The Downgrade Actuality

The ratings agencies are not exactly the most credible organizations following their plank-in-the-eye risk analysis during the housing bubble. So you do not have to agree with their Friday night downgrade of U.S. credit risk from AAA to AA+. In reality, every investor has to decide for themselves if they believe the United States is a deadbeat or creditworthy borrower over the long haul. And recently, there has been a lot of demand for American debt, with Treasury yields at record lows. But if the early losses in Asian markets are any indication, investors are not ignoring Standard & Poor’s decision.

One way or the other, the downgrade is a humiliation for the White House and Congress. You can blame the President for playing politics with the debt ceiling and not declaring months ago that Treasury would prioritize debt repayment and avoid default—this would have given the GOP the upper hand but also signal to the market and ratings agencies that the government would take debt repayment seriously no matter the political cost. You can blame the GOP for being mindlessly opposed to revenue increases—which don’t necessarily mean higher tax rates since a lot can be achieved by reforming the broken tax code and eliminating useless deductions like for mortgage interest. It is not just one party’s fault.

S&P’s statement on the downgrade was very clear: this was a decision based on politics. Back in April when S&P first put the U.S. on negative watch, the reason was concern the political system was so broken that a debt ceiling deal may not be reached. While a deal was put together, S&P argues that it is not enough to seriously reduce America’s long-term debt threat. They fear—and not without merit—that the political system is so broken that Congress won’t be able to effectively address the long-term growing burden of government spending, entitlements, and tax code inefficiency.

President Bush did a lot to grow the size of government, and the Obama years have seen federal spending grow to 25% of GDP. Debt-held-by-the-public to GDP is currently 65%, and is projected to reach 72% by the end of 2011. All federal debt (including internal loans) relative to GDP is 97%, and will cruise past 100% next year. President Obama has himself stated that Medicare is on a path to run out of money. And last year Social Security paid out $41 billion more than it took in, making it already insolvent by some accounting measures.

The best response to this Congress and the White House could come up with was a plan that only slowed an increase in spending. Even worse, the attitudes all along have been wrong. The GOP is right on the need to cut spending, but continues to defend a bloated defense budget and the House Republicans refuse to address the broken tax code. Meanwhile the president’s plan to reduce spending is to increase it. Consider this: as of today roughly 10% of federal revenues go to paying interest on our debt. This is pretty much the typical line S&P and others use to determine whether a nation is AAA creditworthy. But President Obama’s proposed budget for FY2012 that he released in the spring increased spending so much over the next 10 years that it pushed the portion of the federal budget allocated to interest payments to 14.5% in 2015 and nearly 20% in 2021—all without decreasing the rate of expansion for discretionary spending and entitlements much at all.

Again, blame both sides. Though I blame the President more here for a lack of leadership since he and his party have had power for the past three years (minus seven months of GOP House rule) and have failed to address this in a timely manner.

What is interesting, in terms of how markets will digest the S&P decision over the next few days, is that this is all old news. We’ve known about the debt problems for a while. And for the most part, both Democrats and Republicans see the dangers in staying the current course (if you believe them when their mouths are moving). What changed was the debt ceiling deal itself being formulated and signed into law. And with the paltry reduction in long-term debt from an estimated $29 trillion in 2021 to $26.3 trillion in 2012—all up from today’s $14.6 trillion in debt—that came from such a tooth-and-nail fight, it is understandable that the powers that be within S&P took a pessimistic stance on Congressional fiscal responsibility.

I share the pessimism. But I disagree with S&P’s stance in one sharp way: some ways are better than others when it comes to address our precarious fiscal situation. S&P notes in their downgrade statement that they take no position on how to lower long-term debt, either spending cuts or increased taxes. That’s a near sighted approach.

Increased taxes will not address rising health care cost burdens bankrupting Medicare and Medicaid. Increased taxes do not fix social security’s broken formula. Increased taxes do not lower defense spending. But addressing all three of those is necessary and would do the yeoman’s work of taking on the debt problem.

Raising tax rates from the current code simply allows for the deficit to be narrowed in the near-term—assuming they don’t reduce tax receipts, depending on where we are in the Laffer Curve—and ignore the long-term issues. More importantly, they create a dead weight on future economic growth and slow the economy.

This is not to say we can’t have new revenues. Eliminating the mortgage interest deduction would have little impact on the housing market, but could generate around $100 billion in new revenue (according to the JCT). Sure tax bills would be higher, but we’d be eliminating a subsidy that shouldn’t exist. Same thing goes for agriculture subsidies. The state and local tax deduction. And even the deduction for corporate jets (though we should throw out the whole corporate tax code in the first place).

But if the Republicans in the House remain true to their word, we won’t see change in the tax code that increases revenues, much less direct increases in tax rates. Which means Democrats are going to be less willing to deal on entitlements. And that could derail the Joint Special Committee in coming up with a long-term debt reduction plan. A failure there means triggering the $1.2 trillion in discretionary spending cuts. Which is good, but not nearly enough to deal with the long-term debt problem.

And we’re back to the S&P pessimism.

To be clear, we have written numerous times about the credit rating agency oligopoly. If it had been broken up as we advocated during the Dodd-Frank debate last year, this decision may not have carried as much weight. But the lack of credibility doesn’t make S&P wrong.

The best possible outcome from the downgrade is that Congress will recognize what fiscal policy reform really means. It is not exactly likely though, given that the White House and Geithner have spent the weekend accusing S&P of incompetence instead of offering a concrete solution to trimming deficits and long-term debt. Which side investors choose remains to be seen, and even though Asian markets took an early beating, no one can predict how the stock market will fare over the coming days, weeks, and months. Nor will we be able to clearly determine whether falling markets are due to the downgrade, or steady deluge of bad economic news. Ultimately, we do know we are not going to default. But the near-term question isn’t on tap here. How we deal with growing debt over the long-term is what we need to address to get back to AAA.