach.

Of course there is another possibility. It could be that the bond rating agencies are simply being political. That they are trying to impose the budget policies that the Wall Street crowd, of which they are a part, would like to see. While no one would want to accuse the bond rating agencies of using their ratings to push a political agenda, there does not seem to a plausible alternative explanation. If there is, the NYT and other media outlets should supply it.