Tag: Debt

Which Rating Agency Downgraded the U.S. First? Not S&P

The S&P downgrade of U.S. credit has understandably dominated headlines, but S&P was by no means the first mover. At least three other rating agencies had already downgraded the United States.

Egan-Jones was the first Nationally Recognized Statistical Rating Organization (NRSRO) to downgrade. It lowered the U.S. rating from AAA to AA+ in mid-July. NRSROs are the companies that the SEC officially recognizes as credit rating agencies. They number ten in total, with Fitch, Moody’s, and Standard & Poors the most famous (or, in some circles, infamous).

Weiss Ratings was the first U.S.-based rating agency to rate the U.S. below AAA. It initiated official coverage in April at the equivalent of BBB and lowered to the equivalent of BBB- in mid-July, just one notch above junk. Back in May 2010, Weiss challenged the three major agencies to downgrade the United States, but hadn’t yet rated the U.S. itself. Weiss is not an NRSRO.

And then there’s Dagong, the Chinese rating agency. It initiated coverage with a AA rating in July 2010. It then cut the U.S. to A+ in November and to A last week.

So who was first?

Weiss if you count its May 2010 announcement that the U.S. ought to be downgraded. Dagong if you go by the first published rating below AAA. And Egan-Jones if you focus on the NRSROs.

Anyway you slice it, though, S&P wasn’t first.

S&P may want to make that point during the inevitable congressional hearings in September. And committee staffers should consider inviting Weiss or Egan-Jones as well.

ht: Dan D. and David M.

P.S. Apologies for the lack of links; I am writing on an iPad today, and it’s a nuisance to add them.

S&P’s $2 Trillion Error

In the final hours before Friday’s historic downgrade, Standard & Poors gave Treasury an advance copy of its report. Amazingly, that report contained a $2 trillion error in its calculations of U.S. deficits and debt over the next decade. Here are four things you should know about it.

1. Treasury hoped that S&P would change its decision in light of the error, but S&P shrugged it off as not material. 

In a blog post, Acting Assistant Secretary for Economic Policy John Bellows described what happened when the error was discovered:

After Treasury pointed out this error – a basic math error of significant consequence – S&P still chose to proceed with their flawed judgment by simply changing their principal rationale for their credit rating decision from an economic one to a political one.
On Saturday morning, S&P issued a clarification / rebuttal acknowledging the error, but downplaying its importance:

The primary focus [of our analysis] remained on the current level of debt, the trajectory of debt as a share of the economy, and the lack of apparent willingness of elected officials as a group to deal with the U.S. medium term fiscal outlook. None of these key factors was meaningfully affected by the assumption revisions to the assumed growth of discretionary outlays and thus had no impact on the rating decision.

2. Despite S&P’s claim, $2 trillion would “meaningfully affect” “the trajectory of debt as a share of the economy.”

It’s own revised calculations show net general government debt hitting 85% of gross domestic product in 2021 instead of 93%. That’s a big difference.

The 85% figure is still uncomfortably high and may well not deserve a AAA rating. But S&P was too dismissive in its clarification.

3. The error is understandable but remarkably sloppy for such an important analysis. 

The source of the error is painfully familiar to anyone who deals with U.S. budget projections. S&P’s analysts didn’t use the right measuring stick — i.e., the right budget baseline — when analyzing the effects of the recently-enacted Budget Control Act.

In one sense, it’s easy to see how this error happened. Budget discussions are now hopelessly confused by a profusion of different baseline projections of what spending and revenues will look like in the future. Indeed, I have devoted multiple posts to clarifying how different revenue baselines fit together (e.g., here and here). I’ve even used Johnny Depp to highlight the challenge.

A similar challenge exists with discretionary spending. Official budget baselines assume that annual appropriations (the defense and non-defense spending Congress fights over every year) grow with inflation unless subject to an explicit cap. That was the basis, for example, for the official baseline that the Congressional Budget Office used in evaluating the impacts of the Budget Control Act.

Before the BCA, there were no discretionary spending caps, so annual budget authority was assumed to grow with inflation from the most recent appropriated levels. The BCA then generated $917 billion in budget savings by setting annual spending caps below those levels.

