Thursday, June 09, 2011

John Quiggin » When will US debt be downgraded? By how much?

The once unthinkable prospect that US government debt might lose its AAA rating has suddenly become a real possibility. In fact, it now seems about as likely as not. The problem is not so much “can’t pay” but “won’t pay”. The US, like quite a few other countries, has some fairly serious fiscal imbalances, but they aren’t pressing in the short run, and there is plenty of capacity to raise additional revenue or cut spending so as to stabilise the ratio of debt to GDP at a sustainable level.

The problem is that even with a stable debt/GDP ratio the total value of outstanding debt keeps growing and the US Congress requires periodic votes to approve this. They are usually the occasion for some grandstanding, but this time the Republican majority of the House of Representatives is seriously threatening a refusal, unless the Democrats agree to massive (and still unspecified) spending cuts. The due date for raising the debt ceiling passed a while ago, but an actual default is being staved off by some sharp accounting tricks, which will apparently work until 2 August. The other day, to prove they are serious, the Repubs introduced a motion for an increase in the debt ceiling, with the express purpose of voting unanimously against it, which they did.

At this point, loud alarm bells have started ringing for the big ratings agencies, Standard&Poors and Moodys. They will have to decide, well before August, whether to downgrade US government debt and if so by how much.

The problem is essentially a political one. For anyone who is following the news, the fact that the US might default is obvious, and there is no reason (especially in view of their appalling performance leading up to the GFC) to think that the ratings agencies have any insights unavailable to the rest of us. But they have to make a choice and that choice will have significant financial, economic and political implications.

If the standard treatment applied to other governments were followed in this case, the downgrade would already have taken place. While it’s still more likely than not that some way of avoiding default will be found, the stated positions of the two sides are so far apart that there must be a significant probability, at least 10 per cent, that they will fail to agree. A security with a 10 per cent chance of defaulting in the next few months would normally be rated among the worst of junk bonds.

That’s not the whole story of course. Most of the time when bond issuers default, the bondholders’ money is lost for good. It seems nearly certain that even if default took place, the period in default would be short, and the US would pay interest and principal in full. Nevertheless, nearly certain isn’t certain, and once something as unprecedented as a default took place, anything could happen.

More importantly, the US government isn’t “other governments”. The ratings agencies are US firms operating in a US political context, and their actions will be governed by a mixture of concerns, starting with self-preservation, but also including a desire to influence US policy in a way favorable to bondholders as a group. In the medium term, that means support for a rapid return to budget balance or surplus, ideally through cuts in spending on the poor and middle class, but including tax increases if necessary.

The short run picture is more complicated. Avoiding default is presumably the main concern, but if that could be achieved by a Dem capitulation to demands for large spending cuts, so much the better. On the other hand, maintaining any kind of credibility requires a downgrade well before defalt actually takes place, and probably a series of downgrades as the deadline approaches. Even a single downgrade would throw financial markets into disarray (among other things, investors who are required to hold AAA assets would have to dump Treasuries and, presumably, buy the bonds of other governments). That in turn would place huge pressure on the Republicans. While the idea of “not raising the debt ceiling” polls pretty well, the reality of “destroying the US credit rating” probably won’t.

The most likely response seems to be an increasingly loud set of alarms about the need for a short-term agreement on the debt ceiling, combined (both becuase the agencies want it and because they need to placate the Repubs) with warnings about the need for a rapid return to fiscal rectitude. That’s not in fact what is needed (rather the US needs more stimulus now combined with a substantial increase in tax revenue in the long term), but it’s a message that will play well among the Serious People in Washington.

We’re already seeing this, with mid-July mentioned as crunch time. The problem is that the warnings may well not be enough. There’s no sign that the Repubs are willing to give an inch on tax increases. Agreeing to the cuts they want, with no tax increases would be politically suicidal for the Dems, which is not to say they won’t do it, but must raise the possibility of a breakdown.


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