The Emperor's New Clothes

When I was a kid, I read this beautiful story by Hans Christian Anderson about a foolish emperor. The story (called “The Emperor’s New Clothes”) is about an emperor who cares for nothing but his appearance and attire and hires two tailors who promise him the finest suit of clothes that is not visible to anyone who is unfit for his position or stupid. The emperor himself cannot see the clothes but pretends that he can, lest he appear unfit for his position. Wearing the “suit”, he comes out in a public procession and everyone keeps up the pretense praising the emperor for the fine suit. However, a child in the crowd cries out that the emperor is wearing nothing at all. The emperor is embarrassed, realizing that the child is correct, but continues with his procession.

Alas this is just a story. In this real world, the child is severely punished by the emperor. What else can explain the sudden resignation of Deven Sharma, the president of rating agency S & P? His historic decision to downgrade the AAA rating  of USA evoked strong responses from everyone. While some praised him for having the courage and conviction to take on the might of the US government, many others, including US policymakers and economists like Paul Krugman, criticized him publicly. The US government alleged that S &P overestimated future government debt by $ 2 tn. S & P countered by saying that the US government had become "less stable, less effective and less predictable". Global markets have remained volatile ever since.

However, the US government seems to have the ‘shoot the messenger’ attitude rather than focusing on the real issue here. It’s not as if one fine day S & P woke up from a deep slumber and downgraded USA. This had been coming in for a while. The following is an extract from an article on S&P’s website dated April 18, 2011.

“ On April, 18, 2011, Standard & Poor's Ratings Services affirmed its 'AAA' ratings on the United States of America(AAA/Negative/A-1+) but revised its outlook on the rating to negative. Our opinion of the recent and expected further deterioration in the U.S. fiscal profile, and of the ability and willingness of the U.S. to soon reverse this trend, was the driving factor in our decision to revise the outlook to negative.

What Our AAA/Negative/A-1+ Sovereign Credit Rating On The U.S. Means

A Standard & Poor's sovereign credit rating represents our opinion on both the ability and willingness of aparticular sovereign government to pay its market debt in full, on time, and according to the terms of the obligation.

For the U.S., our sovereign rating applies to the $9.0 trillion in publicly held debt issued by the U.S. Treasury outstanding as of Feb. 28, 2011.

According to Standard & Poor's ratings definitions, an obligor rated 'AAA' is one that, in our opinion, has extremely strong capacity to meet its financial commitments. 'AAA' is the highest issuer credit rating we assign. By comparison, when we rate an obligor 'AA', we are expressing our view that the obligor has very strong capacity to meet its financial commitments. Under our ratings definitions, the creditworthiness of a 'AA' obligor differs from the highest-rated obligors only to a small degree. We may assign a plus-sign modifier ('AA+') to what we consider to be the strongest 'AA' obligors.

Our negative outlook on our rating on the U.S. sovereign signals that we believe there is a likelihood of at least one-in-three of a downward rating adjustment within two years. We currently expect that if we do lower the rating, it would be by no more than one notch to 'AA+', reflecting only a small degree of deterioration in our opinion of the U.S.'s creditworthiness.”

The real issue of discussion here is the massive US debt (expected to be close to 75% of GDP), the corresponding deficits and how difficult it would be to close it out. Debts, taken to stimulate the economy in the wake of the financial crisis, have almost doubled since 2007 (as a % of GDP). In the meanwhile, the government has neither been able to raise taxes nor been able to reduce expenditures; nor is there any ideological consensus between political parties on how to handle this situation.

Given this backdrop, S &P’s call, though questionable, cannot be drastically wrong. It could only be right or marginally wrong. The fact that US faces a severe financial challenge is  unquestionable.

Having borne the brunt of public anger and criticism in the sub prime crisis of 2008, the rating agency seems to have learnt its lessons. They do not want to be caught in the same situation as 2008 where they kept on giving high ratings to structured financial instruments only to see them crumble like a pack of cards later.

However, given what we have seen in Greece and Ireland in the recent past, there is no denying that there is a serious threat on the ability of nations to repay their sovereign debt; and the US should be no exception. So Uncle Sam, instead of shooting the messenger, you should focus on getting your house in order and figure a way out to get out of this financial mess.