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That Thomas Friedman remains employed by the NYT while OG eco-blogger Paul Krugman racks up hundreds of thousands of subscribers on Substack is one of the world’s great mysteries.
Of Friedman’s many hilariously bad takes over the years, this one is probably Alphaville’s favourite. In fact, its badness has matured like a fine wine over the three decades since its publication:
. . . Because we now live in an age when governments are basically broke, the only way for most countries to raise cash for development is either to enforce savings at home or attract investors from the world’s major bond markets. Moody’s is the credit rating agency that signals the electronic herd of global investors where to plunk down their money, by telling them which countries’ bonds are blue-chip and which are junk.
That makes Moody’s one powerful agency. In fact, you could almost say that we live again in a two-superpower world. There is the U.S. and there is Moody’s. The U.S. can destroy a country by leveling it with bombs; Moody’s can destroy a country by downgrading its bonds.
As you might have seen, Moody’s bombed the creditworthiness of its rival superpower on Friday night. Toby thankfully handled the immediately obvious question of whether this even matters. The short answer is no.
Treasury yields have ticked up since the credit rating downgrade, but only to the level of . . . last Wednesday. 😱 Maybe that changes once the US trading day gets underway, but it’s doubtful. This is largely because markets had already baked in some squelchiness on the US credit rating, according to JPMorgan’s analysts. Alphaville’s emphasis below:
Ratings downgrades have permanent implications for government bond valuations, as higher-rated countries trade at a smaller discount to matched-maturity OIS than lower-rated countries. Indeed, regressing matched-maturity Treasury/OIS spreads for a number of DM issuers on the ratings rank of each individual country, we estimate that each rating downgrade from all three agencies should cheapen 30-year Treasuries by about 15bp relative to matched-maturity OIS. Thus, this one-notch downgrade from Moody’s should narrow 30-year swap spreads by roughly 5bp, all else equal. However, we note that Treasuries already seem to display a higher risk premium than other similarly-rated DM sovereigns, indicating the cheapening could be more muted than these coefficients imply.
Most analysts have therefore instead focused on what Moody’s downgrade — stripping the US of its last remaining triple-A rating — says more broadly about Washington’s suboptimal fiscal trajectory. Disappointingly, US politicians have also reacted a bit more calmly than when S&P first downgraded the US back in 2011 (for now, at least).
A lot of the subsequent financial commentary has dwelled on the old trope of how weird it is to downgrade a country that issues debt in its own currency, which it can issue at will (conveniently forgetting that President Trump flirted with the possibility of selective defaults just a few months ago). Others have yelled about how credit rating agencies debased themselves in the years leading up to the financial crisis, so any assessment they now make can be ignored anyway.
It does seem empirically true that the importance of sovereign credit ratings has faded in recent years. As three academics found in a 2021 paper:
After splitting the data into pre- and post-crisis periods, we find that ratings go from being significant in the 1996—2007 subsample to insignificant in the 2010—2016 period. These results support the hypothesis that adverse reputational effects weakened the value of rating agencies in investors’ decision-making process after the Great Recession.
The only distinction that really does still matter — for regulatory and/or finance-logistical reasons — is whether you’re still in “investment grade” territory or considered “junk”. But even then, the consequences don’t have to be severe. Many companies understandably think it’s better to be at the top end of the junk bond rating spectrum than at the bottom of the investment grade rungs. The distinction matters more for governments, but not enormously so.
Or to sum things up in meme format:
Nonetheless, credit rating agencies remain a (very profitable) fixture of the financial world, puzzling many outside observers. How can this pointless/malignant/backwards-looking (delete according to personal preference) oligopoly still endure in 2025?
The most common explanation is that their importance remains embedded in the regulatory system, but this fails to explain exactly why that happened in the first place, or why efforts to lessen their grip since 2008 have failed.
The best rationale we’ve come across is from David Beers, the head of sovereign ratings at S&P at the time of the first US downgrade in 2011 (and the father of an amazing public database of sovereign debt defaults). The rating agencies have helped form a “common language of credit risk”, he argues, which allows investors, borrowers and bankers to talk to each other.
The point isn’t that the ratings need to be perfectly accurate, only that they are broadly understandable, widely accepted and at least loosely in accordance with reality.
This is why the grades used by all the major rating agencies are broadly similar despite being ostensible rivals, and why there’s been hardly any innovation in them over the past half-century. Basically, if ratings didn’t exist, we’d probably have to invent them. As Daniel Cash, a professor at Aston University, wrote in his history of Moody’s:
What the rating agencies offer does not find its value in its informational content; quite clearly, because with the rate of failure in the structured finance market alone, never mind anything else, the rating industry would not exist today. What the rating agencies offer is systemically necessary and once we understand that, everything else should fall into place.
