The Constitutional Issue of Standard & Poor's U.S. Downgrade

Standard & Poor’s U.S. Downgrade Response on 8-6-2012

It has been one year since Standard & Poor's has downgraded U.S. sovereign bonds rating. On 9/1/2011, the writer of this article sent the first email to Standard & Poor's and notified them about the response, and the writer had been sending emails and letters to Standard & Poor's since then. Because it was an August 5, 2011 Downgrade, any data providing should be on or before August 5, 2011. Unfortunately, Standard & Poor's has never made any reply. The Downgrade has no supported data and political risks mean political views. Therefore Standard & Poor's has downgraded U.S. based on its political views. The fact is that the so-called political risks were based on one bill. It is a One-Bill-Political-Views U.S. Downgrade.

Before the Downgrade, the writer has never read any sovereign bonds rating document. The writer didn't know how to call document provided by Standard & Poor's regarding the Downgrade. Without naming the document, the writer found it confusing to the reader. From now on, the writer calls it the Downgrade Report.

The writer heard that some people used Undue Influence to describe certain political groups' behaviors. The writer is not saying that those behaviors do or do not induce Undue Influence. When the writer used the term in the Standard & Poor's U.S. Downgrade Response on 8-26-2011, the writer referred to the legal meaning of the term, not necessary the literal meaning of the words. Undue Influence comes from the law of contracts. It is somewhat similar to duress. Duress differs from Undue Influence in that a person yields his or her assent because of fear. The writer believes that the step down of the former Italian Prime Minister is a good example for illustrating Undue Influence. The former Italian Prime Minister was Italy's longest-serving post-war prime minister, 17-year political career which was marred by sex scandals, corruption allegations. No one would believe that he would ever step down. Italy had $2.6 trillion public debt. The financial crisis hit Europe. Credit rating agencies downgraded many European countries included Italy. The Italian government bond yield reached 7% which was viewed as unsustainable to most countries, and the borrowing rate was still heading up at that time. The former Italian Prime Minister stepped down after the Italian Parliament approved austerity measures sought by the European Union. A senior member of his party said he had not been constitutionally required to resign as prime minister. A new Italian Prime Minister with strong background in finance was appointed, and the rate did stabilize at that time. The writer believes that Italian government bond interest rate did play a role in the changing of the Prime Minister. The purpose of bond's credit rating is to reflect the probability of going into default. That means the bond's credit rating is an indicator of its risk, so the rating has a direct, measurable influence on the bond's interest rate. The ability of assessing the credit rating gives the credit rating agencies enormous real power, not soft power. Italy successfully calmed the market at that time by appointing a new Prime Minister. The writer believes that Undue Influence did present in the process of the changing Prime Minister.

The writer never purchased any bond and the writer gets the information of buying treasury securities from the web site http://www.treasurydirect.gov. U.S. Government put treasury securities on auction. It appears that investor places bid specify the yield to maturity (YTM) of the bond that is acceptable. YTM is the approximately rate of interest you will earn on your investment if you buy the bond and hold it to maturity. Since the coupon interest rate is the same, if you accept a lower YTM, you will pay a higher price than the par value (face value of the bond) and vice versa. Currently U.S. has approximately 16 trillion dollar of national debt. The writer tries to make the U.S. public debt discussion simpler. Let's suppose currently U.S. has no debt and U.S. has raised 16 trillion dollar by selling 10 year treasury bonds to finance all the programs. If the interest rate is 7%, the bonds coupon payments will be $1.12 trillion dollar per year. In year 10, the cost will be coupon payments of $1.12 trillion dollar plus the maturity value of $16 trillion dollar. Before year 10, U.S. will have to issue bonds again to prepare for the maturity value of the $16 trillion dollar. Even the largest economy will find it tough to deal with the $1.12 trillion dollar interest payments per year. How many programs need to be cut if the interest cost is $1.12 trillion dollar? One can argue that the borrowing rate is more important than the debt level, although the debt level affects the borrowing rate. The ability of influencing the borrowing rate will give the credit rating agencies enormous real power over countries with high debt level and U.S will not be an exception.

Below are some of the paragraphs in Standard & Poor's 2011 August 5 U.S. Downgrade Report. The writer believes that those paragraphs show some of the Standard & Poor's political views. The writer highlights the parts which the writer believes that they are either related to key policies or an influence to the policies and some of issues are still contentious between the political parties. The writer's responses or comments are in blue color.

" The political brinksmanship of recent months highlights what we see as America's governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year's wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options. In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability." Standard & Poor's Downgrade Report paragraph 6.

" Compared with previous projections, our revised base case scenario now assumes that the 2001 and 2003 tax cuts, due to expire by the end of 2012, remain in place. We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act. Key macroeconomic assumptions in the base case scenario include trend real GDP growth of 3% and consumer price inflation near 2% annually over the decade." Standard & Poor's Downgrade Report paragraph 13.

" Our revised upside scenario--which, other things being equal, we view as consistent with the outlook on the 'AA+' long-term rating being revised to stable--retains these same macroeconomic assumptions. In addition, it incorporates $950 billion of new revenues on the assumption that the 2001 and 2003 tax cuts for high earners lapse from 2013 onwards, as the Administration is advocating. In this scenario, we project that the net general government debt would rise from an estimated 74% of GDP by the end of 2011 to 77% in 2015 and to 78% by 2021." Standard & Poor's Downgrade Report paragraph 14.

