August 12, 2011

Final Word On S&P Downgrade. And A Way Forward.

August 12, 2011

Final Word On S&P Downgrade. And A Way Forward.

Before the S&P downgrade last Friday, I wrote the following about the debt deal:

I have said little about the default possibility simply because I estimated the possibility at near-zero. From my point-of-view what happened was an enormous and bogus media campaign getting people worked up about something an then an illusion that something had been done. This deal does absolutely nothing to address the enormous obligations under Social Security, Medicare and Medicaid. In fact the debt deal contrived precisely NOT to address these. This deal was 98% politics and 2% economics. It is clear to me that politicians are not able to address the issue of fiscal sustainability.

Before addressing what S&P said and the effects, let’s understand what S&P is.

S&P is a private company which expresses its opinions about the ability of borrowers to repay debt. It is one of the three long-standing NRSRO’s (Nationally Recognized Statistical Rating Organizations.) It is one of the three “majors.” The other two: Moody’s and Fitch did not lower their ratings from AAA but Moody’s did assign a negative outlook.

It appears that S&P had notions similar to what I said a week ago. I agree entirely with what S&P said:

– The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.

– 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.

I do not believe that what was recently passed “stabilize(s) the government’s medium-term debt dynamics.” What is happening is that partisans are being appointed and will be appointed to this new committee and it is likely that the issue will simply be (as S&P points out) subject to the unpredictability of “American policymaking and political institutions.”

S&P was hammered by Treasury for overestimating the debt/GDP ratio. There are at least two things wrong with Treasury’s math:

(1) it does not include debt which Treasury owes for the money it borrowed from the Medicare and Social Security trust funds. That is money which is an obligation and if this is counted then debt/GDP is almost exactly 100%.

(2) CBO has not done a good job of estimating future deficits. In 2001 CBO forecast average annual surpluses of approximately $850 billion from 2009–2012. The trustees of the Medicare trust fund may also be seriously underestimating the Medicare shortfall. The health care bill passed in 2010 mandated a > 20% decrease in what Medicare would be paying doctors starting next January. I will believe that when I see it.

What was passed has a trigger for reducing the deficit if the commission failed to achieve consensus. My thinking is “I’ll believe that when I see it.” Moreover, why are we continuing to ignore Simpson-Bowles? Simpson-Bowles was a broad based solution for achieving fiscal sustainability. It addressed everything including the issues which Congress has explicitly stated that it refuses to address: Medicare, Social Security and Medicaid. One last very sad point: four of the people appointed to the debt super commission voted against Simpson-Bowles.

S&P said that it was no longer worried about U.S. debt in the short term but was concerned about it in the medium term (5-10 years.)

There is much to criticize regarding S&P: they made a large error with the CBO data, they massively mis-rated mortgage debt aiding and abetting the mortgage mess and the, along with the other debt rating firms, have, at best, a spotty history of rating government debt. My subjective view is to agree with the heart of what they are saying simply because it is precisely what I have been preaching for the past five years.

The case here is a strage one. S&P expressed the opinion that it was the political process itself which makes fiscal sustainability difficult to achieve. It was subsequently criticized for getting involved in politics.

I am cursed with believing that what Jurgen Brauer and I proposed (an nonpartisan group to set the debt limit) is better that what this committee will come up with.

The standard reply I get to this suggestion is something along the lines of “politicians will not go along with that” and that is precisely the problem. The beauty of what we proposed is that it removes the responsibility of setting the debt ceiling from Congress and give them an important political “out”.

The question is simple: what is more likely to be a permanent solution … a one time partisan group of politicians or a permanent council of nonpartisan economists whose sole task is to regulated the debt ceiling?