Today in Econopolitics

dismal-scienceVictorian historian Thomas Carlyle famously called economics the “dismal science.”  It wasn’t hard to see why this week (even while important economic news was understandably overshadowed by the horrible events surrounding the Boston Marathon), as politics is getting in the way of some of the serious and substantive policy questions raised by some significant new academic findings. 

In research that has been featured prominently in the press and the blogosphere, three economists from the University of Massachusetts at Amherst have cast significant doubt on widely cited findings by Reinhart and Rogoff (RR) which seemed to demonstrate that countries which run up big debts (generally in excess of 90 percent of GDP) suffer a major penalty in terms of economic growth.  Continue reading

Digital Future, Dimly Foreseen

In my 7th grade music class, every student was required by Miss Perkins to give a report on a piece of music.  I picked a popular subject: Iron Butterfly‘s psychedelic hit, In-A-Gadda-Da-Vida. It was a 17 minute reflection of or on something-or-other. My “research” was straight off the album cover (for those of you who remember what album covers were).  “Iron” signifies heavy, man, and so on. I worked hard to learn the drum solo too.

For those of you looking for a frame of reference, Kevin and Winnie Cooper of The Wonder Years are exactly my age and year in school and In-A-Gadda-Da-Vida was playing in the first kiss episode from the 8th grade where Kevin and Winnie are at their first couples party and they head to the make-out room.  That episode also features The Turtles‘ terrific Happy Together. Anyway, here’s the song, which we thought sounded like the future, and a pretty exciting (if drug-induced) one at that.

 

I wanted very much to be groovy but wasn’t.  It didn’t stop me from trying, however, as with my silly report. In-A-Gadda-Da-Vida indeed.

And my parents — founding members of the Establishment that I saw them to be — were anything but groovy and, in fact, were unalterably opposed to anything with even a whiff of groovy.  They were even…Republicans.

To be clear, my parents were hardly of the “country club Republican” sort.  We didn’t belong to a country club.  In retrospect, there was nothing “establishment” about them either.  Neither of them went to college. We didn’t own or run a business. My mom worked outside the home. We weren’t anything remotely close to rich. 

But we were Republicans. Hard work was good.  Entitlements were bad.  Saving was good.  Profligate spending was bad.  Traditional values were sacred.  The idea of turning on, tuning in and dropping out was anathema. Our leaders — all authority figures really — deserved and got our respect if not necessarily our support (Jacob Javits was pretty liberal, after all).

Vietnam was an unfortunate but necessary evil.  Dick Nixon hadn’t been their first choice (or second or third), but he would deal with those hippies and the Soviets too. Watergate (waiting just over the horizon) was horrible and wrong, but it was also stupid and silly.  Nobody was going to vote for McGovern anyway. And FDR had done stuff just as bad.  We were sure of it.

Our government was a creeping socialism and politicians weren’t statesmen anymore.

The clothes worn by “the youth” were just plain bizarre. So was the hair.  So was the lingo.  And the music….

So whenever my school lessons featured FDR saving us from the Great Depression, my parents were quick to point out that it wasn’t FDR.  It was World War II. 

They weren’t wrong, of course.  Producing and distributing what we needed to fight the Axis powers propelled the country out of the Depression and went a long ways toward making us the strongest and greatest economy in the world, not to mention the #1 (with a bullet, literally and figuratively) superpower. 

To hear Paul Krugman tell it, the key was demand (it didn’t and doesn’t matter for what) and we can fix the current mess by spending our way out of it just like FDR did.  As Keynes argued in the 1930s, the only solution in such circumstances is major fiscal stimulus to close the gap between actual and potential output. TARP wasn’t enough.  QE1 wasn’t enough.  QE2 wasn’t enough.  Operation Twist wasn’t enough.  QE3 won’t be enough.

I get his point, but he’s missing something crucial, I think, besides the reality that all the demand we spur will need to be paid for eventually and we have shown no willingness to do so even assuming we had the ability.  It wasn’t just that WWII put people back to work. There was a fundamental change in the nature of the output.

A key problem during the Great Depression was that increased (and increasing) productivity meant that a largely rural and agrarian workforce didn’t have nearly enough work to do.  The War, essentially by force, transitioned that work force to the cities and into industrial and manufacturing jobs. Once the war was over, heavy-duty military spending was still necessary to maintain our new-found status and the other stuff we produced was being used here and shipped abroad too as American hegemony was extended around the globe.