" Our revised downside scenario--which, other things being equal, we view as being consistent with a possible further downgrade to a 'AA' long-term rating--features less-favorable macroeconomic assumptions, as outlined below and also assumes that the second round of spending cuts (at least $1.2 trillion) that the act calls for does not occur. This scenario also assumes somewhat higher nominal interest rates for U.S. Treasuries. We still believe that the role of the U.S. dollar as the key reserve currency confers a government funding advantage, one that could change only slowly over time, and that Fed policy might lean toward continued loose monetary policy at a time of fiscal tightening. Nonetheless, it is possible that interest rates could rise if investors re-price relative risks. As a result, our alternate scenario factors in a 50 basis point (bp)-75 bp rise in 10-year bond yields relative to the base and upside cases from 2013 onwards. In this scenario, we project the net public debt burden would rise from 74% of GDP in 2011 to 90% in 2015 and to 101% by 2021." Standard & Poor's Downgrade Report paragraph 15.

In paragraph 6 and paragraph 13, the writer believes Standard & Poor's hits Republicans a little bit more than the Democrats. As stated in writer's 8-26-2011 Response, the writer is not sure if the Standard & Poor's said party members actually admitted that he or she used the threat of default as political bargaining chips. One can argue whatever they use or not use are just political tactics or maneuvers. Because of the enormous real power that Standard & Poor's possesses, the writer believes that it is inappropriate for Standard & Poor's to blame one particular political party. Is a majority of Democrats in Congress a criterion for Standard & Poor's AAA credit rating?

In paragraph 13, Standard & Poor's assumed the 2001 and 2003 tax cuts would remain in place after 2012 and it was the main assumption of the Downgrade. The writer believes it means that U.S. got a Downgrade in 2011 because U.S. doesn't let the tax cuts expire in the future beginning in 2013. A present Downgrade is linked to a policy in future which can be changed. Does Standard & Poor's want that policy change?

In paragraph 14, Standard & Poor's assumed the 2001 and 2003 tax cuts for high earners lapse from 2013 onwards and it incorporates $950 billion of new revenues. This is still a highly contentious political issue between the political parties. It means that U.S. can keep the downgraded rating if U.S. adopts this policy. In paragraph 15, it states that Standard & Poor's can further downgrade U.S. It means that the threat of further downgrade is real.

Federal Reserve monetary policies can affect U.S. economy. One of the tools is the Federal Fund rate. The bank can raise money from other banks at an interest rate equal to or higher than the Federal funds rate. Banks can take a loan from the Federal Reserve itself at the discount window (funds to keep up their required reserves). It is called the discount rate and it is usually higher than the federal funds rate. Federal funds rate can be viewed as the cost of making bank loan. The lower is the Federal Fund rate; the better will be for banks and businesses. Let's suppose Federal Reserve uses the threat of rate hike to coerce Congress to let tax 2001 and 2003 tax cuts for high earners lapse or not lapse. Is it legal? What if Standard & Poor's uses the Downgrade or the threat of further downgrading U.S. to coerce the Congress to let 2001 and 2003 tax cuts for high earners lapse from 2013 onwards? Is it legal? If Standard & Poor's does coerce the Congress, the writer believes that it is not legal although Standard & Poor's didn't take any public money. As stated in the beginning of this article, Standard & Poor's has downgraded U.S. based on its political views. Some people said that Standard & Poor's was just the messenger. What message? A message of its political views?

Citizen's right to vote is guaranteed under the Constitution. It is the right to be represented in the political process in a democratic society and each citizen has the same voice and equal representation in the political system. The writer believes that Standard & Poor's power is enable it to have a super voice in the political system. The writer believes the effects of Downgrade and the threat of further downgrade pose undue influence to the legislature and deny citizen's right to have equal representation in the political process and injure the Constitution of United States. The writer believes that Standard & Poor's U.S. Downgrade on August 5, 2011 is unconstitutional.

As stated in the beginning of this article, the so-called political risks were based on one bill, and Standard & Poor's U.S. Downgrade is a One-Bill-Political-Views U.S. Downgrade. Why didn't Standard & Poor's choose the bill for the Affordable Care Act? The writer is not saying that it is good law or bad law. Some politicians said that it was a big deal. Many different Congresses in the past had tried and failed. If the "political brinksmanship" was an indicator of the ability of passing bills in future and if it was as bad as Standard & Poor's portrayed, it didn't explain how possible that the bill for Affordable Care Act could passed in this particular Congress. People can look at the political process as it is inside a black box. What is important is that the bill comes out the black box passed. Standard & Poor's is not an expert in politics and it should not add any of its political views to the data. Regardless if there was "political brinksmanship" or not, the bill passed. If politicians' hugging each others was a Standard & Poor's criterion for its AAA credit rating, Standard & Poor's should say earlier. Before the Downgrade, U.S. wouldn't know the effect of the Downgrade and wouldn't know if other credit rating agencies would follow. It wasn't impossible to guess that the interest rate would go up and it wasn't impossible to think that those hugs were worth trillion dollars. For the well being of U.S., the politicians might have complied with such a Standard & Poor's demand.

Sources:

United States of America Long-Term Rating Lowered To 'AA+' Due To Political Risks, Rising Debt Burden; Outlook Negative

Standard & Poor’s U.S. Downgrade Response on 8-26-2011

Response on 08-06-2012