S&P messed up because it based its analysis on another baseline. That “alternative fiscal scenario” assumes that discretionary spending grows at the same pace as the overall economy, not just with inflation. That baseline implies much more spending and debt over the next decade — $2 trillion more, in fact — than the official baseline.

So, again, it’s easy to see mechanically how this error happened. But it’s still remarkably sloppy. Budget experts are well-aware of the problem of multiple baselines. Indeed, we all pepper our conversations and analysis with the question “what baseline are you using?” It’s stunning that S&P didn’t have multiple analysts asking the same question to make sure their original numbers were right.

4. S&P’s response to the error further demonstrates that its primary concern about the United States is political not numerical. 

As S&P said in Friday’s report:

Our opinion is that elected officials remain wary of tackling the structural issues required to effectively address the rising U.S. public debt burden in a manner consistent with a ‘AAA’ rating and with ‘AAA’ rated sovereign peers. In our view, the difficulty in framing a consensus on fiscal policy weakens the government’s ability to manage public finances and diverts attention from the debate over how to achieve more balanced and dynamic economic growth in an era of fiscal stringency and private-sector deleveraging.

In short, S&P worries that America won’t get its act together in time.

Five Things You Should Know About the S&P Downgrade

On Friday night, Standard and Poors announced that it was downgrading U.S. long-term sovereign debt from AAA to AA+, the first such downgrade in U.S. history.

Here are five things you should know about the downgrade — four important, one trivia.

1. S&P downgraded U.S. debt not only because of the deteriorating fiscal outlook, but also because of concerns about America’s ability to govern itself. It said:

The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options. In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability.

2. Moody’s and Fitch recently reaffirmed their AAA ratings on U.S. sovereign debt. On Tuesday, Moody’s reaffirmed its Aaa rating, but assigned a negative outlook given the risk that the U.S. might flinch from further fiscal tightening, borrowing costs might rise, and the economy might weaken. Fitch similarly reiterated its AAA rating on Tuesday, but noted that it would have a fuller reassessment by the end of August. Fitch also emphasized the need for further fiscal adjustments.

One issue (on which I haven’t seen much discussion) is how the impact of a downgrade would increase if it spreads from just one rating agency to two or three.

3. In the past thirty years, five nations — Australia, Canada, Denmark, Finland, and Sweden– have regained a AAA rating after losing it. See, for example, this nice chart from BusinessWeek:

America still has much to learn from other nations that fixed their economies and budgets after financial crises. Sweden, for example, did a remarkable job addressing the fiscal challenges that followed its financial crisis in the early 1990s.

4. This downgrade may set off a cascade of further downgrades for other U.S. debt. The federal government provides an implicit or explicit backstop for many other debt securities. For example, the federal government stands behind trillions of dollars of debt and guarantees issued by Fannie Mae and Freddie Mac, GNMA securities, and securities backed by guaranteed student loans. It implicitly stands behind systemically important financial institutions. And it provides substantial support to state and local governments. S&P did not specifically address these other credits in Friday’s report, but did say that:

On Monday, we will issue separate releases concerning affected ratings in the funds, government-related entities, financial institutions, insurance, public finance, and structured finance sectors.

S&P did reaffirm its highest, A-1+ rating on U.S. short-term debt, which should limit impacts on money market funds and other short-term lending markets.

5. S&P was not the first rating agency to downgrade U.S. sovereign debt. In the category of trivia, China’s Dagong credit rating agency downgraded U.S. credit to A with a negative outlook earlier this week. Dagong had initiated U.S. coverage with a AA rating about a year ago, which was lowered to A+ last November. Dagong apparently views the United States as a greater risk than China. Despite all of America’s problems, that seems a stretch.

Update: In addition, Egan-Jones, a U.S. rating agency, cut the U.S. to AA+ in mid-July. Egan-Jones thus wins the prize as first U.S.-based agency to downgrade. Writing in the Financial Times, Michael Mackenzie noted:

Egan-Jones was officially recognised in 2008 by the Securities and Exchange Commission and, unlike its larger rivals, generates revenue from institutional investors and not from issuers of debt. During the past decade it downgraded US carmakers and structured credit products before similar decisions by the big rating agencies.

Thanks to reader Dan Diamond for pointing out the Egan-Jones downgrade.

