Image: Jim Jubak

Jim Jubak

On Aug. 5, Standard & Poor's downgraded the credit rating of the United States to AA+ from AAA.

What's happened to the debt of the United States since then?

Treasurys have rallied and sent yields to historic lows. Last week the yield on a two-year Treasury was at 0.19%. The yield on a 10-year Treasury closed the week at 2.07%. That was slightly above the low set on Thursday of 1.97%. That was the lowest yield on the 10-year Treasury since 1950.

There's no way to escape a certain amount of schadenfreude. There is pleasure, admit it, in seeing the market thumb its nose at Standard & Poor's, the credit-rating company that got the mortgage-asset market so terribly wrong and helped create the global financial crisis by giving AAA ratings to so much paper that quickly demonstrated it didn't deserve an AAA rating by collapsing in price as the underlying mortgages went sour.

But I wouldn't let the grim pleasure at Standard & Poor's discomfiture become your primary emotional reaction to the rally in U.S. debt markets. That main emotion should be worry. This rally isn't a sign of health in the financial markets.

Reason to worry

First, the rally is a sign of just how much fear stalks global financial markets. It's not so much that investors love U.S. Treasurys but that they hate almost everything else. The money pouring into Treasurys is money that's not going into loans or capital investments that expand the global economy. Money is cheap if you look only at Treasury yields, but it's not readily available to all the creditworthy borrowers who need it. Just ask a prospective homebuyer in the U.S. who has been turned down for a mortgage. Or ask small-business owners in Japan or China who can't get financing at anything less than ruinous rates -- if they can get financing at all.

Second, the rally is a sign of just how unmoored the global financial system has become from past standards -- and how much work needs to be done to create a new system. It's one thing to laugh at Standard & Poor's ratings; it's something else entirely to come up with a new system that accurately reflects credit risk and creditworthiness. Without some system to create confidence among buyers and sellers, whole swaths of modern finance -- the derivatives market comes to mind -- become, at the least, less efficient and, at worst, frozen with indecision.

Standard & Poor's decision to downgrade, the credit rating of the United States -- and the way that the company handled that decision -- has shown how badly the current system is broken.

S&P's bad decision

When Standard & Poor's announced the downgrade, it got caught in a $2 trillion math error. Standard & Poor's initially overestimated the size of future U.S. deficits by $2 trillion, an error that Treasury officials rushed to publicize. Standard & Poor's admitted the error and lowered its projection for the ratio of government debt to gross domestic product for 2015 by 2 percentage points. In its initial downgrade the company had said that the ratio of U.S. debt to GDP would be 77% in 2015 and hit 78% in 2021. In truth, a shift from 77% to 75% doesn't seem significant if you buy into Standard & Poor's framework for making it decision.

But instead of leaving the defense of its decision there, the company then managed to call into question its entire rationale for its downgrade. The $2 trillion math error wasn't significant, Standard & Poor's said, because it had based its decision on its judgment of U.S. politics.

At that point, Congress had finally passed a package that combined an increase in the debt ceiling with $2.4 trillion in spending cuts over 10 years. But Standard & Poor's had calculated that it would take a $4 trillion package of cuts to demonstrate the U.S. government's commitment to long-term deficit reduction.

Realizing, I guess, that you can't argue that a $2 trillion math error is insignificant but a $2 trillion shortfall in the deficit reduction package is significant, Standard & Poor's said its downgrade was based not on the result of the battle in Congress but on what the company called the "extremely difficult" political discussions. The "debate this year has highlighted a degree of uncertainty over the political policymaking process which we think is incompatible with the AAA rating," Standard & Poor's analyst David Beers said in a conference call after the downgrade.

To me, that kind of thinking makes it look like Standard & Poor's is making it up as it goes along. The trends in the U.S. deficit numbers have been clear for a decade or more. The demographic facts of life that have been driving the explosion in medical and retirement costs aren't new. And while U.S. politics are nastier than ever, they don't represent some sudden turn from fiscal responsibility to fiscal recklessness.

Congress is suddenly unwilling to deal honestly with the U.S. deficit? Come on, Standard & Poor's.

Several critics of the downgrade decision have questioned Standard & Poor's sudden assertion of political expertise. They've certainly got a point. What expertise does this company have in political analysis?

To me, it's the shift in criteria that's more disturbing than the issue of credentials in political analysis for Standard & Poor's. If we're suddenly going to rate debt based on politics, won't we be looking at downgrades across the debt landscape? And if today's credit ratings expand to political analysis, what might they expand to include tomorrow?