Today, increased (and increasing) productivity and cheaper labor overseas leaves our workforce underemployed again.  Since the internet boom of the 1990s, we have recognized — if dimly — that our future is a digital one.  But we haven’t yet figured out how to make the transition and there has been no great catalyst (the way the War was then) to force and complete the “creative destruction” needed to make the structural shift once-and-for-all.  The process is a messy one.  It is often unpleasant.  Workers will be pushed out of their comfort zones or even displaced. Some individual results will be unfortunate, tragic even. Creative destruction is still destruction.

Even so, we piddle along, on a slow boat not-even-to China.  Today’s employment numbers provide another series of data points reiterating the obvious.  We have no idea (economically speaking) where we’re going and thus, of necessity, have no idea how to get there.  We’re stuck between preserving a past that no longer works and attempting to forge a future that is unfocused and uncertain (Facebook, anyone?).  The alleged “new economy” isn’t defined a whole lot better today than it was back when almost any kid with a computer and a dream could get a boat-load of start-up money.

The process of “making the future” (to use President Obama’s phrase) is an inductive one that progresses primarily by discovering what doesn’t work so as to ascertain, oh-so-tentatively, what might work.

As the expression goes, if you don’t know where you’re going, any road will take you there.  Unfortunately, today we don’t even seem to be moving much at all. And while we have a pretty good idea what the future consists of, we don’t know what it ought to look like.  Until we do, it’s going to be hard for us to put this Great Recession behind us, no matter how much demand we spur. As my friend Tom Brakke noted on Twitter when he read this piece, economy-wise, we’re not In-A-Gadda-Da-Vida.

Not by a long shot.

Krugman v. Summers

Felix Salmon has published an interesting summary of a debate in Canada last night featuring Paul Krugman and Larry Summers (more here, herehere and here).  The question presented was whether “North America faces a Japan-style era of high unemployment and slow growth.” Krugman thinks so while Summers does not.  As described by Salmon, the heart of the dispute was as follows.

They both quoted Keynes as diagnosing “magneto trouble” — the engine of the economy is broken, and it needs to be fixed. Summers has faith that, in Churchill’s phrase, “Americans can always be counted on to do the right thing, after they have exhausted all other possibilities” — the right thing, here, being to fix the magneto with expansionary fiscal and monetary policy. Krugman, by contrast, sees political gridlock as far as the eye can see, and says that it doesn’t matter how innovative or philanthropic or demographically attractive the U.S. is — if you don’t fix the magneto, the car won’t start, and America’s magneto ain’t gonna get fixed any time soon.

Not surprisingly, I think they’re both wrong and think that David Rosenberg (who was aligned with Krugman for the purposes of the debate) is much closer to the truth than his partner is.  Krugman remains convinced that a the problem with the stimulus implemented so far is that it wasn’t nearly extensive enough.  In his view, much greater borrowing and spending would fix what ails the economy (to be fair, I agree with Krugman that political gridlock will make any solution requiring a political contribution likely to fail). As he wrote in The Return of Depression Economics and the Crisis of 2008, “A recession is normally a matter of the public as a whole trying to accumulate cash (or, what is the same thing, trying to save more than it invests) and can normally be cured simply by issuing more coupons.” 

The question, then, is if this time is “normal” or if the problem is so severe that a few “coupons” won’t do the trick.  Rosenberg is in the “so severe” camp.  He thinks that we’re at the beginning of a massive and worldwide deleveraging that will be necessary before we see substantial economic improvement.  In his view (and that of people like Ken RogoffSteve Landsburg, McKinsey and me), you can’t fix an over-indebted economy by piling even more debt onto it. 

We simply cannot expect people to start spending more when (a) they’re trying to get themselves out of hock; (b) they continue to perceive themselves as financially at risk; (c) the house they have (which may be underwater) cannot be expected to appreciate nearly enough to bail them out; and (d) they keep hearing and seeing why they need to be saving more for the future (especially for retirement) rather than spending.

U.S. Downgrade Deserved

S&P’s decision to downgrade the debt of the United States was understandably controversial.  But it was right. 

