The politics of debt

Standard & Poor’s Ratings Services first rated Uncle Sam’s credit worthiness in 1941, when Standard Statistics merged with Poor’s Publishing. Like both its predecessor institutions, S&P assigned the U.S. government its top AAA rating. The U.S. has maintained this status with a Stable outlook for seven decades, during good times and bad.

No more. On April 18, S&P rocked financial markets and gave budget-bickering politicians in Washington an unexpected kick in the pants by changing the outlook on American sovereign credit to negative.

Not everyone disapproved: more than a few devoted budget-cutters think the world’s largest economy needs a wake-up call similar to the one issued to Canada in 1995, when The Wall Street Journal labelled our nation an “honorary member of the third world.” After all, in the past decade, net U.S. government indebtedness has increased by almost half of national income, from 33% of GDP in 2001 to 75% in 2011. But more than a few observers think now is the wrong time to treat the U.S. like it is one of the European Union’s fiscally challenged PIIGS. Some even go so far as to call the timing suspicious.

A negative outlook is not necessarily a precursor of a rating change. It simply means S&P thinks there is at least a one-in-three likelihood that a rating action will be required within 24 months. Craig Alexander, chief economist at TD Bank Financial Group, sees the downgrade as both justified and constructive, because it raised awareness of a problem that needs to be addressed. “The lesson out of Europe,” Alexander says, “is that you either tackle fiscal issues yourself or markets will come along and force you to deal with it. And again, the lesson from Europe is, you never want the market taking it to you.”

But former New York Federal Reserve official Robert Brusca—now chief economist of FAO Economics—argues that hitting America with an outlook downgrade now is about as helpful as Donald Trump’s questioning of President Barack Obama’s citizenship. The outspoken market watcher freely admits risks related to the growing U.S. debt have grown as the EU’s troubled members succumb to excessive debt burdens. But in a commentary on the downgrade, he said he is at a loss to see what new material information prompted the unexpected move. Brusca points out that U.S. spending was a concern before the Great Recession forced the federal deficit to balloon to more than 10% of GDP. Indeed, he says, economists have been warning of the “coming crunch from Medicare and Social Security” for years.

“So why now?” he asks, noting the S&P stepped in and issued a judgment on the future American economic stability when opposing political camps in Washington were actively “grappling with the concept of what to do.” He wonders if S&P was taking sides with the Republicans or trying to nudge the participants to reach an agreement. Either way, Brusca insists that’s not an appropriate role for a credit rating firm, especially when, he writes, there is no reason to “think that S&P knows anything more about this issue than it did about derivatives risk.”

Nikola Swann, Toronto-based director of S&P public finance and sovereign ratings, stands by the decision. As far as he is concerned, the facts clearly speak for themselves. Nevertheless, when asked for a response, Swann pointed out that S&P has been warning about “U.S. fiscal deterioration as a credit weakness since at least 2006.” And despite lip service to co-operative deficit fighting on Capital Hill, he says recent battles between the White House and Republicans led by Paul Ryan, the chairman of the House of Representatives budget committee, do not imply a credible, medium-term fiscal consolidation program will be agreed upon by 2013. And that’s why S&P decided the time had come to move its outlook on U.S. credit from Stable to Negative.

David Kotok, a high-profile U.S. fund manager, respects Brusca, but he doesn’t think the S&P move was poorly timed. “Tell me what would be a good time,” he says, adding “there is no such thing.”

Nevertheless, while Alexander has no issue with S&P, the TD economist thinks the U.S. outlook downgrade could have come at a better time if the goal was to actually influence a serious change in American spending. He notes the political cycle in the U.S. requires bad news to be issued by any administration immediately after it is elected. “There is no way,” Alexander says, “that a first-term president in the second half of his first term is going to raise taxes and cut spending in a serious way, even when there is an enormous deficit.”

As a result, the TD economist says a U.S. wake-up call would probably have been more helpful if it was issued after the next election, when America will have to deal with its spending regardless of who wins the White House. But then again, Alexander says timing a downgrade for optimal political impact isn’t a rating agency’s job. And that’s a good point. Japan certainly didn’t benefit from having its outlook downgraded to Negative in late April, while it was still attempting to recover from a perfect storm of disasters—which S&P projects will increase its fiscal deficits above prior estimates by a cumulative 3.7% of GDP through 2013.

The U.S. books have been in worse shape. Federal debt held by the public was 109% of GDP in 1946. But back then, America was the pre-eminent global economic power, and its currency was one of the very few freely convertible worldwide. So a high debt burden weighed far less on its credit standing.  However, times change, and so does creditor confidence, even for managers of the world’s reserve currency. Folks in Washington soon need to seriously wrap their minds around that fact if Uncle Sam wants to keep his credit card.