I shall not want capital in Heaven / For I shall meet Sir Alfred Mond / We two shall lie together, lapt / In a five per cent. Exchequer Bond. — T. S. Eliot, “A Cooking Egg”
On Feb. 7, 2010, the secretary of the Treasury, Timothy Geithner, was asked whether persistent deficits put the United States in danger of losing its AAA credit rating. “Absolutely not,” he said. “That will never happen to this country.” A little over a year later it did, when the ratings agency Egan-Jones downgraded the United States to AA.
Egan-Jones, though a member of the cartel of ten credit-rating agencies recognized under federal law, is not one of the Big Three (Moody’s, Standard & Poor’s, and Fitch), and its ratings do not generate the same kind of headlines. But it is an interesting firm, and not beloved by the other agencies. One reason for that is the fact that it makes its money by charging bond investors for its information, rather than by charging bond-issuers for ratings, and makes much of this practice, accusing its competitors of having a conflict of interest built right into their business model. Further, the firm’s principal went to Congress in 2008 to accuse the ratings industry of having engaged in a race to the bottom for credit standards, which did not make him popular. In some investors’ minds, these are reasons to regard Egan-Jones as more credible than its household-name competitors. In any case, the Big Three themselves have warned that, absent a credible deal to rationalize U.S. public finances, a downgrade is likely. And their downgrades would have consequences.
The judgment of the Big Three agencies is taken as gospel by practically no serious investor; their ratings are largely of technical and legal concern. The role of the credit-rating agencies is not to provide guidance and insight to the marketplace, but to certify the findings of the marketplace as conventional wisdom. But their role is important because of the way banks, insurance companies, pension systems, and other financial firms are regulated. (Contra Rep. Barney Frank et al., our problem was never deregulation; our problem was, and is, regulation written and enforced by dopes.) One of the regulations faced by banks is the “capital requirement,” which mandates that a bank must hold a certain amount of capital in reserve to offset its liabilities. But not all capital is created equal, and so $1 million in AAA bonds offsets more than does $1 million in AA bonds. Insurers and pension funds operate under similar restraints.
Financial firms hold trillions of dollars in Treasury securities, and a downgrade to AA (or worse — Greece is now down to Ca) would have meaningful consequences, though not necessarily catastrophic ones. Financial firms would be sent scrambling to raise new capital, in a market that would no doubt be panicked by the fact that the United States of America and its once-unshakable Treasury bond have been caught with their fiscal pants down. This would be in a sense a replay of the 2008 credit crisis, in which declining mortgage securities forced banks to raise capital, which they did by selling those same declining securities, which drove values down further still, necessitating the raising of more capital, in a kind of subprime death spiral. The impact of a Treasury downgrade is likely to be wider, but possibly not so deep or so radical — whereas there was no bottom under mortgage securities, investors are more likely to hold on to their Treasuries until maturity and redeem them than to dump them in a fire-sale panic — so long as the prospect of a real default remains remote.
#page#Beyond that, the immediate result of a downgrade of Treasury bonds to AA is anybody’s guess. There are a number of major economic powers, Japan among them, whose government bonds are AA or lower. But none of those economies accounts for 25 percent of the planet’s GDP. The usual assumption is that a downgrade will send interest rates up: That’s what downgrades are supposed to do. Downgraded countries, like individuals with bad credit, pay higher interest rates. Demand for U.S. debt is likely to fall, but the Federal Reserve, and possibly foreign central banks, will be inclined to counter that effect, buying up Treasury debt in the interest of what they believe, naïvely, to be stability. Some contrarians expect that U.S. interest rates could fall after a downgrade, at least in the short term, as investors who see no immediate signs of inflation in the United States but expect economic disorder and a possible global recession once again seek safe haven in the U.S. Treasury.
So there remains a great deal of uncertainty in the marketplace.