INTRODUCTION

Standard & Poor’s recently downgraded the credit rating of the United States by one notch for the first time in the history of its ratings.  With respect to sovereigns specifically, per S&P:  “Sovereign credit ratings reflect Standard & Poor’s Ratings Services’ opinions on the future ability and willingness of sovereign governments to service their debt obligations to the nonofficial sector in full and on time.”

The symbolic difference between AAA and AA+ may be great, but the substantive difference is not.  As described by S&P, “[a]n obligation rated ‘AA’ differs from the highest-rated obligations only to a small degree. The obligor’s capacity to meet its financial commitment on the obligation is very strong.” 

With respect to the downgrade, therefore, the appropriate question is whether S&P is correct that the U.S. is or can reasonably be expected to be slightly less able or willing to pay its obligations going forward.  In my estimation, the answer to this question is clearly “Yes.”

ANALYSIS

Criticism of S&P’s actions has centered upon three main contentions.

  1.  S&P has no credibility[1];
  2. There is no question as to the ability of the U.S. to pay its obligations[2]; and
  3. S&P has no business evaluating political risk (a sovereign’s willingness to pay).[3]

Let’s look at these contentions in turn.

1.       S&P Credibility

S&P and all of the ratings agencies have been under significant pressure since at least the 2008-2009 financial crisis when they rated dangerous securitized mortgage-backed paper as AAA while being paid enormous fees for doing so by the sponsoring banks.  The Financial Crisis Inquiry Commission claimed that S&P and Moody’s were “key enablers of the financial meltdown.”  A Senate panel accused the ratings agencies of engaging in a “race to the bottom” to assign top grades on sub-prime securities in order to win fees from banks. The Justice Department is now said to be investigating S&P for improper conduct in rating these securities. 

The agencies also missed the Lehman Brothers bankruptcy, missed the AIG collapse and are still struggling to handle mortgage debt properly.  Moreover, S&P didn’t downgrade Ireland (once AAA) until long after its financial problems had become obvious and the price to buy insurance on its debt had increased tenfold from a year earlier.  Its dealings with Greece were similar.  And, don’t forget, Enron and WorldCom were once AAA. Some go so far as to suggest that ratings agencies have surpassed their usefulness and that they ought to be ignored.

Moreover, the S&P process is not a transparent one, and the ratings agencies as a whole have a poor record of predicting sovereign defaults. Indeed, S&P’s ratings have not performed very well (as Nate Silver does a good job pointing out here) even as a general indicator of future financial health. As a consequence, the SEC is weighing sweeping new rules designed to improve the quality of ratings in light of their poor performance during the financial crisis.  Of course, S&P vigorously opposes such changes and, on August 8, issued an 84-page letter of protest.  S&P has also balked at an SEC proposal to reveal ratings errors.  Not surprisingly given the controversy over the downgrade, S&P President Deven Sharma has announced that he is stepping down.

S&P did not help its credibility during its review of the U.S. credit rating by making a major analytical error with respect to debt calculation.  Immediately after the downgrade announcement, a source familiar with the discussions said that the Obama administration had demonstrated that the original S&P analysis contained “deep and fundamental flaws.”  The Treasury’s official response to the S&P downgrade made that point and showed that S&P had indeed made a mistake in its debt-sustainability calculations. Accordingly, Treasury claimed that “the credibility and integrity of S&P’s ratings action” must be called into question.

Treasury Secretary Timothy Geithner claimed that the “S&P decision to cut U.S. credit rating shows stunning lack of knowledge about basic U.S. fiscal budget math.” He also accused S&P of “terrible judgment.” Of course, this is the same Tim Geithner who had earlier proclaimed that there was “no risk” of such a downgrade. The Senate Banking Committee is looking at reviewing the downgrade, which Committee Chair Tim Johnson called “irresponsible.”

S&P responded with a statement that conceded the error and lowered its forecast for the U.S. debt-to-gross domestic product ratio in 2015 by two percentage points.  S&P’s original calculations showed net general U.S. government debt hitting 93% of gross domestic product in 2021.  The corrected figure is 85%. However, while S&P did remove a prominent discussion of the economic justification from its analysis, it also stated that these revisions did not change its decision to affect the downgrade.  

