S&P downgrade: Is it as bad as it sounds?

There's no way to know how the markets will react starting later today in Asia and tomorrow morning in the U.S. The early going is almost certain to be volatile, but perhaps a better indication will come in the last couple of hours of trading in NY - and then into Tuesday. At last check, S&P futures were off sharply and gold prices were up sharply, but that's to be expected. Among some of the commentary I've run across:

An immediate joke in the wake of the U.S. downgrade was that investors confronted by the lesser standing of U.S. Treasurys will flee to the safety of, well, U.S. Treasurys. There is possibly some truth in the quip. The move by Standard & Poor's to lower the long-term U.S. rating to AA+ is huge symbolically and could cause some in markets to flee risk. But the impact may be less than feared and might even produce some counter-intuitive results. This is partly because markets knew there was a good chance S&P would act, given its earlier warnings and the lackluster deficit-reduction deal that emerged from Washington after the debt-ceiling debacle. Another factor is that the one-notch downgrade was by just one ratings agency. Moody's and Fitch haven't so far followed S&P's move. This was the most benign outcome, if a downgrade was to happen. --David Reilly, WSJ

A key part of creating any "rating" on a security is evaluating the future, and the future cannot be evaluated precisely. And the truth is that there's no precise difference between an AAA rating and an AA+ rating (or a "Buy" or "Hold"), at least not one that can be proven with an honest assessment of future scenarios. So, ultimately, no matter who or what is involved, the rating process contains significant subjectivity. Ratings are opinions, not facts, and analysts are entitled to have opinions that are different than those held by "management." In other words, the S&P downgrade is playing out the same way pretty much any other big downgrade plays out, albeit at 100-times the scale. S&P blew it big-time by making that boneheaded $2 trillion mistake. In so doing, they gave the Treasury something to seize on while ridiculing them, one that will persuade a lot of people that S&P is just incompetent (or politically motivated). But the downgrade itself was perfectly justified, and the Treasury knows it. --Henry Blodget, Business Insider

The point here is not so much the $2 trillion, which makes very little difference to real US fiscal prospects; it's the fact that S&P stands revealed as not understanding basic analysis of budget estimates. I mean, I don't think I would have made that mistake; real budget experts, like the people at the Center on Budget and Policy Priorities, certainly wouldn't have. So what we just saw was amateur hour. And these people are pronouncing on US credit-worthiness? --NYT columnist Paul Krugman

S&P has downgraded the U.S. because it doesn't think we're on track to reduce the nation's long-term debt enough to satisfy S&P -- and we're not doing it in a way S&P prefers. "The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics," says S&P. It also blames what it considers to be weakened "effectiveness, stability, and predictability" of U.S. policy making and political institutions. Pardon me for asking, but who gave Standard & Poor's the authority to tell America how much debt it has to shed, and how? If we pay our bills, we're a good credit risk. If we don't, or aren't likely to, we're a bad credit risk. When, how, and by how much we bring down the long term debt -- or, more accurately, the ratio of debt to GDP -- is none of S&P's business. --Former Labor Secretary Robert Reich

Harvard University's Kenneth Rogoff astutely summarizes what might be happening:

The phrase "Great Recession" creates the impression that the economy is following the contours of a typical recession, only more severe - something like a really bad cold. That is why, throughout this downturn, forecasters and analysts who have tried to make analogies to past post-war US recessions have gotten it so wrong. Moreover, too many policymakers have relied on the belief that, at the end of the day, this is just a deep recession that can be subdued by a generous helping of conventional policy tools, whether fiscal policy or massive bailouts. But the real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation. A more accurate, if less reassuring, term for the ongoing crisis is the "Second Great Contraction."

[CUT]

In a conventional recession, the resumption of growth implies a reasonably brisk return to normalcy. The economy not only regains its lost ground, but, within a year, it typically catches up to its rising long-run trend. The aftermath of a typical deep financial crisis is something completely different. As [Carmen] Reinhart and I demonstrated, it typically takes an economy more than four years just to reach the same per capita income level that it had attained at its pre-crisis peak. So far, across a broad range of macroeconomic variables, including output, employment, debt, housing prices, and even equity, our quantitative benchmarks based on previous deep post-war financial crises have proved far more accurate than conventional recession logic.