Treasury Downgrade: A Shock But No Surprise

Nobody knows how Wall Street will react today when it digests Friday’s downgrade of U.S. Treasury debt by Standard & Poor’s. This is one of those situations, like the death of a close relative, which comes as a shock even when it is not a surprise.

But we carry on even after we lose someone dear to us, and we will certainly carry on after the credit downgrade. If stocks take a dive today, I would shrug it off as an emotional reaction to news that, in the first place, was not really news and, in the second place, has little direct effect on most companies. Stock prices are ultimately driven by profits. The downgrade alone is unlikely to have much impact on corporate profits.

There are plenty of other reasons for investors to be nervous about profits for at least the next year or two. Worldwide economic expansion is slowing. Nations whose economies are still growing smartly, like India, China and Brazil, are deliberately trying to cool things off because their inflation is already uncomfortably high and rising. Countries where growth has slowed virtually to a stall, including the United States, Japan and most of western Europe, are so burdened by debt and deficit that they are almost out of resources with which to put their private sectors back into growth mode.

Just as bad, there is no political consensus in any of those places behind policies that might persuade business executives to expand production and hire more workers. Businesses want labor flexibility, lower taxes, streamlined and sensible regulation, and enough political stability to anticipate that pro-growth policies will be sustained. The United States is not offering this package, and neither is Europe or Japan. Businesses currently proceed defensively as a result. Recent strength in corporate profits, despite the weak recovery from the recession, makes a good case that executives deserve high marks even as political leaders and central bankers skate by with, at best, barely passing grades.

Those same political leaders reacted with fury to S&P’s downgrade announcement. They were especially outraged that the credit agency, after acknowledging a $2 trillion error in its debt calculations (and in its press release), stood by its decision to reduce Treasury borrowings from AAA to AA+. Yet S&P correctly notes that last week’s deal raising the debt ceiling did nothing to fix the growth of entitlements, will not stop the enlargement of U.S. government debt relative to the size of the American economy (from 74 percent now to 85 percent a decade from now, according to S&P), and does not make it obvious that the two parties can agree on a credible long-term fiscal reform package.

Last year’s presidential budget commission came up with a package of sensible recommendations that the president ignored. This year’s congressional super-committee, evenly divided between the houses and the parties, is a recipe for gridlock, and even if it comes to some agreement, it still has to get legislation passed. Otherwise the series of automatic budget cuts that will go into effect, primarily to the Pentagon and to doctors and hospitals, is so draconian that some of those cuts are likely to be quickly reversed.

Nobody ought to blame S&P for concluding that Washington has not gotten its budgetary house in order. But plenty of people did blame S&P. The Obama administration, facing yet another piece of bad economic news as the president gears up his re-election campaign, launched an all-out attack. But there was criticism from Republicans too. Understandably so; the mess S&P identified has been at least a decade in the making, and both parties have helped make it.

The United States did not abruptly become a less-than-AAA risk on Friday. Friday just happened to be the day S&P announced its opinion. The two other big agencies, Moody’s and Fitch, have thus far not cut their own AAA ratings, though I think the only thing that can stop them from ultimately doing so is a reform of Medicare, Social Security and Medicaid next year, which is improbable, or maybe a somewhat less improbable GOP sweep of 2012 elections that convinces the agencies to wait to see what happens in the next Congress.

When did the United States really stop being a AAA credit risk? Possibly as early as the weeks after the 9/11 attacks, when we became suspicious of foreigners and hostile to the talent that wanted to come here to study and work. One of America’s greatest strengths has always been its ability to absorb the world’s entrepreneurial spirit. Even as China rose to economic prominence in the 1990s, its rigid political system and the memories of Tiananmen Square made the U.S. look more appealing as a place to start a business. This is far less true today. Chinese, Brazilians and other immigrants who might once have stayed here are far more likely to return to their home countries today.

Democrats argue that the Bush-era tax cuts of 2001 and 2003 undermined U.S. fiscal stability. Some Republicans ruefully point to the Medicare drug benefit that passed with GOP support, also in George W. Bush’s first term. Both arguments have some truth. But while Democrats now accuse Republicans of extremism in refusing to cancel the Bush tax cuts for upper income taxpayers, Obama and his party proudly refuse to restore the Clinton-era rates for, as Obama often notes, the 98 percent of Americans whose taxes he does not want to raise. As a result, Democrats favor a system that takes nearly half of American households off the income tax rolls, and encourages most citizens to look at government not as a service that they pay for, but as a source of lifetime financial support. This is not how a AAA-rated government should operate.

The failure of Bush’s 2005 proposal to reform Social Security, which came before the program became the net drain on national cash flow that it has been in the current decade, contributed the credit downgrade. So, too, did the massive health care reform Congress enacted last year in the political high point of Obama’s first term. Congressional calculations that the reform would reduce Washington’s deficit, even as tens of millions of people receive free or subsidized coverage, simply are not believable. The long-term fiscal burden on the states was all but ignored, though the same taxpayers who support Washington also must pay state and local taxes that are increasingly sucked up by Medicaid. At a time when federal finances were already deteriorating rapidly, passage of the health care legislation destroyed the national pretense that we are managing our affairs with the utmost prudence, which is what a AAA rating requires.

The AAA rating’s last line of defense is the Federal Reserve and its monetary printing press. Strictly speaking, S&P’s downgrade is misleading, because there is hardly any risk that the U.S. government will not pay its debts in full and on time. If necessary, it will print the money to do so. That money would of course be worth much less than lenders expected, and the Fed presently vows that it will not “monetize” the debt in this way. Given the consequences of an actual default, those vows are baloney. So S&P elevated substance over form, as it should, when it concluded that the U.S. is not a top-tier borrower anymore.

The only thing that is new in the markets today is that S&P finally came out and said what everyone was already thinking. The announcement will not enhance the calm that policy makers so desperately want to restore, but it provides no new information.

There is a silver lining in the S&P announcement. In the 17 months since health care reform passed, we have gone from piling new commitments on Washington’s tapped-out purse to talking about how we lost our AAA rating and what we must do to perhaps someday get it back. We have finally gotten around to asking how much value we receive at all levels of government and how we are going to pay for it. We are talking about what the private sector really needs to see before it will invest in the plant and work force of the future.

The nation’s fiscal position has gotten worse in the past 17 months, but the policy discussion is dramatically better. The S&P announcement did not create our debt problem and it did not, in any tangible way, make the problem worse. By promoting a more honest discussion about where we are and where we are going, it serves as a small part of a future solution.

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