The magnitude of this error is particularly noteworthy in that the original 93% figure and the corrected 85% figure bracket the economic and policy guidance offered by economists Carmen Reinhart and Kenneth Rogoff, authors of the outstanding This Time is Different.  Their work showing how countries that reach a 90% ratio slide into recession and see slowing growth well before that has become increasingly important in this area. The current level in the U.S. per S&P is 74% and, as noted above, will rise to 85% (but not 93%) by 2021. S&P’s rationale for the downgrade closely tracks the Reinhart/Rogoff logic, even after the correction.  Had S&P been able to establish a move to 90% or above, its case would have been much cleaner and easier to make in light of this influential research. 

But whatever else is happening here, by refusing to accept an issuer’s approach, rationale and models (in this case, the issuer is the United States), S&P is not repeating its past mistakes.  Indeed, on account of S&P’s past issues and damaged reputation, we should not be surprised when its ratings decisions are biased toward making sure it does not miss future problems.  S&P’s downgrade decision should be evaluated strictly on its merits and not based upon past problems. 

2.       U.S. Ability to Pay

At the most straightforward level, the U.S. need never default on its debt because it can simply print money to pay it off. But that is not the only appropriate credit consideration.  Relative credit weakness matters and the U.S. is decidedly weaker today from a financial standpoint than it has been in the past.  The ability of the U.S. to pay its debts has been compromised in a very real – if not crippling – sense.

U.S. gross debt stands at $14.5 trillion and unemployment is 9.1%. Except for a brief period at the peak of the business cycle around the turn of the century, deficits have been a constant for decades, as shown below. 

Source:  Congressional Budget Office

Federal revenue has fallen substantially over the past several years for a variety of reasons (I detailed them here), exacerbating the problem.  Receipts are far short of revenues, as illustrated below.

Revenue was 14.9% of the economy in 2009 and 2010, the least since 1950, according to the Office of Management and Budget.  At the same time, total U.S. debt generally and as a percentage of GDP has grown substantially, as illustrated below for the period from 1962-2010.

Sources:  Federal Reserve Bank of St. Louis and Bloomberg

Until recently, post-WWII tax revenue had tended to hold fairly steady at about 19.5% (“Hauser’s Law”) irrespective of the highest marginal tax rates (see below, from Political Calculations).

Accordingly, the current figure of less than 15% is a dramatic decline.  The recent debt ceiling deal provided for almost no immediate debt relief and surprisingly little relief longer term (more here), as shown below.  The economic problems described by S&P are real, substantial and growing.

As noted above, S&P projects that U.S. debt will reach 85% of gross domestic product within a decade.  According to S&P, that debt level approaches an “inflection point on the U.S. population’s demographics and other age-related spending drivers,” so as to accelerate potential problems. S&P notes that the debt agreement “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.” Per the CBO:  “The retirement of the baby-boom generation is a key factor in the nation’s long-term fiscal outlook. It portends a significant and sustained increase in the share of the population receiving benefits from Social Security, Medicare, and Medicaid.” The debt problem is obvious and growing and there seems to be no limit on the federal government’s desire both to enlarge the problem and to push it into the future and onto future generations.

I do not doubt that U.S. bonds are money good.  But that does not mean that the ability of the U.S. to pay its debts has not been impaired.  Even so, despite the obvious financial issues, it is unlikely that S&P would have downgraded the U.S. without the political problems highlighted in its report. 

3.       Evaluating Political Risk

I worked on a landmark $1 billion Chinese government global bond deal in 1994.  The deal did not go well.  To be fair, it struggled for a variety of reasons.  The Fed was tightening and interest rates were rising.  The managers of the deal (including my firm) wanted it to price at an extremely tight level to show what great execution they could get so as to obtain future deals and future business from the Chinese. Indeed, the deal priced at too tight a level and the managers were stuck with a lot of bonds and lost a lot of money (but they did end up getting a lot more business later). 

A significant (if largely unexpressed) reason for the deal’s problems was political risk, a type of risk that is exceedingly difficult to quantify since it is predicated not upon financial realities, but upon the whims of people.  There was no real concern about China’s ability to make good the bonds.  Even then, China’s economy had great potential and the government had substantial assets.  The problem was not really China’s political stability (or lack thereof).  Nor was it a hangover from the 1989 protest and massacre in Tiananmen Square (although some were nervous about a recurrence). 

