The Corner

The S&P Downgrade

Whether or not Standard & Poor’s should have downgraded the credit rating of the United States, whether or not they hold any credibility, whether or not investors will take the downgrade seriously, the rating agency’s rationale for doing so seems relatively consistent with its July 14 report on the matter. And it boils down to a fear that America could fail to get its financial act together in time.

But how do we put our house in order? Anyone who has looked at the Congressional Budget Office baseline knows that even if lawmakers allow the Bush tax rates to expire at the end of 2012, the debt-to-GDP ratio is still projected to go up quite dramatically over the next decade. And then the real problems kick in with the explosion of Social Security, Medicare, and Medicaid. The whole picture of course looks better, only on paper, if Congress allows the AMT to bite as much from as many people as it would without the sort of patches that have become expected, and realizes all the (unconvincing) savings included in the health-care bill. However, the likelihood of these policies is close to zero and the savings or revenue from them even shadier.

The bottom line is that the debt problem in the United States will not go away as long as we don’t reform the major sources of the spending explosion — Social Security, Medicare, and Medicaid — which will blow apart any possibility of an equilibrium between revenue (no matter how high marginal rates get) and expenditures.

Unfortunately, the debt-limit deal failed to even fake a solution. The debt ceiling was raised. We got downgraded.

Now, some are using the S&P downgrade and claiming that the Republicans’ refusal to raise new or increased revenue in the debt-ceiling deal is the only cause of this punishment. I don’t see how that is the case.

First, the main tax proposal Democrats were interested to see on the table was the expiration of the Bush tax cuts for higher income earners. Here is the president on July 25:

And keep in mind that, under a balanced approach, the 98 percent of Americans who make under $250,000 would see no tax increases at all. None. In fact, I want to extend the payroll tax cut for working families. What we’re talking about under a balanced approach is asking Americans whose incomes have gone up the most over the last decade — millionaires and billionaires — to share in the sacrifice everyone else has to make.

Yet, if the Democrats had gotten their way and Republicans had agreed to raise rates on wealthy taxpayers, without cutting much more spending than is scheduled in the current deal, the country would still have been downgraded. #more#In the S&P report, we see that most of the difference between their upside and downside scenarios comes from swings in revenue driven by the partial expiration of the Bush tax rates (as requested by Democrats). However, even under the upside scenario (where the Bush tax cuts on high earners expire), the country remains at an AA+ rating.

Here’s S&P on August 5:

Our revised upside scenario — which, other things being equal, we view as consistent with the outlook on the ‘AA+’ long-term rating being revised to stable — retains these same macroeconomic assumptions. In addition, it incorporates $950 billion of new revenues on the assumption that the 2001 and 2003 tax cuts for high earners lapse from 2013 onwards, as the Administration is advocating. In this scenario, we project that the net general government debt would rise from an estimated 74% of GDP by the end of 2011 to 77% in 2015and to 78% by 2021.

So while the Republicans refused to raise any tax rates, the Democrats were focused on high-income earners (the smallest share of the revenue increase from letting the Bush tax cuts expire), which was not enough to change the rating in the context of the current spending cuts — much more in spending cuts would have been necessary, or much more in tax increases. Hence, it seems that they shouldn’t be getting credit for being the responsible ones in this debate either.

Second, there is no doubt that the unwillingness of both Republican and Democratic leaders to agree on a meaningful debt-ceiling extension was an important part of S&P downgrade. In July, the agency said that if lawmakers couldn’t find a way to change our financial path during the deal-ceiling debate, and didn’t show a bipartisan willingness to do so, it would be unlikely that they would have an incentive to address it in the medium run.

On Sunday, the head of Standard & Poor’s sovereign ratings, David Beers, reaffirmed this position when he explained that the downgrade announced on Friday “was not due to the budget positions of any political party and that on any future agreement, ‘We think credibility would mean any agreement would command support from both political parties.’” In that context, the agency lists the GOP’s resolve to keep revenue off the table as evidence of a political impasse. However, that is different from arguing that more taxes were a prerequisite for a return to the highest credit rating.

Finally, while S&P notes that revenue options are low on the list of realistic options today, it explains that “most other independent observers regard [Medicare and other entitlements] as key to long-term fiscal sustainability.” But only minor policy changes were included in the deal — basically, the deal failed to reform entitlement spending.

Here is S&P about its decision (emphases are mine):

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.

In other words, to avoid a downgrade, it would have been key in S&P’s opinion to show signs of willingness to cut (contain) Medicare and other entitlement spending. That didn’t happen, since many lawmakers in Congress (Democrats mainly, though not exclusively) refuse to talk about how much we can really afford to spend on Social Security, Medicare, Medicaid, and other social programs.

As a result, it is difficult to claim that the Republicans’ unwillingness to raise revenue is the only reason for this downgrade. It seems to me that there is enough blame to go around.

Now, by maintaining a negative outlook on the U.S. credit rating, S&P has served notice to the country that a further downgrade is likely if more progress is not made at upcoming deficit-reduction meetings — real reforms to reduce the debt-to-GDP ratio within the next few months (recall that prior to the debt-limit deal, S&P had talked about wanting a real long-term plan in place by October). And that means doing precisely what our leaders refused to do over the past seven months: Reform entitlement spending significantly, pass real institutional reforms to lock in spending cuts, and engage in fundamental tax reform.

Those are always easier said than done, but here are some policy ideas about where to start. Also, in a timely paper, my colleague at the Mercatus Center Matt Mitchell summarizes the academic research that looks at the successful and failed paths taken by nearly two dozen developed economies in the last 40 years to reduce their debt-to-GDP ratios.

Veronique de Rugy — Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.

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