Spain’s 1575 Default

If all goes according to plan, the hoopla over the debt limit will soon recede. Policymakers and analysts will move on to the next new thing. And, sadly, some fascinating questions will forever go unanswered. For example, which president would appear on the trillion-dollar coin?

 But if you are up for one last article about default, yesterday’s piece by Christophe Chamley at Bloomberg is a good one (ht: Donald M.). Chamley recounts Spain’s intentional bond default way back in 1575:

Spain, at the time, was the world’s sole superpower. Contemporaries described it as an empire “over which the sun never sets.” Yet the king needed the cities’ consent to borrow at a reasonable rate. And he needed it for a reason: The cities collected the taxes.

Each of the 18 main cities of Castile levied a special tax earmarked for long-term debt service. The level of this tax was set every six years through negotiation with the king. Tax collections were used first to pay off local long-term bondholders, with the rest sent to the central government. The local long-term bondholders were, in large part, the elderly living in the area. So local taxpayers realized that if they didn’t pay, their parents would be hurt. Thus, this precursor to Social Security had an effective enforcement mechanism — the ire of the elders.

But the king could only exploit this confluence of interests so far. The Cortes set the earmarked tax rate by majority rule, and that limited the king’s issuance of what were, in effect, his AAA securities. The king also issued other bonds secured by other, non-earmarked revenue. These securities were of a lower grade and sold at lower price.

Thanks to Philip’s expensive military adventures in the Netherlands and the Mediterranean, Spain’s debt had reached half of gross domestic product by 1573. At that point, the cities balked at paying higher taxes. For the next two years, they refused to budge in their confrontation with the king.

Finally, in September 1575, Philip took a circuitous route to outmaneuver the Cortes. He suspended payments not on the long-term debt, but on the short-term debt, which was owed primarily to Genoese bankers. The people cheered. Resentment against bankers ran as high then as now — perhaps higher, because the bankers were foreigners. The upshot, however, was default and a full-blown credit crisis.

 And then what? Well, as Chamley recounts, it wasn’t pretty.

Does the Gang of Six Cut Taxes or Raise Them?

Here’s a quick multiple choice quiz about the Gang of Six’s new budget proposal.

Over the next ten years, would the proposal:

a. Cut taxes by $1.5 trillion

b. Increase taxes by $2.0 trillion

c. Increase taxes by $1.2 trillion

d. All of the above.

If you answered (d), you have a fine future as a budget watcher (or you peeked at the answer from the last time we played this game).

The answer depends on the yard stick you use to measure changes in tax revenues. Unfortunately, people now use at least three different yard sticks.

The first, known as the current law baseline, assumes that Congress doesn’t change the tax laws on the books today. That means every temporary tax cut expires in the next two years, including the individual tax cuts enacted in 2001/2003 and extended in 2010, the “patch” that limits the growth of the alternative minimum tax, and the current estate tax.

The second, known as the current policy baseline, assumes those three temporary tax cuts all get permanently extended.

The third, known variously as the Fiscal Commission’s plausible baseline or the alternative fiscal scenario of 2010, assumes that those three temporary tax cuts all get extended with one big exception: the tax cuts that benefit “high-income” taxpayers expire.

With three different yard sticks, we get three different measures of the impact of the Go6 proposal.

Relative to the current law baseline, the Go6 plan would be a $1.5 trillion tax cut. In other words, the Go6 plan would raise $1.5 trillion less in revenue over the next ten years than if Congress did nothing, and all the temporary tax cuts expired. That’s an important number because the Joint Committee on Taxation and the Congressional Budget Office are required to use current law in preparing official budget scores.

Relative to the Fiscal Commission’s baseline, the Go6 plan is a $1.2 trillion tax increase. That includes three pieces: $1.0 trillion from reducing tax preferences (some of which may be the moral equivalent of cutting spending), $133 billion in new revenues for the highway trust fund (but not from higher gas taxes), and about $60 billion from using a lower measure of inflation – the chain CPI – to index the tax code.

Relative to current policy, finally, the Go6 plan is roughly a $2 trillion tax increase. In addition to the $1.2 trillion in tax increases noted above, it assumes an additional $800 billion in revenue – equivalent to what would be raised by allowing the “high-income” tax cuts to expire.* The Go6 plan would thus raise about $2 trillion more in revenue over the next ten years than if Congress simply kept in place the tax policies that apply in 2011 (except the payroll tax holiday, which everyone assumes will eventually expire).