At that time, the Chinese had not had a great deal of international capital markets experience, and the experience they had did not bode well for the future.  You see, in a few relatively minor transactions that didn’t go their way, the Chinese had shown an unfortunate willingness to walk away without paying Wall Street as agreed. The problem was not ability to pay, it was willingness to pay. 

Unlike other ratings agencies, S&P’s approach emphasizes subjective considerations about a country’s political environment, and is much criticized as a consequence. That approach, while difficult to implement, makes perfect sense.  As a creditor, my debtor’s cash position means absolutely nothing if that cash is not used to pay the obligation owed to me in full and on time. 

The S&P statement is clear that political risk was crucial to the downgrade decision:

“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….

“[W]e have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration … to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics any time soon.

“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.”

As The Economist points out, “whatever the flaws in its financial logic, S&P’s political analysis is spot on.  … The agency says that its decision was based not only on the modesty of the savings contained in the final deal hammered out by Republicans and Democrats but also on the way the agreement was reached.”  As Elizabeth Drew summarizes:

“This country’s economy is beset with a number of new difficulties, among them that recovery from the last recession remains more elusive than was generally expected, while the US is confronting a variety of international economic instabilities, especially the large debts and possible default of several countries in the [E]urozone, bringing on unpopular austerity measures. Recent experience with what should have been a simple matter of raising the debt ceiling, normally done with no difficulty, is reason for deep unease about our political system’s ability to deal with such challenges.” 

The failures of the recent debt ceiling debate are hardly new, if more obvious and more intense.  For example, as recently as last year the Simpson-Bowles Commission was appointed by President Obama to great fanfare, deliberated for a number of months, and provided a careful (if controversial) outline designed to identify “policies to improve the fiscal situation in the medium term and to achieve fiscal sustainability over the long run.”  It has been unceremoniously ignored by essentially everyone.   S&P’s decision represents its calculation that the ongoing debt problem, coupled with increased political discord such that a solution to the debt problem over the near to intermediate term is unlikely, merits the downgrade.

As Felix Salmon points out, “S&P and Moody’s can look at all the econometric ratios they like, but ultimately sovereign ratings are always going to be a judgment as to the amount of political capital that a government is willing and able to spend in the service of its bonded obligations. If Treasury really believes that S&P based its judgment fundamentally on debt ratios and the like, it’s making a basic category error about what it is that sovereign raters actually do.”

Simply put, a majority in Congress (consisting of members of both parties) has been and remains unwilling to require the federal government to live within its means[4] over the long-term while the President cannot or will not do anything about it.[5]  At the same time, a (different but still) majority in Congress (consisting of members of both parties) has been and remains unwilling to enact tax legislation sufficient to pay for the spending it has authorized while the President cannot or will not do anything about it.[6]  Democrats who complained loudly about budget deficits during the (most recent) Bush administration are silent now while Republicans who failed to criticize deficits during those years[7] are vocal about them now.  Finally, and perhaps most tellingly, there is little reason in the current political climate to expect one side to compromise if there is a significant chance that credit for any subsequent benefit will be attributed to the other side.  Today, political positioning seems to take precedence over the national interest far too often.

Meanwhile, neither stimulus nor qualitative easing appear to have not helped much to this point and, given the amount of debt already incurred, further action is not likely to help.  As I noted here, I agree with Ken Rogoff that the answer lies elsewhere[8] and that a different approach is needed.[9] 

There is also little left in the Fed’s toolbox now that it has pledged for the first time to keep its benchmark interest rate at a record low at least through mid-2013. Stimulus policy has a chance to work when governments have the capacity to take on more debt without harm.  But we may well be past that point now.  Additional debt will likely create further problems that will result in a bigger crisis later. 

The actions of the U.S. government suggest that its highest ideal is “kicking the can down the road” as long as possible. Irrespective of who has the better case to make, Republicans are clearly inclined to reduce debt but will not authorize additional revenues and appear to have the votes to maintain that approach.  At the same time, Democrats are clearly inclined to maintain current programs without reduction.  Indeed, there is little reason to suspect that if the Democrats prevailed and negotiated a delay in dealing with U.S. debt in order to deal with what they see as more pressing matters (which, in the current political climate, is not going to happen), that they would actually deal with the debt problem after the crisis passes.  Classic Keynesian economics requires restraint.  Deficits are supposed to be temporary rather than structural.  Loose monetary policy is supposed to be temporary, not lingering. Even if we allowed more “pre-heating” of the economy and even if we turned up the heat to boot, there is no reason to think that Democrats would turn off the stove once matters improve.

