S&P Downgrade, Another Move in a High Stakes Game of Chicken
My inaugural post was meant to be so different. I was planning to pay homage to Andreas Schleicher who has done extensive analysis on education using data from the international PISA scores. According to a recent Atlantic Monthly article, the last slide in his presentation reads: “Without data, you are just another person with an opinion…” I have borrowed his tag line for this blog and will come back to him and his work often. But that will have to wait for another day, as the S&P downgrade of the United States must take front and center.
There are several ways to look at the downgrade of the long-term rating from AAA to AA+. What are the facts, what did the S&P report say? One can also consider the reasons for the downgrade, and why in this very high stakes game of chicken the government might have actually welcomed a downgrade to send a message to the TEA Party and their steadfast view that revenue-raising measures are taboo. And finally, there is the impact on interest rates, the markets and the real economy.
What did the S&P report say?
You can read the full report here. However, to summarize, the debt-ceiling increase did not achieve the long-term goals S&P had suggested were necessary to avoid a downgrade; S&P specified that spending reductions of $4tn are required over the next 10 years, the package only seeks to obtain $2.4tn. To us, the key sentence in the report is as follows: “More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.” Due to wide and seemingly intractable political divisions S&P is skeptical that the Administration and Congress can leverage their agreement last week into a broader accord about fiscal consolidation that stabilizes current US debt dynamics. We recently heard Carmen Reinhart note that incidents of default are rarely due to unwillingness to pay. Yet we note that unwillingness to negotiate a credible plan takes the US pretty far down the path of unwillingness to pay. We agree with S&P’s view that the difficulty in even framing a consensus is all the more problematic with a backdrop of low economic growth and private sector deleveraging.
S&P now assumes that the Bush era tax cuts remain in place. This, combined with the recent legislation, leaves them projecting deficits of 74% of GDP by the end of 2011 to 79% in 2015 and 85% by 2021. However even these dire projections are rather optimistic because of the assumption of 3.0% GDP growth, which is looking more and more elusive in the face of continued deleveraging. S&P acknowledges this in talking about the BEA’s GDP revisions and growth in general: “First, the revisions show that the recent recession was deeper than previously assumed, so the GDP this year is lower than previously thought in both nominal and real terms. Consequently, the debt burden is slightly higher. Second, the revised data highlight the sub-par path of the current economic recovery when compared with rebounds that followed previous post-war recessions. We believe the sluggish pace of the current economic recovery could be consistent with the experiences of countries that have had financial crises in which the slow process of debt deleveraging in the private sector leads to a persistent drag on demand. As a result, our downside case scenario assumes relatively modest real trend GDP growth of 2.5% and inflation of near 1.5% annually going forward.”
In a high stakes game of chicken, might some in the government welcome a downgrade?
When compared with other AAA-rated countries with high levels of debt, namely France (83%) and the UK (80%), the difference is the trajectory of fiscal consolidation and the political landscape. This leads us to our second point. Surely the US is an equal credit risk to France or the UK? One can credibly argue the US economy is as viable as that of France or the UK, perhaps even more so. The difference is politics. One is tempted to blame whichever side one disagrees with. But as my wise colleague Alexander Avtsin says, “the Tea Party is just the messenger.” The fact is both parties are willing to engage in the game of chicken now playing out, and we did not just arrive here suddenly. The discontent has been brewing, and the backdrop of a great recession and massive deleveraging are only part of the problem. The other part of the problem is that many Americans have seen their ability to gain upward mobility truncated in the last five years as housing wealth proved a mirage and retirement needs have grown due to growing life expectancy and health care costs.
There are mutterings in the blogosphere and amongst friends in DC that the administration wanted the downgrade to provide a foil. To say to the Republicans, you want to do this without raising revenues, well here is what that plan looks like. This seems like a very risky game to me. In my view, failing to seize on the compromise offered in the Bowles-Simpson fiscal commission was a tragic mistake on the part of the Obama administration. There was real bipartisan compromise and promise in those pages. Likewise, failing to bring together moderate Democrats and Republicans was a failure of the leadership of both parties. One potentially positive aspect of the Super Committee of 12 members of Congress (6 Senators, 6 Congressmen – 3 from both parties, sent by each chamber) is that their proposals are immune from filibuster and they require only a simple majority to pass. This is an important technical detail that should help government function a bit better than it has recently.
What will the market reaction be?
Despite calls to end the US dollar as the reserve currency (and it could happen one day) and despite the rise of gold prices and the fall in equities (which we believe has more to do with the economic outlook), we think there is a good chance the near-term response is rather benign. We take as our example Japan after its downgrade in 1998. Bearing in mind that the US has not nearly the level of private savings nor a current account surplus two things that could change in the next 5-10 years we believe the longer-term market reaction will be similar to what it was when Japan was downgraded. (We note that in November 1998, it was post Long Term Capital Management, the Fed was cutting aggressively, and Japan was on the verge of recovery. So we do not mean to suggest the next quarter will be similar, but the next several years are very likely to be.)
The US Treasury market is still the home of the risk-off trade. Further, when one considers who owns US Treasuries (the Fed, foreign institutions, money market funds, and institutional managers) it is difficult to imagine a large selling cohort. Then there is the 13% of treasury holdings by individuals, what do these people do in the face of this news? Here there may be some selling pressure but we doubt it will have more than a 48-hour impact. What we do worry about is the ability to leverage the treasury market to make purchases in so-called riskier assets. Risk-on markets are likely to experience some level of dislocation. Further, equities must still respond to growth prospects that are looking rather grim. The unfortunate confluence of a balance sheet recession (presentation by Nomura’s Richard Koo), low consumption rates, reduced confidence that is not helped by a great deal of uncertainty about regulation, taxes, and long-term entitlement commitments does not present a positive backdrop for stocks. As for the dollar, it is likely to continue its weakening trend, especially versus the Swiss Franc and Japanese Yen. But ultimately, this dollar weakening will be our savior; the US will import less and will be able to manufacture more competitively, and this will help with rebalancing.
The real question is can the US politicians and the electorate that put them in power find a way to compromise and build a stronger, more viable path for the future? Only if “we the people” choose to vote for candidates who can find a common ground and who can put economic prosperity over partisanship, something increasingly difficult to do with our over-gerrymandered congressional districts. The electoral landscape has only reinforced the prevailing modus operandi in Washington that believes compromise is a sign of weakness. At this point, only the voters can change the minds of those in Washington. Will the heretofore un-galvanized center step forward and find its voice; is it up to the task?
25 Responses to “S&P Downgrade, Another Move in a High Stakes Game of Chicken”
So clear and insightful. Thank you for making a complicated situation understandable. It is so difficult to motivate the center… I don't really understand why, as I am honored to have the privledge to vote and fall over myself to do so.
The early test will be who is actually appointed to the supercommittee. If it is able to replicate the work of Simpson-Bowles, then things may turn out OK. If they deadlock, a further downgrade would be appropriate. Either way, S&P will be justified. They will be able to take credit for catalyzing the supercommittee or able to say "I told you so" with regard to political deadlock.
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