It Doesn’t Take a Rating Agency to Tell Which Way the Debt Grows

After the close of the markets on Friday, S&P downgraded US long term debt from AAA to AA+.

This is news, but shouldn’t be a surprise.  The rating agencies are like the cop who draws the chalk line around the murder victim’s body.  They just validate the obvious.

No, the arithmetic tells all.  When the government spends roughly 25 percent of GDP, is currently generating revenue at less than 15 percent of GDP, and historically has had receipts no more than 20 percent of GDP, the debt will grow at between 5 and 10 percent of GDP per annum.  The debt is already at high levels, both historically, and relative to levels that have sparked fiscal crises in other countries.  The official debt, moreover, is only a fraction of the government’s commitments.  Add it all up and the blind should be able to see the writing on the wall.  It reads “fiscal crackup coming to a country very near you.”

The administration and its acolytes have two stock responses.  The first is to screech that S&P made a “math error.”  As John Taylor notes, it’s not a math error: it’s a disagreement about assumptions.  The administration claims S&P should have assumed that discretionary spending would grow at the rate of inflation.  You know, because all the king’s horsemen and all the king’s men have pinky sworn on it.  They passed a bill and everything.  In this scenario, due to real GDP growth, spending would fall as a fraction of GDP.

S&P assumed that discretionary spending would rise at 5 percent, roughly the rate of nominal GDP growth (real growth plus inflation).  In this scenario, discretionary spending as a fraction of GDP would remain constant.  Given the historical record, this may in fact be conservative.  But under this assumption, the increase in debt over 10 years totals $2 trillion more than the administration claims.

The administration and its pilot fish have also huffed that S&P’s analysis is “political.”  Uhm, isn’t sovereign risk all about politics?  If not, please tell me what the hell it is about.

The second response is purely political–and Orwellian.  It is to repeat ad nauseum the Big Lie that this is the Tea Party downgrade, attributable lock, stock, and barrel to the failure of the Tea Party caucus in Congress to even countenance taxes as a part of any debt ceiling deal.

Like all Big Lies, this one is based on a kernel of truth: S&P did explicitly mention the unwillingness of the Republicans to include tax increases as a part of any deal as one of the justifications for its decision.

But pinning the blame on the Tea Party is fundamentally dishonest because if its adherents had its way on spending and taxes, S&P would probably give the US a AAAA rating.  Indeed, the singlemost important thing driving the Tea Party is concern bordering on obsession that the country is headed into the fiscal abyss.  The Tea Party caucus’s objection to all the proposed debt ceiling deals was–and is–that the deals did not confront this existential problem in a serious way.   They thought that something has to be done now, and the looming debt ceiling would give them the leverage to make such a confrontation possible.  I think their tactics were counterproductive because they did not take into account the objective correlation of forces (to use the old Soviet military phrase).  But they were–and are–the only sizable group that is taking seriously the underlying structural problems that led to the downgrade.

Ask yourself this: if Obama had gotten his original wish, and the debt ceiling had been raised “cleanly”–no deals on spending or taxes–would S&P have downgraded the US?  I can’t see how it could have been otherwise.  If anything, the Tea Party rebellion made a deal with a higher likelihood of slower deficit growth possible.  Under any reasonably plausible counterfactual, it is highly likely that the objective factor that drove the S&P decision–i.e., debt growth–would have been higher without the Tea Party than with it, because the ancien regime would have just gone on with business as usual.  Which means that the downgrade cannot be credibly laid at the feet of the Tea Party.

The reason the divide between the Tea Party and the ancien regime is so wide is that the two factions have fundamentally different views of the problem, based on fundamentally different views of the proper scope and size of government.  The Tea Party doesn’t consider raising taxes to be a constructive part of any effort to address the problem because its members believe that spending is the problem, not the way the spending is financed.  They believe that the government is too big, it spends to much, it spends badly, and that raising taxes just extends, but only for a little while, the life of Destructive Leviathan–whom they would rather starve than feed.

In contrast, the ancien regime–which is dominated by the left, but which includes much of the Republican Political Class as well–doesn’t believe that the government is too big.  Many of them–especially in this administration and the progressives in Congress–think if anything the government is too small.  From that perspective, the only issue is how to fund Constructive Leviathan, which makes taxes the beginning and end of the conversation.  From this perspective, the Tea Party is completely unreasonable in its refusal to raise taxes, and hence responsible for the downgrade.

That’s the divide, and it’s an unbridgeable one.  That should be the issue on which the 2012 election is fought.  If that election produces a new correlation of forces that moves policy closer to the Tea Party ideal of less spending, entitlement reform, and tax reform, there is a very good chance that the US will be upgraded.  If, in contrast, it merely perpetuates the ancien regime–where continued stalemate would constitute perpetuation–we’ve only taken the first step on the Downgrade Trail.  And if Obama prevails, the rest of the trip is more likely to be a sprint than a stroll.

And I cannot close without reminding you all of Timmy! the Treasury Secretary’s unqualified assertion, repeated often, that a downgrade would not occur.  “No risk,” sayeth Timmy!  Asked a second time, Timmy! repeateth: “No risk.”

Another fail.

But be there gladness in your hearts, peasants, for Timmy! will stay through the 2012 election.  For nothing succeeds with this administration like failure.

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About Craig Pirrong 238 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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