A Year After Downgrade, S&P's View on Washington Unchanged
Last August, a previously unknown English-lit major turned government-bond expert named John Chambers was the man on the spot. A year after Chambers led Standard & Poor's move to cut the USA's AAA debt rating for the first time ever, he still is.
S&P's conclusions about the strength of the U.S. economy and the U.S. government's political dysfunction and ability to begin to limit the growth of the national debt, are as topical as the day S&P cut the U.S. credit rating to AA+ last Aug. 5. The Friday night move set off a storm of criticism — of S&P and the Washington leaders whose circus-like fight over raising the debt limit made the nation flirt with a historic default just days before S&P's move.
In the short term, it hasn't meant much. The stock market dropped almost 7 percent the next Monday, but gained most of that back on Tuesday. Critics snark that because the downgrade hasn't made interest rates jump, it showed up S&P as a toothless tiger. Chambers himself, with a sarcastic wit belying his buttoned-down looks, says U.S. finances are still deteriorating so fast, he's got nothing to apologize for. Instead, he mocks the bond market that he says took years to figure out how risky European government bonds were, despite S&P downgrades.
Either way, the debt is still huge and growing, the economy may be even shakier than last year, and Congress faces another wave of policymaking at year's end that will test the capacity for mature decision-making that S&P's downgrade said Washington conspicuously lacks.
So, was S&P right?
A year later, most critics still think Chambers' team was too bearish on America's credit: Global demand has pushed down interest rates on U.S. Treasuries, a vote that they're about the safest investment there is, if only because alternatives are worse.
S&P's view of the economy might seem too optimistic, with growth slowing and new recession fears a persistent minority view.
"S&P sticks by its decision," said Chambers, the 56-year-old chairman of S&P's sovereign-debt rating committee. "Since the downgrade, our projection for the national debt as a percentage of the economy in five years has actually gotten worse."
The downgrade, which had the whole world talking but soon faded from headlines, was never completely about the numbers. It was about the chaos of Washington — as the downgrade report called it, "the political brinkmanship of recent months (that) highlights what we see as America's governance becoming less stable, less effective and less predictable." That conclusion will be tested anew very soon, even as the S&P's budget math remains in dispute.
Before year's end, Congress and President Obama are supposed to solve the "fiscal cliff" — the catch-all term for the scheduled expiration of tax cuts and imposition of new spending cuts that could suck $560 billion a year out of the fragile economy, reducing the deficit much faster than even S&P wanted. With Republicans and Democrats bickering already, it could make the debt-ceiling fight a warm-up act.
On that, S&P has markets' support, said Ethan Harris, co-chief economist at Bank of America Merrill Lynch .
"That we even have a fiscal cliff is a sign they're right," Harris said. "It's not that the economy is so poor. It's that the management of USA Inc. is so poor."
The Balance Sheet
Of all the stands S&P took in the downgrade, its view of the U.S. government's balance sheet was the most instantly controversial. Chambers insists that events since back him up.
S&P's point was that the national debt now equals 71 percent of gross domestic product, up from 40 percent in 2008. It's a lot, but hardly the worst in the developed world: Italy's is above 120 percent. Jabbing at critics such as Princeton University economist and New York Times columnist Paul Krugman who say the U.S. can easily afford its interest payments, Chambers says the point isn't where the debt is but where it's going.
"It's not just us — it's the Fed, it's pretty much any economist," who believes that America must contain deficits eventually, Chambers said. "Professor Krugman would say the same thing."
"For nine years, they all thought our ratings were wrong. They don't think that anymore."
Believers in the strength of U.S. debt point to the bond market, where surging demand from buyers has pushed 10-year Treasury yields as low as 1.4 percent, from 2.58 percent, as bond prices have risen. One reason for that, however, is that investors have chosen Treasuries over bonds of other nations that have even bigger problems, while 10-year German and British bonds that S&P still rates AAA have even lower rates. More telling, says Undersecretary of the Treasury Mary Miller, is that the cost of buying insurance against a U.S. default, using derivatives called credit-default swaps, has dropped 18 percent since last August.
This means the market has little doubt the U.S. will pay, Miller says.
