Perhaps the most prominent domestic economic event during July and early August involved Congressional approval of an increase in the federal debt ceiling. After a crescendo of often acrimonious debate, the debt ceiling was raised by $2.4 trillion in exchange for $2.1 trillion in budget cuts over a 10-year period. We followed the debate rather closely because we believe sovereign debt, including that of the United States, will inflict an increasing toll on economies across the globe. We were unimpressed by the debt ceiling agreement for a number of reasons, three of which are discussed below:
· First, spending will rise rather quickly (the debt increase is intended to tide the Treasury over only through the 2012 election) whereas the cuts will be spread out over the next decade (only 2 percent occur prior to the 2012 election).
Admittedly, phasing in the cuts makes some sense in light of the U.S. economy’s fragility. While we believe reducing the federal deficit and debt is necessary, we disagree with those who advocated draconian cuts as a recipe for immediately unleashing economic growth. The federal government’s contribution to GDP is variously estimated at between 9 to 16 percent, and deficit spending currently represents roughly 50 percent of that amount. Eliminating between 4.5 to 8 percent of the economy (half of the 9 to 16 percent) would initially result in a severe economic downturn. That reality seemed to have been lost in the debt-ceiling squabble.
· Second, if we could believe the small initial spending cuts were a means to navigate the difficult economic shoals, we would not be as critical. In too many past budgets, however, future cuts have been promised in return for higher near-term spending, only to never see the cuts materialize. As if to drive home that point, the debt shot up by $239 billion – eating up nearly 60 percent of the first tranche of $400 billion in new borrowing authority that was supposed to last through mid-September, and causing the debt to top 100 percent of GDP – one day after President Obama signed the bill.[1,2,3] By contrast, the proposed cuts are largely illusory; capping expenses related to fighting the wars in Iraq and Afghanistan and savings in interest on the public debt because of the lower deficits were counted as cuts.[4] Such accounting gimmickry caused one pundit to wonder why one could not assume $1 quadrillion in savings by not declaring war on Mars.[5] Moreover, the alleged cuts will only slow the rate of future spending increases.[6]
· Finally, the spending reductions were divided into two categories: $917 billion that all parties agreed to before the bill went to the president, and another $1.2 trillion to be specified later. Congress will create a Joint Select Committee (some have called it a potentially unconstitutional “Super Committee” and a “Politburo”[7]), comprised of six Democrats and six Republicans, that will be tasked with identifying the other $1.2 trillion in additional cuts. Should Congress fail to go along with the Committee’s recommendations, automatic cuts of $1.5 trillion will be triggered; those reductions would fall most heavily on the military and Medicare payments to doctors. Many are concerned the committee could raise taxes, which could put more hurdles in front of the struggling economy.[8]
To sum up, then, Congress agreed to a $2.1 trillion slowdown in the rate of spending increases during a 10-year period in which expenditures are projected to top $45.8 trillion – i.e., a 5 percent hypothetical reduction. Casey Research’s Bud Conrad produced a graph comparing the initial $917 billion in “cuts” to projected outlays. As one can see from the nearby chart, the cuts are miniscule compared to expenditures.[9]
Click image for larger view
Walker’s comments echoed those by the Bank of International Settlements (BIS), known as “the central bankers’ central bank,” which cautioned in a paper published in mid-July that “overall, risk premia on government debt will likely be higher and more volatile than in the past. In some countries, sovereign debt has already lost its risk-free status; in others, it may do so in the future.” The BIS warned that while the United States, Great Britain and Japan had so far been less affected by sovereign risk concerns, they were not “immune,” given their sharp increase in public debt ratios in recent years.[11]
In the case of the United States, at least, that immunity appears to be weakening. Last November, fledgling Chinese rating agency Dagong Global downgraded U.S. treasury bonds after the second round of quantitative easing commenced;[12] that downgrade was largely dismissed as a political move and ignored. In mid-July, however, rating agency Egan-Jones followed Dagong Global’s lead. Egan-Jones said its action, which cut U.S. sovereign debt to the second-highest rating, was not based on fears over the country not raising its debt ceiling. Instead, the cut was due to the U.S. debt load standing at more than 100 percent of GDP.[13] That downgrade was ignored as well, probably because Egan-Jones is not one of the “Big Three” agencies.
The markets began to pay a bit more attention, though, when Moody’s assigned a “negative” outlook to its U.S. rating in mid-July and Fitch made noises about possibly following suit. “Further measures will likely be required to ensure that the long-run fiscal trajectory remains compatible with a Aaa rating,” Moody’s said.[14] But then Standard & Poor’s delivered a “slap across the face” on 5 August by lowering its long-term U.S. debt rating from “AAA” to “AA+” along with a negative outlook[15,16] because the $2.1 trillion in budget cuts negotiated in the debt ceiling agreement were only about half the amount S&P had said in April were necessary to prevent the downgrade.[17,18,19,20] Dagong Global was quick to claim vindication, saying “S&P has proved what its Chinese counterpart has done is nothing but telling the global investors the ugly truth.”[21] At the time of this writing, the main reaction from the U.S. Treasury was to criticize S&P for not incorporating the Treasury’s more optimistic economic growth assumptions into its computations.[22]
The effects of S&P’s downgrade will probably take some time to be fully realized; in fact, given the economic turmoil in the Eurozone, yields on U.S. treasuries have fallen since the downgrade, rather than increasing as many may have expected (due to the higher degree of risk associated with the downgrade). The drop in yield since the announcement has brought much gloating in the financial press about the meaninglessness of S&P’s downgrade.[23] Most analysts acknowledge, however, that the lower yields reflect money “hiding out.” Although the U.S. economy does not look pretty, the Eurozone debt situation is even uglier, and so investors are parking money in U.S. debt until the investment situation stabilizes.
To a certain extent, the downgrade may not carry much weight if Moody’s and Fitch leave their ratings unchanged. In the grand scheme of things, wrote Michael Pento of Euro Pacific Capital, the rating agencies’ verdicts could ultimately prove largely irrelevant anyway. Yes, Pento wrote, “the fallout could be devastating to money market and pension funds that must hold AAA paper” because those institutional investors would have to dump the downgraded assets for whatever price they could get. “But an even worse outcome will occur when the real debt downgrade comes from our foreign creditors, when they no longer believe the United States has the ability to pay our bills.”[24]
No comments:
Post a Comment