The Debt Downgrade and Stock Prices

Copyright, The New York Times Company

The big financial story in the last few days has been the declaration by Standard & Poor’s that United States government bonds were no longer worthy of its AAA rating. The agency, in a nutshell, thinks there is some chance that the government will default or be delinquent on its debt payments.

The announcement was followed by a wild ride in the stock market in the last two days — a plunge of almost 7 percent in the Standard & Poor’s 500-stock index on Monday, followed by a surge of almost 5 percent on Tuesday.

But with the index down almost 18 percent from its April peak, it is clear that investors’ concerns long predated the downgrade.

The real news is how poorly the economy is doing, and how poor its prospects seem. The chart below shows the changes in several indicators of economic activity over the last nine months. The blue series is an inflation-adjusted stock price index, which (even with Tuesday’s big gain) is lower than it was nine months ago. Through May 2011, real housing prices (black series) were down 7 percent. Real consumer spending (red series) has failed to increase, and inflation-adjusted spending on consumer durables has fallen four months in a row.

All of these indicators are forward-looking in the sense that they depend on what people expect to happen to incomes and profits in the future. These indicators had been looking better during much of 2010 but now it seems that consumers and investors are not optimistic about what is ahead (are they worried about riots like in London? higher taxes? government program cuts?).

In my view, a rating agency does not move the market but rather reacts to some of the same prospects that are reflected in the decisions of consumers and investors. For example, to the degree that incomes continue to remain low, tax collections will also remain low, making it that much more difficult for governments to pay their obligations.

Recovery for the stock market, and the wider economy, needs a lot more than an agency to change its mind about government bond ratings.