The Midnight Ride of Standard & Poor’s

Three cheers for Standard & Poor’s (S&P). On Monday, the rating agency issued a critical warning that America’s debt burden is growing too great. By doing so, it has helped make it less likely for the Washington budget debate to keep going down the path to national bankruptcy. We are now faced with a clear choice between a big-government, high-tax welfare state and a small-government, low-tax republic, such as the founders envisioned.

S&P did its job, which is to issue warnings based not on speculation, but on the best available financial information. This, by the way, is why credit rating agencies are often “late to the party,” but it also shows that in this case, the only people who don’t know we’re heading over a cliff are sitting in places like the Treasury Department.

Indeed, Treasury Secretary Timothy F. Geithner strongly disagreed with the rating agency, saying there was “no risk” that the United States would lose its AAA rating. Frankly, that’s not his job to say, nor should it be his job. Imagine if countries could set their own credit ratings. The resulting meltdowns, when reality caught up with fantasy, would make the recent recession look like a bank overdraft notice.

A living example of this is the International Monetary Fund (IMF), which issues pronouncements on countries’ financial health, but only after financial crisis has set in. It also acts as a lending agency. Farsighted finance analysts have warned for decades that this is a big problem, as it makes countries more likely to get into financial trouble in the knowledge that the IMF will bail them out.

A model in which Standard & Poor’s and other non-political agencies provide early-warning signals that enable governments to act to fix their finances seems far more merciful to the people of the world than one in which the IMF enters only when economies are at a breaking point and then requires costly adjustments, which come far too late. Perhaps, though, that is Mr. Geithner’s plan for deficit reduction.

Speaking truth to power, however, is a dangerous game. The head of the Federal Deposit Insurance Corp. (FDIC), Sheila C. Bair, recently upbraided the rating agencies for realistically continuing to include the prospect of government bailouts when rating banks. “[T]hey shouldn’t be speculating on whether the government’s going to come in or not,” she complained. “That’s not their job. I don’t think it’s appropriate.”

Of course, it is their job. As noted, their job is to issue ratings based on full information. For example, if governments have a track record of bailing out “too big to fail” institutions, it is informed assessment to include that probability in rating such institutions. The idea that the Dodd-Frank financial reform bill’s provisions to prevent bailouts could not be circumvented is, at best, naive. Remember that the federal government ran roughshod over some parties’ legal claims and precedents in its rescues of General Motors and Chrysler.

Of course, the rating agencies are not perfect. The two main agencies have a privileged regulatory position that may lead to complacency and in some cases – like the ratings of mortgage-backed securities – fails to convey full information. Opening the market to competition would solve this problem.

We should be grateful to S&P for its timely warning to Washington and for reminding us of the vital role that rating agencies play in a free economy. Thus, it is hardly surprising for economic interventionists to loudly complain about them now.