Entitlements in the crosshairs: how sovereign credit ratings judge the welfare state in advanced market economies

Abstract

How do credit rating agencies (CRAs) judge welfare policies in advanced market economies (AMEs)? Scholars worry that market pressures constrain AMEs’ ability to retain their welfare arrangements, but the role of ratings in generating such pressures remains unstudied, despite their well-known influence on governments’ funding costs. CRAs’ communications indicate that CRAs assign lower ratings to countries with large spending commitments that are difficult to promptly change in response to adverse economic shocks, as insurance against drastic negative corrections (‘rating failures’). Therefore, we hypothesize that famously inflexible entitlement programs trigger rating penalties, but welfare spending that is easier to adjust does not. Our panel analysis of ratings from Standard&Poor’s, Moody’s and Fitch awarded to 23 AMEs between 1995 and 2014 demonstrates that entitlement spending systematically incurs lower ratings, but discretionary spending on public employment and social services does not. In contrast, bond-spreads are not affected by entitlement spending, once the effect of ratings is controlled for. We conclude that CRAs’ desire to avoid ‘rating failures’ is an important factor in generating negative market reactions against entitlements.