S&P Negative Rating: Premonitions of a debt crisis?
On Monday, Standard and Poor’s pinned a “negative” rating on the United States fiscal outlook. US stock markets reacted poorly. The Dow fell 140 points (1.14%) and the other major indexes suffered similar declines.
The S&P report and the market’s reaction puzzled some analysts. “The idea that the U.S. public finances are on an unsustainable trajectory is hardly new news,” said Capital Economics (as reported in New York Times).
Indeed, the fiscal situation might be a little rosier now given that both sides have started pushing plausible plans to reduce the debt. But those plans and the rhetoric surrounding them don’t necessarily fuel optimism. The Republican plan, put forward by House Budget Committee Chairman Paul Ryan, basically reiterates the party line that the debt is a spending problem alone and that tax increases must not be part of the solution. The president’s plan repeats the campaign pledge to finance debt reduction with new taxes only on millionaires. While there’s more encouraging news coming from the Senate, it’s not at all clear what will keep us from driving off the cliff.
The bottom line is that the news about the S&P report scared me. Yeah, it is probably a false alarm. It might even serve the salutary purpose of frightening the political establishment into working together to prevent a debt crisis. But it might also mark the point at which the bubble in the market for Treasury securities bursts.
The bubble scenario is this: US Treasuries are a safe asset only as long as investors believe they are. As the safe asset, they command incredibly low interest rates. The Treasury can borrow short term at an interest rate of ¼ percent. As long as interest rates stay really low, Treasuries are completely safe. The US can always roll over its debt as it comes due and interest payments will be manageable for a very long time.
The problem arises if people start to believe that Treasuries might be risky, say because of a negative report from a ratings agency or some other kind of shock. If the market started thinking that way, they would demand a higher interest rate, but at higher rates, our debt becomes much less manageable. There’s also fallout for the private sector, which might be thrust back into a recession. That would depress tax revenues and add to spending pressures, further adding to the debt. If markets figure this additional risk into their assessment, they’d raise rates further, which would just make the problem worse. Very quickly, the US government might not be able to borrow at any reasonable rate.
At that point, we become insolvent. If the debt crisis occurred now, we’d probably muddle through, although not without serious damage to our fragile economy. And given that our debt, while large, could be easily managed in a less dysfunctional policy environment, I’d bet that this isn’t “the big one.”
But the scary thing is that the bubble will burst eventually, when financial markets lose confidence in us. It’s probably not now, but that means that the bubble could get much bigger before it explodes. As the saying goes, “the bigger they are, the harder they fall.”
Warranted or not, I’m hoping that the S&P report serves as a wake-up call.
Here is a possible scenario that may be driving S&P and their potential downgrade which is because far from having gridlock result in the 2010 tax cuts to expire, there is high probability that they will continue and even be made permanent.
Near the end of 2011 Grover Norquist and his allies will declare that allowing the one year provisions of the 2010 tax cuts to expire is a tax increase. Consequently the House will vote to extend them, and the Senate, facing a tough election will pass that bill. Obama will sign the bill because raising taxes on all working Americans, even those that do not pay income taxes is simply not consistent with being re-elected.
In 2012 Obama will campaign on allowing the Bush cuts for the wealthy expire, but it won’t hurt him in the election because he will have no credibility on the issue. If he is re-elected (If he is not re-elected, well you really don’t want to go there) he will not get a clean bill that allows only the tax cuts on the wealthy to expire. Such a bill cannot pass the House. Instead he will get the same bill he got in 2010, extending or making permanent all of the Bush tax cuts and all of the 2010 additional cuts. Obama will likely sign the bill, why, because that is what he has done in the past. Without massive spending cuts, the deficit remains at its current level or even increases.
What if Obama refuses to sign such a bill and allows all of the tax cuts to expire? In that case the 2014 election will be the Republican position that “give us a veto proof majority and we will not only reinstate the tax cuts, but give you a check for the extra taxes you have paid in 2013 and 2014” against the Democratic position of “well, maybe”. Given the trend in elections in the sixth year of a Presidency and the horrible math for Democrats in the Senate in 2014 and the likelihood that vulnerable Democrats will sign on to the Republican position, the Republican position becomes law in 2015.
In that case the deficit is so large that only massive cuts in social programs can bring it under control. This contractionary policy will result in a contraction in the economy (that’s why they call it contractionary policy). Deficits increase when the economy contracts, and so by 2015 the debt crisis is real.
Forecasting the economy and politics and elections for five years out is a fool’s policy, guilty as charged. But if you have a more likely scenario, one that could happen as opposed to one you want or wish to happen, let’s hear it.
[...] Len Burman is nervous that the market for U.S. debt is on the edge: “The bottom line is that the news about the S&P report scared me. Yeah, it is probably a false alarm. It might even serve the salutary purpose of frightening the political establishment into working together to prevent a debt crisis. But it might also mark the point at which the bubble in the market for Treasury securities bursts.” [...]
I wish our leaders would believe Len’s excellent advice on the government debt bubble. If they did, they might be willing to make a grand bargain combining Ryan’s health care savings with Obama’s tax increases, going beyond the most extreme proposals of both sides. This will not happen before an actual crisis arrives.
Len, given that the bubble must burst, and that the damage will be greater the larger the bubble is, would it not be better for the bubble to burst immediately? If yes, then wouldn’t Congress be doing the country a service if it precipitated a default by refusing to increase the debt ceiling?
I realize that such a proposal is like discussing amputation with a patient who suffers from terminal gangrene. Failure to amputate in such a case would be malpractice, regardless of the patient’s opinion on the need to act.
I was going to accuse you of mixing your bubble and gangrene metaphors, but further research revealed that there is a type of gangrene (wet gangrene) that involves the formation of gas bubbles in the affected muscle tissue. So, it is indeed a good question.
The impetus by Wall Street and the ratings agencies to push for action is because they don’t like what will happen automatically should no deal be reached – a tax only solution on January 1, 2013.
I suspect that S&P is realizing what the rest of us know – that gridlock means that the 2010 Tax Cuts expire automatically.
There is, in essence, no scenario where the debt gets worse unless Obama agrees to a plan that is less rigorous than this.
The alternative is that S&P represents those forces that don’t want their personal income taxes to return to Clintonian levels in the event that there is no agreement. Combined with spending cuts on defense, which will happen once withdrawl plans in the eastern and southern Asia are complete, the US is actually on a pretty good long term footing, even with gridlock.