Downgrade

On Friday, August 5 after the market close, Standard and Poor’s (S&P) announced a downgrade of U.S. Treasury debt from AAA to AA+. This announcement followed Congressional approval of a debt limit increase and ten year plan to cut projected deficit relative to baseline by $2.1 trillion. Evidently, the debt deal was not convincing evidence to S&P that Congress and the Administration were serious about corralling ballooning budget deficits. Indeed, the S&P release noted their view that “the effectiveness, stability, and predictability of American policymaking and political institutions have weakened” as a key factor in the downgrade.

The market reaction was swift and severe. On Monday equity markets moved down sharply. Interestingly, Treasury yields also fell sharply, even though they had already fallen the week before on fears of continued economic weakness. Perhaps the strength in Treasury prices still reflects a flight to quality. AA+ is worse than AAA, but there are very few AA+ investments around.

The long-term consequences of the downgrade are likely to be widespread, in large part because many large portfolios of assets are managed under ratings mandates. For example, a quality bond fund may stipulate that the average rating will be no worse than single A. Also, many funds along with banks and insurance companies are mandated to own no securities that are not investment grade. Thus, the downgrade will have consequences for many other types of debt. Securities that are currently rated AAA due to express or implied guarantee of the U.S. Treasury, like FHA/VA or agency mortgage backed securities (MBS), will presumably be downgraded as well. The average ratings of portfolios holding trillions of dollars of assets will be affected. Portfolio managers will be forced to sell their lower rated holdings and to purchase higher rated bonds, like Treasuries (still the highest rated security around, even after the downgrade). This could be another reason why Treasury yields are falling even as their creditworthiness is being called into question.

Wakeup Call

The response from the Administration was to attack the S&P methodology and conclusion. But even if the credibility of the ratings agencies is not what it used to be, the S&P downgrade and threatened downgrades by others may serve as a valuable wake up call. The current and projected budget picture in the U.S. is awful and the willingness to address it is not apparent.

Republicans point to the rise in federal government spending to GDP from 20% in 2007 to 25% in 2011 as the primary culprit. The $750 billion TARP and $800 billion stimulus seem to have become embedded in the budget baseline along with projected growth rates in spending averaging 5% over the next ten years (this is even after the latest budget deal). With nominal GDP expected to grow at a 5% pace (this is the S&P assumption), the ratio of government spending to GDP will stabilize around 25%. The Republican plan is to lower the growth rate of spending below the growth rate of GDP, thereby gradually reducing the ratio of spending to GDP and eventually bringing it back to the historical average of 21%.

Democrats claim the Republican plan is folly. They argue that aging of the American population necessarily means rising expenditures relative to GDP and the key to resolution of the deficit issue is to raise tax revenues. Over the past 50 years, federal tax receipts have averaged 18% of GDP, but this ratio has declined to 15% due to the Great Contraction (with actual GDP currently running 10% below potential GDP). As the economy improves, the tax share will probably rise back to its historic norm. But this is not enough to accomplish budgetary balance according to the political left, inasmuch as spending should be increasing more rapidly than GDP. The solution is higher tax rates and closing tax loopholes. Can this approach work?

The country needs to come to a consensus regarding the proper role of the federal government in the economy. There is room for reasonable people to differ on this issue. No one argues that federal spending should be zero, but some argue it should be in the range 10-15% of GDP. Others believe that the federal government spending should constitute 30-40% of GDP. My view is that economic growth will probably be stronger the closer the government spending share is to 15% than 30%. On the tax side, I would favor a broadening of the base and flattening of the rates. The target revenues should be established so as to match the amount of spending. We need a national debate on the proper size of the federal government.

Why do the ratings agencies have so much power?

If the S&P downgrade pushes Congress to seriously address looming budgetary issues, then it may have been a good thing. But it does raise another question, why do the major ratings agencies have so much power? They have missed nearly every major credit blow up in the past, and some argue constituted one of the primary factors driving the financial crisis of 2007-2009. By assigning AAA ratings to thousands of tranches of mortgage backed securities, S&P and Moody’s supported final demand for these securities and enabled underwriting standards to continue to weaken.

Some argue that the incentive structures were at fault in that the agencies were paid by the issuers of the securities rather than by investors in the securities. Another problem is that ratings agency ratings are built into too many investor mandates and are too deeply embedded in bank capital requirements. Both of these issues should be addressed. We should strike references to ratings in investor mandates and bank capital regulations and we should eliminate the ratings oligopoly currently cemented by SEC and bank regulations.

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The capital city Pennsylvania is broke and will be skipping this month’s multi-million dollar bond payment.On Sept. 15, Harrisburg, Pa., was scheduled to make a $3.29 million payment on the bonds it issued to build a trash plant. But, the cash-strapped city doesn’t have the dough.

Vallejo CA previously filed bankruptcy, and I suppose that is possibility for Harrisburg.  We’re likely to see a lot more headlines like this.  The economy will be too weak too long to bailout many governments.

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I have no doubt that California’s public employees are overpaid.  Their combination of salary, retirement, work rules, and health-care benefit is among the best in the world, and a contributor to California’s fiscal crisis.  It is also true that some of the package has been gained by holding essentially holding California citizens hostage.

Still, their methods do not justify unethical behavior by California.  If we have trouble with public employees’ their negotiating methods and pay package, we change the rules and renegotiate their salary.

We have plenty of economic pain in California, and public employees should share that pain, but holding them hostage is not the way to do it.

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The first alternative is based on the reasonable assumption that Congress does what it normally does, follow the path of least resistance.  The second scenario is based on the administration’s budget proposal.  It is an easy, but grim, read.  The takeaway is that the CBO budget forecast is the best possible outcome.  The money charts are on pages 20, 21, and 22.

One possible criticism comes from evidence that tax rates may be irrelevant to federal tax receipts.  The Wall Street Journal recently ran a very interesting chart indicating that federal receipts are 20 percent of gross product, no matter what the tax rate.  If that is true, the scenario with higher tax rates would generate the lowest gross product and hence lower tax receipts.

The post A Serious Look at Future Deficits appeared first on Center for Economic Research and Forecasting.

The problem is that deficits are not all the same. In WWII and the Cold War, we did save the world, but it wasn’t because of the deficits. They merely facilitated what had to be done. The deficits bought us something. The same is true of the 1930’s spending. While there was much waste, counter-productive spending, and inefficiencies, the spending included things like the Rural Electrification Program and the Tennessee Valley Authority. These were investments. They made private capital more productive.

By contrast, the current stimulus has very little spending that will increase private capital’s productivity. At least some of the spending is worse than wasting money, as much of it actually rewards bad behavior.

Krugman can’t seem to differentiate between investments, wasting money, and counter-productive spending. It is all about the deficit. Digging holes and filling them back up is just as good for him as building public infrastructure. Of course, that’s not true.

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