Standard & Poor’s surprised markets today with a warning that the AAA rating of US debt is now on “negative watch”, implying that there is a one-in-three chance that the US might lose its triple-A status in the next two years. Although there was nothing new in the underlying data cited by S&P, their judgment has clearly been impacted by the sharp political differences which have recently emerged in Washington about how to cut the deficit.
Both political parties agree that a large fiscal consolidation plan is needed, but they have widely different points of view on how the savings should be found. This has caused S&P to express scepticism about whether Washington can reach agreement on a deficit reduction plan and then stick to it over a series of difficult years.
There is no doubt that the US is now in a worse fiscal condition than most other advanced economies. Not only did the US budget deficit rise more during the financial crisis than in other economies, but America has been unique among the major economies in allowing its deficit actually to increase further between 2010 and 2011. Consequently, the deficit of 10.8 per cent of gross domestic product this year will be roughly twice the average level for other advanced economies.
Furthermore, there is no credible plan in place for reducing this deficit in the short, medium or long term. President Obama has set a target of halving the deficit by 2015, and it will actually start to fall markedly next year if Congress can agree to allowing “temporary” tax reductions like the Bush tax plan and the payroll tax cut to lapse. Fiscal policy would then tighten by around 2.5 per cent of GDP in 2012, putting the US on a similar path to that being followed by the UK, albeit about two years in arrears. But there are very good grounds for doubting whether Washington will allow taxes to rise in an election year, in which case the start of the fiscal correction would be delayed by another 12 months.
After that, it would be left to the new President and Congress to agree on a medium-term plan for deficit reduction. The House Republicans, led by Paul Ryan, have proposed a plan under which the deficit would be reduced by $4,000bn over a decade, and President Obama’s own proposals, refined last week, would have roughly the same effect. In both cases, the deficit would fall by around 3.5 per cent of GDP on average over a decade, which would be enough to stabilise the public debt ratio at about 110 per cent of GDP in 2016 (on IMF definitions), and then to reduce it slowly thereafter. In fact, the president’s plan would enforce further spending cuts automatically if sustainability is not reached by then.
However, there are few, if any, overlaps in the methods proposed to implement the savings in the two respective packages. The Ryan package relies on massive reductions in healthcare and other spending, while taxation is actually reduced, especially for upper income groups. The Obama plan, in contrast, relies for a quarter of its savings on tax increases for the wealthy, and it includes only minimal savings in healthcare costs.
These traditional differences between Republican and Democrat approaches have thwarted many previous attempts to get the deficit under control, and may do so again. Even if (as seems highly probable) an agreement can be reached between the parties in the context of raising the debt ceiling in the next two months, the actual implementation of the plan, with new political actors and new economic circumstances arising over many years, could be quite another matter.
What is more, over the even longer term, the US has even larger unfunded commitments on social security and healthcare than many other developed economies. For example, the IMF estimates that, on present plans, the US government’s annual spending on healthcare will rise by 5.1 per cent of GDP by 2050, compared to a rise of 2-3 per cent in most other advanced countries. Consequently, the IMF estimates that the US needs to make a cumulative, long term fiscal adjustment amounting to 11.3 per cent of GDP in order to achieve a debt ratio of 60 per cent of GDP in 2030. This required adjustment, which is exceeded only by Ireland and Japan among the advanced economies, is much larger than anything the US has been able to achieve in the past.
It is indisputable that the US public debt position is already unsustainable, in the sense that the debt ratio will rise without limit, unless the primary budget deficit is reduced sharply from its present level. S&P has chosen to point this out today, but actually it has been known to the markets for some time. Nevertheless, the markets have chosen to ignore this unpalatable truth, just as they have in the much worse case of Japan over a much longer period.
The markets have taken this view because they still see the risks of an actual default on US government debt as vanishingly small. The US dollar is still the world’s reserve currency, the available taxable capacity of the US economy remains enormous, and the Fed can, in extremis, ensure that the Treasury remains solvent (though perhaps with very bad consequences for inflation). Because of all this, sovereign debt markets are still pricing almost no risk of a US default, and they will probably maintain that opinion for several years to come, even if S&P eventually removes America’s triple-A status.
So it is unlikely that today’s S&P announcement will prove to be the trigger for a major sell-off in the US bond market. Nevertheless, it is a useful reminder to the folks in Washington that something has to be done, sooner or later, to put the nation’s debt on a sutainable path. It is all a matter of timing.
