In criticizing S&P for its downgrade watch, Benjamin Zycher says that the ratings agency is incorrectly thinking that
[t]he world capital market cannot distinguish between a government that literally cannot pay its bills and one that may delay some interest payments for a week or two due to a political dispute over spending and taxation, but almost certainly will not because tax revenues are wholly adequate to cover debt service.
But the ratings agency is correct this time. (They’ve got to be right once in a while, so they may as well be right when being right is a big bang.)
For U.S. Treasury bonds, missing an interest payment is, from a ratings agency’s perspective — and from most other perspectives — default (D), or at least, Selective Default (SD, choosing to pay some debt obligations and not others).
Defaulting on an interest payment would be a huge, huge, huge deal. Treasury bonds are supposed to be perfectly safe. Whether it’s Grandma who depends on her timely interest payment to pay for her cable, or a global lender that depends on timely interest payments on Treasury bills so it can hold such bills against overnight lending to companies who need short-term cash to pay workers ahead of their payments from customers . . . no one expects a Treasury default. It would shock the global financial system.
Beyond that, though, S&P doesn’t just look at whether or not tax revenues are “adequate” for “debt service.” Bond analysts look at whole bunch of things besides just mathematical capacity to pay.
S&P must consider both willingness and practical ability to pay, too. These are long-term issues, sure. But a short-term default would make them worse in that long term, because a default — including a missed interest payment — could send the economy down into recession again.
On practical ability to pay: we may have enough financial resources to pay debt for a while absent a ceiling hike, but, as Karl Rove noted yesterday, it’s a stretch.
A couple of decades from now, it will be a bigger stretch. Could, for example, the U.S. government indefinitely delay or reduce Social Security payments, food-stamp disbursements, aid to state and local governments, and the like without causing unacceptable social unrest?
It is at least a fair point for S&P to consider, qualitatively, whether America could pull off this feat as entitlements squeeze revenues.
On just plain willingness to pay — bond observers, including S&P, will learn something from the outcome of this battle. Zycher criticizes S&P for thinking that “an effort to use the dispute over the debt ceiling to impose fiscal discipline upon the federal government suggests lower creditworthiness.”
But using the debt ceiling in such a fashion implies the possibility of default. To that end, global investors will have to determine if is there a growing mass of political officeholders who would rather default rather than give up a core principle, whether it is holding the line on entitlement cuts or getting rid of special-interest spending in the tax code.
If so, the world would have to grow accustomed to the risk that sovereign default, in some circumstance, sometime down the road, would be a political option for the United States of America.
Even if markets were functioning properly today, such a signal would be jarring for investors to digest — yes, even after a successful debt-ceiling hike.
With most credits, investors would demand a higher interest rate, because they would see higher long-term risk. The problem is, though, that from a credit standpoint, Treasury bonds are supposed to be riskless.
There is no risk premium. Adding one, then, isn’t moving slightly — or even a lot — along a continuum. It’s switching a binary “off” suddenly to an “on.”
Traumatic — but even more so because markets aren’t functioning properly anyway. The financial system is still dependent on the idea of bailouts on demand from the U.S. government.
That’s why S&P, less than a day after putting the U.S. on downgrade watch, put a slew of government-related credits from Fannie Mae, Freddie Mac, and 126 “FDIC-guaranteed ‘AAA’ rated debt [instruments] issued by 30 financial institutions under the Temporary Liquidity Guarantee Program” — that is, a crisis-bailout facility — on downgrade watch, too.
If global markets came to think that the bailer of last resort wouldn’t even bail itself out, well . . . it would be another interesting summer and fall.
— Nicole Gelinas is a contributing editor to the Manhattan Institute’s City Journal.