A review of the debt ceiling crisis:
Over the past week, the Market has been absorbing the official downgrade of US debt by ratings agency Standard and Poor’s. In fast moving markets, punctuated by continuous triple digit swings in the Dow Jones Industrial Average and a twenty-four hour news cycle, a week can seem like a very long time; we thought it was worth reviewing the situation
As a reminder, we declared that there were three negative outcomes to the debt-ceiling debate: default, downgrade and deterioration. Even if the debt ceiling had not been raised last week, the incoming tax revenues flowing into the US Treasury would have been enough to prevent an actual default on interest payments to US debt holders. Still, the immediate suspension of debt issuance, the delay on critical payments (e.g. – social security) and a partial government shutdown would have been an unwelcome shock to an already fragile system. We appreciate that members of Congress coalesced in the eleventh hour on a bill that avoided a technical default, although we hope that future negotiations will be less contentious.
At the closing of our July newsletter, we wrote:
“We find it difficult to believe that foreign investors are going to consider US Treasuries as the safe and secure investment it once was, given the recent drama in Congress... In short, we may get through this crisis with our credit rating intact, but the high-stakes game of brinkmanship has already damaged our national credibility and our ability to work co-operatively in Congress.”
As it turned out, Congress did ultimately settle on a smaller two stage plan to raise the debt ceiling, but the plan has done little to restore confidence to our political system or optimism in the markets. The $2.7 trillion plan was significantly below the $4 trillion deficit reduction target Standard & Poor’s set as a requirement for our AAA status.
The response from the rating agencies:
Moody’s and Fitch went on to reaffirm the AAA status for the time being, but Fitch is conducting a full review and Moody’s, given their negative-outlook, continues to place our AAA rating at risk. On the other hand, Standard & Poor’s made good on their threat and announced a downgrade on US Debt from AAA to AA+, with a continued negative outlook.
Far from being the end of the matter, Standard and Poor’s continues to advise US policy makers to ramp up their efforts for spending reduction and / or revenue increases to close the deficit gap. Standard and Poor’s warns that it “could lower the long-term rating to AA within the next two years if we see that less reduction in spending agreed to, higher interest rates or new fiscal pressures during the period.”
We find it notable that Standard & Poor’s, when justifying the downgrade, highlighted the risks in the political environment over any fundamental weakness in the ability of the US to pay its debtors. Standard and Poor’s begins their rationale for the downgrade thusly:
“We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process... 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.”
The full analysis is here: http://www.standardandpoors.com/ratings/us-rating-action/en/us/
Another example highlights the political impact on the downgrade decision. A few hours after the downgrade, Standard & Poor’s was informed that they made a $2 Trillion error in their calculation of US deficits over a 10 year period. After a few quick revisions, the ratings agency reaffirmed the downgrade saying: "The primary focus remained on the current level of debt, the trajectory of debt as a share of the economy, and the lack of apparent willingness of elected officials as a group to deal with the U.S. medium term fiscal outlook. None of these key factors was meaningfully affected by the assumption revisions.”
In other words, the acrimonious political climate is now having a measurable negative effect on the assessment of the US economy.
The Short Term Market Reaction:
The downgrade prompted fearful investors to place their money in safe assets: a “flight-to-quality” rally. Ironically, the flight to quality led to a huge rally in US sovereign debt. Other countries which retain their AAA rating (e.g. – France & the UK) are facing their own unique challenges (Eurozone bank exposure; civil unrest) so the relative strength in sovereign debt ratings has not translated into superior return. Apparently, investors continue to have faith in the US government’s ability to service US debt payments despite the headwinds of a divided political system.
The Long Term Effect:
The long term effect is still unknown. We have read the analyses from many lead economists and financial institutions, but they only assessment they offer with any certainty is the uncertainty of the situation. Because of the relative size of the United States economy, there is no perfect historic analogue for this downgrade. The long term impact on treasury yields, credit availability & financing, consumer spending and the economy will take time to become apparent.
The Way Forward:
As a point of reference, and perhaps a point of optimism, consider that Canada experienced a downgrade of its sovereign debt from AAA to AA+ in 1992. Canada, a domestically oriented spending state more akin to the European model than the US model, quickly slashed government spending, reformed its tax system (lowered corporate taxes, added a value added tax) and rapidly returned to surpluses after years of deficits. In 2002, Canada was rewarded with reinstatement of its AAA rating. Policy makers in Washington have been considering this example (and other counties which restored their AAA ratings: Australia, Denmark, Finland and Sweden), but they do not anticipate immediate restoration of the US rating. Restoration of the AAA debt ratings have taken a decade or longer.