The Corner

The Real S&P Warning: A $4 Trillion Deal or a Downgrade

As the debt-ceiling showdown heads into its final stages, the political maneuvering has intensified. Yet I fear that we are losing sight of the only reason why the fight over the debt ceiling matters: It forces a discussion of the country’s real problem — unrestrained government spending and the tremendous fiscal imbalances that jeopardize our financial safety.

This is the real message in the July 14 S&P report.

First, S&P writes that unless there’s a credible $4 trillion deal within the next three months, they will downgrade us. By “credible,” S&P explains, they mean a plan that will actually be put into place (i.e., not one where the tax increases happen but not the spending cuts). Not $2 trillion, not $1 trillion,  but $4 trillion. And it has to be credible.

We expect the debt trajectory to continue increasing in the medium term if a medium-term fiscal consolidation plan of $4 trillion is not agreed upon. If Congress and the Administration reach an agreement of about $4 trillion, and if we [were] to conclude that such an agreement would be enacted and maintained throughout the decade, we could, other things unchanged, affirm the ‘AAA’ long-term rating and A-1+ short-term ratings on the U.S.

Second, the door is left open for raising the debt ceiling without a deal, but not without conditions: The negotiations leading to the debt-ceiling increase have to make it clear that a $4 trillion deal is coming within the next three months:

If a debt ceiling agreement does not include a plan that seems likely to us to credibly stabilize the U.S.’ medium-term debt dynamics but the result of the debt ceiling negotiations leads us to believe that such a plan could be negotiated within a few months, all other things unchanged, we expect to affirm both the long- and short-term ratings and assign a negative outlook pending review of the eventual plan. If such an agreement is reached, but we do not believe that it likely will stabilize the U.S.’ debt dynamics, we, again all other things unchanged, would expect to lower the long-term ‘AAA’ rating, affirm the ‘A-1+’ short-term rating, and assign a negative outlook on the long-term rating.

Third, S&P warns that a failure to make a $4 trillion change today makes it unlikely that lawmakers will address the debt problem before it’s too late. This is the more interesting part of the report. It raises an issue that I have been talking about from the beginning: If lawmakers can’t find a way to change the path we are on during the deal-ceiling debate, how likely is it that they will have an incentive to address it in the short run? S&P says almost zero, and that’s a reason to worry — and a reason to downgrade us.

U.S. political debate is currently more focused on the need for medium-term fiscal consolidation than it has been for a decade. Based on this, we believe that an inability to reach an agreement now could indicate that an agreement will not be reached for several more years. We view an inability to timely agree and credibly implement medium-term fiscal consolidation policy as inconsistent with a ‘AAA’ sovereign rating, given the expected government debt trajectory noted above.

The bottom line is: Do not lose focus on the real problem, which is that unrestrained government spending has set this country on an unsustainable path that will lead to fiscal ruin. The real problem is that the United States spends too much money.

So, if raising the debt ceiling without a $4 trillion deal (either now or in the next 90 days) means a downgrade, why isn’t everyone talking about it? Here are some possibilities:

1. Is the view that S&P is bluffing? Writing about a possible Moody’s downgrade, James Kwak of Baseline Scenario claims it won’t happen because it would be super irresponsible, and besides, no one cares what bond rating agencies think.

2. Is it that a downgrade in the current worldwide financial context won’t have real financial implications? I have to say, I do wonder about that. I mean, where would investors put their money right now? Europe? China? Basically, we aren’t the ugliest at the beauty pageant, which may not be much comfort, but it saves us for now. However, my friend and Mercatus colleague Prof. Garett Jones tells me that a downgrade would have serious consequences, and he is a very reliable source. And if the view is that a federal downgrade won’t affect municipalities and states, the things I read seem to rule that out, too (see Megan McArdle here).

3. Is the view that a default wouldn’t be so bad? I know that some very respectable people are making the case that a default, as part of a conscious effort to clean our financial house, wouldn’t be so bad. However, it seems risky to me, and I think it should be avoided at all costs.

Ultimately, the only way to avoid the potential negative consequences that come with a downgrade, a default, or an increase in the debt ceiling without a deal is to commit to addressing our long-term fiscal issues within the next few months: cut spending significantly, pass real institutional reforms to lock in the spending cuts, and engage in fundamental tax reform.

On that front, the plan introduced by Senator Coburn is interesting: a $9 trillion plan with $8 trillion in cuts and some serious attempts to upset every special interest group in the United States. It beats the Gang of Six deal that we are just now hearing about, which has more revenue increases than cuts and no Social security reform included. 

Update: Here is Dan Mitchell on the Gang of Six’s deal.


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