8 August 2011
Standard & Poor's (S&P) downgraded US sovereign debt from its top AAA-rating to AA+ after global financial markets closed on August 5. Initial market reaction today was negative (the dollar and equity markets fell), but appeared contained (ten-year Treasury yields declined). S&P warned in July that a downgrade was likely, absent agreement between the White House and Congress on a fiscal consolidation package of approximately 4 trillion dollars over ten years; in the event, the agreement approved by Congress was half that size. Given that US expenditure on debt maintenance is currently very small relative to GDP, S&P justified its move mainly on the grounds that political stalemate in Washington risked another "debacle" like the debt ceiling debate. In other words, while the United States has the economic wherewithal to get its debt situation under control, policymakers may fail to take sufficient remedial steps.
- The most negative impact of the downgrade will be on confidence -- retarding economic recovery -- rather than on the cost of borrowing.
- S&P will certainly downgrade other enterprises closely tied to the US government, including Fannie Mae and Freddie Mac.
- Taxes on higher income households and capital gains will likely rise during the 'lame duck' congressional session of late-2012.
- The bipartisan fiscal commission will exceed its mandate to achieve at least 1.5 trillion dollars in savings over ten years.
Initial market reaction may push up Treasury yields marginally, but the medium-term rise in the US cost of borrowing will be very small. While potentially severe market volatility will continue this week, loss of the US AAA-rating is very unlikely to provoke a systemic credit crisis similar to 2008. Despite its apparent dysfunctionality, Washington will enact significant fiscal consolidation on both the revenue and spending sides by 2013 -- though the bulk will be put off until after presidential elections next year.
The United States spends just 1.9% of GDP on debt maintenance -- less than other AAA-rated sovereigns such as the United Kingdom (2.6%) -- and S&P's own projections peg the net US debt-to-GDP at 79% in 2015, compared to 83% in AAA-rated France. Therefore, S&P's justification for the downgrade focuses heavily on concerns that a supposedly dysfunctional US political system would fail to control the federal deficit over the medium-term. This line of reasoning appears compelling in the aftermath of political brinkmanship over the federal 'debt ceiling' earlier this month -- but may be less valid over the medium-term.
Case for downgrade
The essential S&P analysis is that US government debt is growing rapidly, and that in current political conditions the "effectiveness, stability and predictability" of US policy had "weakened" at a particularly inopportune moment. This assertion is unquestionably true, in the sense that the showdown between the Republican-majority in the House of Representatives and Democratic-controlled Senate and White House over the fiscal year 2011 budget and the unprecedented clash over the normally pro-forma vote to raise the statutory 'debt ceiling' undermined business and consumer confidence the context of tepid GDP growth.
Yet solutions are readily available. According to 2010 OECD data, the United States has the lowest tax burden in the developed world:
- US tax revenue as a percentage of GDP is just 24%, approximately half that of high tax jurisdictions including Denmark (48.2%) and Sweden (46.4%).
- Large OECD economies, including France, Germany, the United Kingdom and Canada also have tax takes greatly exceeding Washington's.
- Strikingly, middle income OECD members and those considered relatively low-tax, including Ireland, South Korea, Slovakia and Turkey also collect a larger percentage of their GDP in taxes than the United States; only Mexico and Chile collect less.
While headline US tax rates are often very high (eg US corporate taxes are second only to Japan in the G7) the amount of revenue collected is exceptionally low -- not, as in the case of Greece, due to evasion, but due to legal tax loopholes assigned to interest groups.
Thus, with a modest increase on the revenue side through tax reform (reducing headline tax rates, while increasing revenue), accompanied by more substantial budget cuts (including mild entitlement reform), the trajectory of the US fiscal outlook would greatly improve.
Fiscal consolidation politics
S&P rightly observes that Congress is unlikely to acquiesce to such an approach (as embodied by the 4 trillion dollar plan nearly agreed late last month between President Barack Obama and House Speaker John Boehner) due to irreconcilable opposition among House members aligned with the 'tea party' movement.
Yet something very like it is likely to emerge even before 2013, in two stages (see UNITED STATES: Deal averts disaster but risks remain - August 1, 2011):
- The bipartisan commission authorised by the August 2 'debt ceiling' law will now likely consider spending reductions over ten years higher than the 1.5 trillion dollar minimum -- perhaps up to 2.5 trillion.
- Unless Congress agrees on a compromise (an unlikely prospect due to the very political gridlock S&P cites) tax cuts enacted under former President George W Bush are scheduled to expire at the end of 2012; if only taxes on wealthier households are allowed to increase (favoured by Obama), this would generate an additional 800 billion dollars over ten years.
The US debt downgrade has inspired fears of a reprise of the 2008 crisis, which led to a collapse in short-term credit markets. While the downgrade is unprecedented and may have some unpredictable effects, there are powerful arguments against the notion that a 2008 scenario is imminent:
- S&P affirmed its highest possible rating for short-term US debt (A1+), meaning that forced money market fund sales will not occur.
- The Federal Reserve and Federal Deposit Insurance Corporation confirmed that the change will not affect US banks' capital requirements; under Basel I and II, OECD sovereign bonds rated AA carry a risk weighting of zero.
- Almost all US and international bond funds authorise Treasury holdings, but do not specify a risk rating.
- Despite official Chinese complaints, foreign central banks have few alternative reserve options.
The 2008 crisis was caused primarily by an inability effectively to price the risk of common securities (US mortgage-banked securities and associated synthetics), and a resultant counterparty risk-driven panic due to concerns over certain banks' holdings. This is not the case for US Treasuries -- ten year yields were off four basis points in European trading this morning.
Real and imaginary risks
- Through confidence effects and (perhaps) a marginal increase in the cost of borrowing, it increases the chance of negative economic scenarios -- perhaps including a double-dip recession (see INTERNATIONAL: Scenarios worsen as extreme risks rise - August 5, 2011).
- Global equity markets are in a febrile state, raising the chances of a late summer bear market.
- As threats to developed world growth rise, the danger of a substantial commodity sell-off is increasing; if this occurs, it would have a highly negative impact on commodity-dependant economies.