Downgrades ‘R Us

Feds Join California in the Credit Risk Club

To Californians, the Standard & Poor’s downgrade of America’s credit rating delivers a double sting. Like other Americans, we share the embarrassment of landing in the second rank of nations, behind the elite that still enjoy an AAA bond rating (and that all have universal health insurance to boot).

But we Californians carry an extra measure of shame. We can read the rebuke coded between the lines of S&P’s message:

America has lost its AAA rating because it has become too much like California.

That feeling doesn’t come from paranoia or hypersensitivity. It speaks with the voice of experience. California knows downgrades.

connectingca_template3Only a decade ago California looked like fiscal paradise. The tech boom was in full flower, and the tax revenues from Silicon Valley IPOs poured into the state treasury. The ratings agencies gave California top grades. They praised the state and its leaders for soundly managing state finances and for not using a temporary revenue windfall to commit to ongoing spending. Blessed with high bond ratings, California paid less-than-average interest on its debt.

Then the dot-com bubble burst. The hot money disappeared, and a huge hole opened in the state budget. California went from a budget crisis to a Gray Davis recall, then on to Schwarzenegger’s deficit borrowing, followed by permanent budget gridlock. The downgrades came, one after the other, until California landed at the bottom of the list of states with an A- rating. The lower the rating, the more Californians had to pay to bondholders in interest, adding to the state’s budget woes.

These downgrades were good fodder for news stories and an occasion for handwringing. They made little sense, however, in terms of what debt ratings are supposed to convey: the actual risk that California would default on its debt.

Because that risk was, and remains, exceedingly small.

California general obligation debt enjoys three levels of protection. Every bond is the product of a law, passed by the legislature and ratified by the voters, which obligates the state, and gives it the authority, to raise the money needed to repay the bond. Each bond act also comes with a continuing appropriation to pay the principal and interest due to bondholders. The appropriation is good whether or not the legislature passes a budget. And under the state constitution, the appropriation stands second in line, behind only the public schools, as a claim on the state’s revenue.

Even after the hard economic blow delivered by the collapse of the housing bubble, the state still collects 10 times more revenue than needed to pay debt service on its general obligation bonds. California has never defaulted on its debt, and short of an economic cataclysm–one that would likely devastate every other state too–it never will.

“The [rating] agencies have known full well that government borrowers with investment grade ratings almost never default,” California Treasurer Bill Lockyer wrote in 2008. Corporations with AAA ratings have defaulted at a rate nine times higher than even lower-rated governments, the rating agencies’ own data show. “Yet,” Lockyer noted, the agencies “have held such borrowers to much higher standards than they’ve imposed on corporations.”

If California is not more likely to default than blue-chip corporations or other states, what do the agencies mean when they give California the lowest credit ratings?

Simply put, they do not like what passes for governing in California.

Reading the agencies’ ratings on California is like ploughing through a stack of the kind of tut-tutting op-eds written by interns on behalf of earnest but dull politicians:

  • From S&P: “Significant constitutional requirements reduce legislative discretion over general fund spending and require what we consider unusual levels of political consensus to affect tax increases or to pass budget laws.”
  • From Fitch Ratings: “Effective budgeting by the state is hampered by inflexibility imposed by voter initiatives.”
  • From Moody’s Investors Service: “Contentious political debates slow state reaction to budgetary stresses.”

This is the rating agencies’ way of saying that California’s unique and radical approach to governing departs from their political preferences.

In the agencies’ ideal world, governments would be free to amputate public services at will and place an intravenous line into the arm of every taxpayer, to be tapped at the first sign of budget trouble. Instead, California has chosen to be America’s house of budget bondage, where constitutional chains bind legislators to priorities set by long-dead voters and two-thirds vote rules empower anti-tax minorities. One price we Californians pay for such folly is a low debt rating–not because we threaten bondholders’ pockets but because our political antics jangle their nerves.

And so we are better prepared than our fellow citizens to understand what S&P’s downgrade of America means.

The downgrade is not about the economics of debt or any special rating agency expertise on the federal budget. As many economists have noted, the United States, unlike California or Greece, can always repay its debts by printing more dollars. And S&P did not go to the trouble of making an economic case for why U.S. debt should be now considered more risky. (The agency was so careless about numbers that it had to hastily correct a $2 trillion miscalculation in its analysis of federal finances.) The most decisive economic assessment of S&P’s action came from investors, who responded to the announcement by rushing to buy the very Treasuries S&P had just downgraded.

No, the S&P downgrade, as we Californians should understand better than anyone else, is a political statement: that Washington has become too much like California.

“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,” S&P explained in its federal downgrade. As in Sacramento, “Republicans in Congress continue to resist any measure that would raise revenues,” leading S&P to conclude that the Bush tax cuts for the wealthy will not expire as scheduled in 2012. As in California, conservatives in Congress push to impose on the nation the kind of budget straitjackets-spending caps, tax limits, balanced budget amendments, supermajority vote rules–that lock Sacramento in permanent crisis.

Worst of all, in S&P’s assessment, the Tea Party wing of Republicans took a step beyond anything ever seen in California. “The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy,” S&P wrote in its downgrade. In Sacramento, there is no legal path open to politicians who might want to stiff bondholders nor has there ever been any doubt about the state’s willingness to repay its debts. Washington can no longer make that claim.

You can question the rating agencies’ expertise to make such political judgments. They read the same news and peer into the same cloudy crystal balls we do. You can also question their moral authority to judge others. Having helped inflate the housing bubble and cause the subsequent financial crisis by promiscuously (and lucratively) handing out AAA ratings to toxic mortgage bonds, S&P can fairly be compared to the madam at the brothel who declares the neighborhood streetwalkers lacking in virtue.

But when S&P points to dangerous signs of a national government becoming more like California’s, there’s one thing you can’t say.

You can’t say S&P is wrong.

Mark Paul, formerly deputy treasurer of California, is co-author of California Crackup: How Reform Broke the Golden State and How We Can Fix It. He blogs at The California Fix.

*Photo courtesy of ollipitkanen.


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