The markets have not reacted well to the downgrade announcement and politicians have predictably blamed each other.  Rep. Bachman, the tea party favorite, called on President Obama to fire Treasury Secretary Geithner.  Even after the downgrade, Rep. Cantor joined Speaker Boehner to call on congressional Republicans to resist attempts by President Obama to increase revenue in an effort to reduce the nation’s debt.

Republican presidential candidate and former Massachusetts governor Mitt Romney blamed President Obama for the S&P downgrade. “America’s creditworthiness just became the latest casualty in President Obama’s failed record of leadership on the economy,” Mr. Romney said in a statement. Sarah Palin agreed via Facebook.

On the other hand, Sen. John Kerry (D-MA) called the situation a “tea party downgrade,” Former Democratic National Committee Chair Howard Dean claimed  that the opposition’s positions were “not founded in reality.”  Maryland Governor Martin O’Malley blamed Tea Party “obstructionism.” Massachusetts Rep. Barney Frank said that the downgrade of the U.S. government’s credit rating was the Republicans’ fault.

There is little reason to expect political leaders across the board to come together and reach any kind of serious solution.  The credit of the United States is thus impaired accordingly.

CONCLUSION

The major criticisms of S&P and its analysis are largely accurate.  S&P’s credibility remains a problem and the $2 trillion calculation mistake was a disgrace. Yet these realities miss the fundamental point. David Beers, global head of sovereign ratings for S&P, told CBS News that the downgrade was a reflection of the increasingly “unpredictable” nature of the debate surrounding U.S. economic decisions. Outgoing S&P President Deven Sharma, in a CNBC interview, pointed out that going from a AAA to AA+ rating “doesn’t mean [the U.S. is] going to default, it just means it’s more risky today than a year ago.”  They are surely right about that, and there is very little basis for optimism going forward. ,” As  Sharma summarized,. “our job is to tell the investor: This is where we think the risk is.”

Besides, those who wistfully long for the days of non-politically influenced ratings decisions are deceiving themselves.  Those days never existed.  The dollar’s status as reserve currency and the status of U.S. Treasuries as crisis investment of choice did not come about via fiat from the IMF.  They were earned based upon the reasoned judgment of investors – one at a time – with respect to their analysis of all relevant factors, many of which were and are political.  A ratings agency that does not consider political risk when evaluating sovereigns is simply not doing its job. 

S&P’s action can be seen as a clarion call with respect to the country’s eroding economic strength and global standing. Our need to regain the initiative through better economic policymaking and more coherent governance is clear. But instead of responding to that call, I fear that various political factions will continue to focus on S&P’s alleged lack of credibility, to blame everyone else, and to continue to forego real, substantive and increasingly necessary change. The S&P downgrade was entirely deserved.  It may have even been overdue.


[1] For example, Paul Krugman responded to the downgrade as follows: 

“[I]t’s hard to think of anyone less qualified to pass judgment on America than the rating agencies. The people who rated subprime-backed securities are now declaring that they are the judges of fiscal policy? Really? … 

“This is an outrage — not because America is A-OK, but because these people are in no position to pass judgment.” 

Robert Reich, Brad DeLong and Barney Frank (among others) took similar positions.

 [2] For example, President Obama responded (full speech here) to the downgrade by maintaining that “No matter what some agency may say, we’ve always been and always will be a triple-A country.” Treasury Secretary Timothy Geithner claimed that the “S&P decision to cut U.S. credit rating shows stunning lack of knowledge about basic U.S. fiscal budget math.” The Fed, the FDIC, NCUA, OCC issued a joint statement making it clear that “the risk weights for Treasury securities and other securities issued or guaranteed by the U.S. government, government agencies, and government-sponsored entities will not change.” Gene Sperling, director of the National Economic Council, combined criticisms 1 and 2 by asserting that “the magnitude of [S&P’s] error combined with their willingness to simply change on the spot their lead rationale in the press release once the error was pointed out was breathtaking.” Of course, a former Moody’s official disagrees with S&P too and is consistent with Warren Buffet’s view of the downgrade (note, however, that Buffet’s company owns a substantial stake in Moody’s and has an interest in pushing the Moody’s position vis-à-vis S&P’s). 

