Dear Everyone: Stock Market Problems Are Not Directly Due To S&P Downgrade

The Market

from the how-to-read-a-market dept

This morning we posted about the total silliness of people overreacting to S&P downgrading US debt from AAA to AA+. We received a couple of “you clueless idiot” type comments, with people pointing out that this “matters” because some institutions are required by law to hold certain percentages of certain grade investments. Of course, we did mention that in the post, so I’m going to take the blame and admit that I perhaps wasn’t clear enough and now will try again: my point is that it’s stupid that anyone has to react because one firm (with a rather poor track record) in “rating” debt suddenly makes a slight shift in its opinion, and that such a change in opinion represents no real change in how people view the market.

My point — which again, was perhaps not clear even though it was the final line of the post is this:

Markets are made based on the interaction of buyers and sellers. Not the (sometimes questionable) opinions of just a few firms.

Now, let’s prove it. All of the press reports today are saying that the stock market collapse is due to the S&P’s downgrade. And that may be true in a very indirect way (which we’ll get to), but there’s no way it’s a “direct” response. Here’s why: the S&P is saying that US debt is just ever so slightly riskier than it was before. If that’s true, then the market would likely be dumping treasuries and the interest rate would be going up. Instead, the exact opposite is happening. It looks like buyers are flooding into treasuries and the interest rate is dropping. Even economists, who generally take totally opposing opinions to one another, are trying to point this out. You’ve got Paul Krugman (self-described liberal) complaining about people missing this point… and you’ve also got libertarian Arnold Kling making the same point.

Now it could be that the downgrade indirectly triggered the stock sell-off, but it’s not because S&P is suddenly afraid of the US debt being less trustworthy. As Kling notes (and I suggested in my original post), the market already can determine how risky US debt is and has priced that into the market. One firm’s opinion should not change that. If anything the action in the market suggests that people are rejecting the S&P’s change, not freaking out because of it.

So then why is the stock market dropping? There could be a variety of indirect reasons. One might just be that some investors are generally overreacting to the news without understanding it at all, and thinking “bad news means sell.” Another theory is that this move jolted some people’s attention to larger problems elsewhere (mainly the fear of Italy running into trouble). But I actually tend to think that Krugman’s analysis here is actually the most reasonable. He argues that the reaction in the stock market means that US policy makers are about to overreact badly, because of the S&P downgrade, and do something stupid to harm the economy even more:

And maybe, maybe there is an S&P story ? but not the one you think. Arguably, that downgrade will bully policy makers into even more deflationary, contractionary policies than they would have undertaken otherwise, which has the perverse effect of making US debt more attractive, since the alternatives are worse.

But, why isn’t anyone talking about a very serious problem: the fact that we allow ratings agencies to have so much power in the first place? A ratings agency is just an opinion. What’s wrong with letting the market set the opinion of the likelihood of default on debt, rather than suddenly trusting firms that don’t have the greatest track record?

Filed Under: debt, markets, ratings agencies
Companies: s&p