Bottom line: You should expect to hear the plan characterized as anything from a $1.5 trillion tax cut to a $2 trillion tax hike.

P.S. For a similar discussion comparing two of the three baselines, see this nice piece by David Wessel of the Wall Street Journal.

P.P.S. What really matters, of course, is the plan itself, not how it scores against some possibly arbitrary baselines. Bob Williams makes that point here.

* I revised this sentence to emphasize that the plan includes revenue equivalent to letting the “high-income” tax cuts expire; it doesn’t actually let the rates expire – instead, it includes a wholesale reform that includes lowering the top rate to no more than 29 percent. 

Let’s Eliminate the Debt Limit

My latest column at the Christian Science Monitor:

America’s leaders need to get to yes on a budget deal – one that marries substantial deficit cuts with a much-needed increase in the debt limit.

But that’s not enough. Rather than merely increasing the debt limit, we should eliminate it.

I realize that sounds strange. With all the Sturm und Drang in the budget talks, you might think that the debt limit is essential to controlling Washington’s profligate ways. It’s not.

Washington has other tools for managing its finances. The annual budget process includes a series of steps by which Congress decides how much to spend and to collect in taxes. Those decisions determine the size of America’s deficits and debt.

That simple fact often gets lost in the debate, so let me say it again: When Congress decides how much to spend and how much to tax, it is also deciding how much to borrow.

Unfortunately, the debt limit allows lawmakers to pretend that they can separate the two. Members routinely try to wrap themselves in the flag of fiscal responsibility by voting against debt limit increases. In most cases, though, those members have also voted for spending and tax policies that make those debt increases necessary.

Votes on the debt limit thus usually reflect raw politics, not substantive policy differences. Everyone knows that the debt limit has to rise. But they also know that voters hate debt. So law-makers jockey to see who can win the right to vote no and who must bear the burden of voting yes.

Democrats opposed debt limit increases when President George W. Bush was in office and Republicans controlled Congress. Republicans returned the favor under President Obama and the Democratic Congress. The only times we’ve seen hints of bipartisanship are when, as now, divided government has placed some responsibility on both parties.

A larger problem is that the debt limit institutionalizes risky brinkmanship. In divided government, both parties must agree to raise the debt limit. If they don’t, the United States can’t pay all its bills. We might even default on our debt. That’s the economic equivalent of driving over a cliff.

Both sides would regret that outcome. But they face very different incentives. The party that holds the White House has to make sure that the government functions. That’s why Treasury Secretary Timothy Geithner has repeatedly warned Congress about the damage that would result if the debt limit isn’t raised in time.

But the opposing party wants to extract the highest possible price for agreeing to more debt. So they have to act as though hitting the limit is no big deal. That’s why many Republicans have been discussing the potential to prioritize payments (putting interest first), and some have flirted with endorsing temporary default.

The problem with that strategy is that negotiations can fail, prioritization might not work, or we might be surprised with a sudden need for funds. In short, we might accidentally go over the brink.

Even if we don’t, dancing on the edge is costly. Alone among major nations, the US talks openly about the possibility of default. Financial markets usually discount that rhetoric as mere politics. As the deadline nears, however, that rhetoric will sow doubt in financial markets, inspire warning shots from credit-rating agencies, and potentially increase our borrowing costs.

There’s no reason to subject ourselves to those needless costs. The debt limit is an anachronism. Congress should eliminate it.

P.S. In conjunction with the eliminating the debt limit, I would strengthen the existing budget process along the line the Bipartisan Policy Center’s SAVEGO proposal. We do need budget procedures to force action, just not the brinkmanship of the debt limit.

P.P.S. Reuters reports that Moody’s is also recommending the elimination of the debt limit.

A Big Error in the Senate Republicans’ Balanced Budget Amendment

Senate Republicans made a striking error in the balanced budget amendment they introduced last week. As written, the amendment would limit federal spending far more than those senators realize or, I suspect, desire.

The Republicans want the budget to be balanced by keeping spending down rather than by raising tax revenues. They thus propose limiting spending to no more than 18% of gross domestic product (GDP). That’s in line with average tax revenues over the past four decades, but well below average spending, which has been just short of 21% of GDP.