One reason is that the deficit is already shrinking, she argues. The White House projected last month that the deficit, which hit nearly 10 percent of GDP in 2009, will be 3.9 percent in the fiscal year beginning in fall 2013. By fiscal 2018, the U.S. will pay its bills out of current revenue, except for interest on debt it took on to fight the recession, the Office of Management and Budget says. S&P says the deficit will still be 5 percent of GDP in 2016.
Chambers isn't overly impressed by the wisdom of the market crowd. Bond markets have disagreed with S&P's sovereign-debt ratings before, he says. Through most of the last decade, European government bond rates were nearly uniform, following ultra-safe Germany, even though S&P cut debt ratings on countries that are now in trouble, he said.
"For nine years, they all thought our ratings were wrong," Chambers said. Then he pauses, waiting for the joke. "They don't think that anymore."
A year ago, S&P's deficit-cutting prescription was close to conventional wisdom. Now it's controversial enough that even Chambers is changing emphasis.
The downgrade teemed with frustration about Congress' inability to contain the deficit. Even the $2.2 trillion deficit-reduction deal Congress reached last year — about $1 trillion in spending cuts over 10 years plus another $1.2 billion in automatic cuts if the so-called supercommittee failed to recommend more deficit reductions — wasn't enough, S&P wrote. It warned that even the 2012 election might not produce the political will needed to rein in Medicare, Social Security and other entitlements.
"By then the government debt burden will likely be higher, the needed medium-term fiscal adjustment potentially greater," S&P said.
S&P's judgment that Congress needed to begin now to make hard decisions on deficit spending implied that U.S. economic fundamentals are strong enough to tolerate deficit cutting. The idea is to get Washington to slash borrowing before debt overwhelmed strengths like the wealthy, diverse U.S. economic base, S&P said in a June 8 report.
Europe's worsening fiscal crisis teaches what happens to economies when hard decisions are postponed too long and countries are forced to adopt severe austerity measures. Eurozone unemployment is at 11.2 percent and Spain is at 24 percent. At the same time, the U.S. economy has weakened, with growth dropping by more than half since late last year. That's one reason S&P's June 8 report, unlike the initial downgrade, emphasized that S&P seeks "medium-term" changes because "abrupt short-term measures could be self-defeating when domestic demand is weak."
"We're not austerians," Chambers says. "We aren't calling for a short-term solution. It was calling for a credible medium-term plan."
Economists such as Harris say one reason growth has fallen by half since last fall is the very plans for deficit reduction before Congress — which, if left unchanged, would impose a much faster, more dramatic fix than S&P wanted.
"...One of our concerns is that the U.S. will stumble into a mostly self-imposed recession."
Other bond-rating agencies also say much more austerity soon would be a mistake. The U.S. can easily absorb another year or two of big deficits to get the economy unjammed, said David Riley, head of global sovereign ratings at Fitch Ratings, which still rates U.S. debt triple-A, as does Moody's Investors Service. A new recession would mean even-bigger deficits and debt problems later, so it's better to pass a bill now that sets a firm schedule of deficit reductions a year or two out, Riley said.
"The U.S. doesn't need stringent financial austerity," Riley said. "In fact, one of our concerns is that the U.S. will stumble into a mostly self-imposed recession."
Most economists expect a compromise, slicing 1.5 percent to 2 percent off next year's GDP, said Mark Zandi, chief economist at consulting firm Moody's Analytics. (Moody's Analytics and Moody's Investors Service are both owned by Moody's Corp., but Analytics isn't involved in debt ratings.)
Zandi and Harris think that would let the U.S. avoid a recession next year — narrowly.
The key is an improving housing market, said Zandi. After a fiscal-cliff compromise cuts government spending, that leaves about 1.5 percent growth overall next year, he said. S&P says the economy will grow between 2 percent and 3.5 percent a year through 2016, assuming the Bush tax cuts are extended and all of the automatic spending cuts take effect.
"That isn't too different than this year," Zandi said.
That assumes housing's recovery helps offset shrinking government and the higher taxes on high-wage earners Democrats propose. Government cost-cutting is already shaving a half-point off 2012 growth, with little reason to expect state and local cuts to end.
That's why Chambers emphasizes that S&P wants U.S. fiscal discipline "in the medium term."
"There's not going to be a major fiscal drag," Chambers said. "They're going to kick the can."
As the fiscal-cliff deadline nears, each party is pushing pet ideas and blaming the other for the supercommittee's failure.