Insolvency, like a striptease, moves in stages. After a downgrade, the next and more serious concern is default. There has been much talk of default during the debt-ceiling debate, but that seems premature. It is probable that we will come up against the debt ceiling again, in much the same circumstances, and the word “default” will once again be on official lips. While there would be some difficulty in rolling over large chunks of debt that come due all at once (a consequence of our increasing reliance upon short-term rather than long-term Treasury securities), the cost of debt service at present is less than 10 percent of federal spending, and current revenues would be more than adequate to make necessary debt payments. We can pay our creditors, but there are other bills that cannot be paid without increasing the debt ceiling. Hardliners have talked a good game about paying for Social Security, Medicare, and the troops, all without raising the debt ceiling, but their numbers don’t quite add up: The Office of Management and Budget estimates that federal tax revenues will amount to $2.17 trillion in 2011, while Social Security, Medicare, national defense, and debt-service payments by themselves will outstrip that number, amounting to $2.21 trillion. The Republicans’ talking point apparently was derived by counting only the troops’ salaries, as though we could stop buying them diesel and food and ammunition, or suspend operation of the bases and hospitals and aircraft necessary to their work. Our deficit is currently more than 40 percent of spending, and it has been foolish of Republicans to pretend that we can eliminate it without inconveniencing anybody other than ethanol producers, federally subsidized cowboy poets, and foreign-aid welfare queens. Just as their railing against Medicare cuts during the health-care debate has made it more difficult for Republicans to undertake necessary Medicare reforms, Republicans have done themselves a disservice by minimizing the size and scope of the spending cuts that will be necessary to salvage our national finances.
Despite the recent loose talk, default remains unlikely under most scenarios for the simple reason that the possibility is something that the political class fears and loathes. Default would make it impossible for Washington to continue to borrow money at concessionary rates. But the threat of default, with its banana-republic connotations, remains a potent rhetorical bomb: Secretary Geithner, who just over a year ago was contemptuous of the notion of a credit downgrade, has spoken earnestly about the threat of a sovereign default. He is not to be taken seriously. (Not yet.)
#page#We have been lucky in our timing: During the debt-ceiling debate of 2011, American public finances could still boast of being on more solid ground than those of the Europeans, wracked as the Continent is by the technical default of Greece and the persistent fiscal troubles in Ireland, Italy, Portugal, and Spain. At the same time the Japanese, with a national debt totaling 200 percent of GDP, inspire little confidence. There are only so many Swiss bonds in which to invest, and the United States thus remains the leader of the pack, even if the pack is running toward insolvency.
We have learned a few useful things from the debt-ceiling debate. The most important is that Pres. Barack Obama’s insistence upon tax increases as part of a debt-ceiling plan is largely political rather than ideological or economic. Senate majority leader Harry Reid and Speaker of the House John Boehner had worked out the basics of a medium-term deal without tax increases, but the president dismissed it out of hand when his fellow Democrat presented it to him. For the president, taxes aren’t about revenue — they’re a cultural issue. Soak-the-rich talk is to Democrats what promises to kill the National Endowment for the Arts are to Republicans: a way to fire up the partisans. And Obama needs them fired up. A July poll found that only 31 percent of self-identified liberal Democrats expressed “strong support” for the president, down from a majority, while the number of black voters who believe Obama’s policies have helped the economy declined from 77 percent to about half. With Gitmo still open for business and U.S. bombs dropping unilaterally around the Muslim world, President Obama’s natural loyalists are hungry for some red meat. But President Obama, in addition to continuing the larger part of George W. Bush’s counterterrorism program, also oversaw the extension of Bush’s tax cuts. He owes the Left some scalps. This is worth knowing, since it means that sensible tax reforms of the sort sought by the Simpson-Bowles commission or Paul Ryan’s plan will be difficult to achieve, because they are exercises in revenue-raising rather than in class warfare. The president is positively fixated on the amortization schedule for corporate jets.
So the debate has been instructive. What we will learn now is whether any of this will prove sufficient to forestall a downgrade and the disorder threatened by it, whether Republicans can achieve long-term entitlement reform, and whether Barack Obama will be remembered, to emend a phrase of Daniel Hannan’s, as the downgraded president of a downgraded nation.