So what’s the problem? The way the amendment would implement the spending limit:

Total outlays for any fiscal year shall not exceed 18 percent of the gross domestic product of the United States for the calendar year ending before the beginning of such fiscal year, unless two-thirds of the duly chosen and sworn Members of each House of Congress shall provide by law for a specific amount in excess of such 18 percent by a roll call vote.

The amendment compares spending in one period (the upcoming fiscal year) to the size of the economy in an earlier period (the last complete calendar year). If the amendment were in force today, for example, spending in fiscal 2012, which starts in October, would be limited to 18 percent of GDP in calendar 2010. That’s a gap of 21 months.

As Bruce Bartlett pointed out in analyzing an earlier version of this amendment, that time lag can add up to big money. Why? Because both real economic growth and inflation will expand the economy during those 21 months.

The Congressional Budget Office projects, for example, that nominal GDP will grow about 4.5% annually in the latter part of this decade (the earliest the amendment could go into effect). Over 21 months, that works out to roughly 8% growth. The amendment would thus limit federal spending in those years to about 16.7% of each year’s GDP (16.7% = 18% / 1.08) not the advertised 18%. In 2020 alone that amounts to a difference of more than $300 billion in spending.

That’s a big error.

I doubt that Senate Republicans really want to limit spending to only 18% of GDP. Even the House Republican budget calls for spending of more than 20% of GDP for at least two decades. But if the Senate Republicans are serious, their first step should be to fix the drafting error in their amendment.

Playing with Fire with the Debt Limit

My latest column in the Christian Science Monitor:

America sometimes takes its exceptionalism too far.

Case in point: We are the only major economy that talks openly of default.

Government debt has ballooned throughout the developed world in the aftermath of the Great Recession. France and Britain are as deep in debt as the United States, for example, and Japan is much further in the hole.

But their leaders never mention the possibility of default. Why would they? If you have the ability to pay your bills, there’s no reason to scare your creditors.

But that’s exactly what we do in America. Treasury Secretary Timothy Geithner has been warning about the risks of default since January.

If we don’t increase the debt limit by early August, he tells us, default becomes a real possibility. And that could pose grievous risks to our already weak economy.

Many Republicans play down that risk. Echoing famed investor Stanley Druckenmiller, some argue that a temporary default would be acceptable if it’s part of a larger political strategy that brings future deficits under control.

But that is a dangerous game.

Large swaths of America’s financial infrastructure have been built on the assumption that US Treasuries pay on time. And financial markets would likely punish the US with higher interest rates if we defaulted. That’s what happened in 1979, for example, when back office snafus caused Treasury to unintentionally miss payments to some investors.

This time, Fitch, Moody’s, and Standard & Poors are threatening to cut the US credit rating if we choose to default. Given the risks, most observers recognize that default is not, and should not be, an option. The US is not a deadbeat nation.

But does that mean the debt limit has to go up in early August? Some Republicans say no because of a simple fact: Every month, the federal government collects more in taxes than it pays in interest. With careful cash management (which would likely have to start before the August deadline), Mr. Geithner should be able to prioritize debt payments and thus avoid debt default.

As best as I can tell, that argument is correct, but it’s hardly a reason for complacency. America is currently spending about $100 billion more each month than it collects in revenues. If we hit the debt limit, we won’t be able to pay everyone who is rightly expecting to be paid.

Geithner can and should ensure that our debtholders get paid.

But someone – perhaps millions of someones – won’t be paid on time. Contractors, federal workers, program beneficiaries, or state and local governments will suddenly find themselves short on their cash flow.

That won’t be good for the economy. Even though it’s not as bad as debt default, it still would paint the US as a deadbeat.

The US faces severe fiscal challenges in the years ahead. It’s perfectly reasonable that lawmakers want to combine an increase in the debt limit with efforts to rein in future deficits.

But that worthy goal should not weaken our commitment to paying – on time and in full – the obligations that we have already incurred.

As the debt limit draws near, our leaders should stop playing with fire and craft instead a plan to rein in future deficits without threatening our struggling recovery.

That’s a difficult balancing act, requiring tough compromises across the political spectrum. But as everybody knows on Capitol Hill and beyond, it would be the best step for the nation and our fragile economy.

It would also be exceptional.