[3] For example, the OECD has objected to this practice. Similarly, Jeffrey Stibel, Chairman and CEO of Dun & Bradstreet Credibility Corp., writing for the Harvard Business Review, does not dispute S&P’s political analysis, but claims that “that is not the point of a credit ratings agency.” 

[4] This language, suggestive as it is of personal finance, is potentially deceptive.  In times of emergency (for example, World War II for the U.S.), governments may prudently spend substantially more than they take in to deal with the emergency.  My comments here relate to the U.S. government’s consistent and ongoing unwillingness to deal with both debt and deficits and thus “live within its means.” 

[5] To be fair, those deficit hawks elected for the first time in 2010 can hardly be painted with the hypocrisy brush, but one can still rightly question their actions.  Throughout the debate, House Speaker John Boehner described a debt-ceiling increase as a favor to President Obama: “He gets his increase in the debt limit” in exchange for meeting Republican demands on spending cuts without tax hikes. After the President capitulated, Senate Minority Leader Mitch McConnell boasted that the deal “creates an entirely new template for raising the nation’s debt limit. … Never again will any president from either party be allowed to raise the debt ceiling … without having to engage in the kind of debate we’ve just come through.”  Sen. McConnell even chortled that Tea Party loyalists in his party “thought the default issue was a hostage you might take a chance at shooting,” which taught the leadership that “it’s a hostage that’s worth ransoming.” 

Every Republican presidential candidate except Jon Huntsman came out against the final debt-ceiling deal. These candidates were, in effect, advising congressional Republicans to let the United States default. From a political standpoint, the Republican strategy was a tremendous success (at least to this point). There is no reason to expect the success of that approach (at least as it relates to perception) will not continue to drive Republican strategy. While the debt ceiling will not be dealt with again before the 2012 election, there is no reason not to expect every budget resolution to become a major (and partisan) budget referendum. The players see it as good politics, but S&P rightly recognizes that this political success comes with some major costs. 

Indeed, Republicans are already gearing up to oppose any and all tax increases.  No plan which seeks revenue growth (even by closing tax loopholes) will be countenanced.  “Over the next several months, there will be tremendous pressure on Congress to prove that S&P’s analysis of the inability of the political parties to bridge our differences is wrong,” House Majority Leader Eric Cantor wrote in a letter addressed to House Republicans. “In short, there will be pressure to compromise on tax increases. We will be told that there is no other way forward. I respectfully disagree,” the Virginia Republican added. House Speaker Boehner echoed Mr. Cantor’s position, noting that “raising taxes is simply the wrong approach.” Sen. Jeff Sessions, (R-AL) called tax hikes “unthinkable.”

Republican presidential candidates also remain committed to intransigence.    Rep. Bachman went so far as to label warnings of dire consequences on account of not reaching a debt ceiling deal as a “scare tactic.”  Moreover, all six Republicans nominated to the debt ceiling compromise “super committee,” which is supposed to effect additional debt reductions by November 23, have signed a pledge devised by Americans for Tax Reform to forswear all tax increases.  These leaders make it plain, from their perspective, that impasse is both necessary and desirable. Some Republicans unabashedly want to starve government to death (more here) and, accordingly, are not concerned that current revenues cannot possibly meet expenses.

[6] Democrats were similarly inclined but from the other side. They have offered precious little in terms of actual debt reduction.  Indeed, Democrats in both houses of Congress are essentially united on protecting Social Security and Medicare even though the White House concedes (video of President Obama here) that Medicare reform is necessary from a budget standpoint. As Elizabeth Drew points out, even “liberal-leaning budget analysts agree that the budget is on an ‘unsustainable’ path,” yet Democrats were not really interested in substantive compromise, particularly on entitlements. 

House Democratic Leader Nancy Pelosi was melodramatic in her attacks on the cuts in domestic spending that Republicans attached to the debt measure, minimal though they were. She commented that Democrats were trying “to save life on this planet as we know it.” She even asserted that the deal was probably a “Satan sandwich with Satan fries on the side.” Indeed, Democrats continue to oppose nearly all spending cuts and minimized the need for net reductions throughout the negotiations. Even so, Salon editor Joan Walsh accused the President of selling out “core Democratic principles.” On the other hand, Pelosi promises to “hold true to our values of protecting and strengthening Medicare, Medicaid and Social Security” going forward. 

To be fair to the Democrats, there is a reasonable argument to be made that while U.S. debt levels are a major long-term problem, the current economic crisis lies elsewhere.  Many economists are focusing on consumer demand, jobs and various ways to stimulate the economy.  As summarized by Ryan Avent of The Economist: “American growth dropped to stall speed in the first half of the year, and the government is content to saddle the recovery with substantial fiscal tightening over the next year. Europe is on the brink, and its leaders are on vacation. Falling markets will add to reduced confidence. At this point, the self-fulfilling spiral back into recession is underway.” Accordingly, focusing on debt and deficits *now* (what some wags are calling “deficit attention disorder”) is misguided.  However, given the general unwillingness of Democrats to make serious and long-term commitments to fiscal restraint, Republican skepticism about Democrats’ willingness to make such commitments after the crisis is surely understandable. 

[7] In late 2002, Vice President Dick Cheney summoned the Bush administration’s economic team to his office to discuss another round of tax cuts to stimulate the economy. Then-Treasury Secretary Paul H. O’Neill pleaded that the government – already running a $158 billion deficit – was careering toward a fiscal crisis (quaint, isn’t it?). But by O’Neill’s account of the meeting, Cheney silenced him by invoking his take on Reagan’s legacy:   “Reagan proved deficits don’t matter.” 

[8] “But the real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation.” 

[9] “Many commentators have argued that fiscal stimulus has largely failed not because it was misguided, but because it was not large enough to fight a ‘Great Recession.’ But, in a ‘Great Contraction,’ problem number one is too much debt. If governments that retain strong credit ratings are to spend scarce resources effectively, the most effective approach is to catalyze debt workouts and reductions.”

How to Respond to an U-G-L-Y Market

In today’s edition of The New York Times, Nobel Prize winning economist Paul Krugman of Princeton notes that the stock market is in terrible shape — which is obvious — while also making the point that the bond market highlights what is really going on. 

The US 10-year [note] rate is now down to 2.5%. So much for those bond vigilantes. What this rate is saying is that markets are pricing in terrible economic performance, quite possibly a double dip.

Brad DeLong of Berkeley agrees, as does Ryan Avent,economics correspondent for The Economist.  As Avent puts it:

WALL STREET is betting on a double-dip recession.

All financial-market signs now point to a return to economic contraction. The S&P 500 has dropped 9% in two weeks. American government borrowing costs are plummeting, which could conceivably be construed as a result of increased confidence in America’s finances in the wake of the debt-ceiling deal, except for three things: 1) the deal didn’t fundamentally improve America’s finances, 2) equities are tanking, and 3) so are inflation expectations. Yesterday afternoon, yields on inflation-protected Treasuries signaled a 5-year expected inflation rate of about 2.08%. That has since fallen to about 1.86%. The yield on 3-month debt is back to 0.0%, the yield on the 30-year Treasury is 3.79%, and 10-year yields are back to levels observed last August, which prompted the Fed to engage in QE2. Commodities are dropping like rocks—oil is back below $90 a barrel—except for gold, which continues to hit nominal highs. The dollar is also strengthening.

Ask why if you want; there’s no shortage of reasons. American growth dropped to stall speed in the first half of the year, and the government is content to saddle the recovery with substantial fiscal tightening over the next year. Europe is on the brink, and its leaders are on vacation. Falling markets will add to reduced confidence. At this point, the self-fulfilling spiral back into recession is underway.

Clearly, the news is ugly.

Krugman, DeLong and Avent focus their prescriptions on what the Fed should do in response.  But Ken Rogoff of Harvard and one of the authors of the outstanding This Time is Different suggests that the answer lies elsewhere

But the real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation.

Accordingly, he suggests a different approach.

Many commentators have argued that fiscal stimulus has largely failed not because it was misguided, but because it was not large enough to fight a “Great Recession.” But, in a “Great Contraction,” problem number one is too much debt. If governments that retain strong credit ratings are to spend scarce resources effectively, the most effective approach is to catalyze debt workouts and reductions.

I’m with Rogoff.