Keeping the U.S. From Defaulting on Its Debt

Credit rating agencies like Moody’s and Standard & Poor serve a single function: to assess the creditworthiness of borrowers so lenders can decide how much interest to charge. Historically they have done a lousy job. Orange County and Enron went bankrupt with a stellar credit rating, assorted mortgage bonds that turned out to be worthless had good credit ratings, and it is easy to continue this list.

Perhaps the recent failure to assess the risk of mortgage instruments served as a wake up call to make the rating agencies more vigilant. Alternatively the financial problems of many western countries are so severe that even a comatose rating agency can’t fail to recognize them.

The real truth

The truth lies somewhere in between. Today Italy joined the US in having the outlook for its credit rating cut by S&P. Fitch, another rating agency, revised Belgium’s outlook to negative. Washington does not seem to be sufficiently concerned by this growing pessimism about sovereign debt.

The debt to Gross Domestic Product (GDP) ratio is often used to assess a country’s ability to pay back its loans. According to the IMF, these ratios are currently 93% (US), 100% (Belgium), and 118% (Italy). The respective credit ratings are AAA, AA+, and A+ (More A’s mean a better rating). This makes sense. The higher the debt load, the worse the rating.

The US takes in about 15-20% of GDP in taxes. Leaving aside the ability to print money, this means the US owes about five times as much as it takes in per year, yet it still enjoys S&P’s top credit rating. The same would probably not be true for you if you made $100,000 per year but carried $500,000 of credit card debt, and for good reason.

We have argued before, that Europe as a whole can afford to bail out their over-extended members. This is mainly true, because the larger economies in Europe have also been the most fiscally responsible.

However, financial markets are more sensitive to changes in perception than to changes in reality. These outlook downgrades are probably the beginning of a shift in perception. Debts loads that previously seemed perfectly sustainable, e.g. Italy’s or ours, suddenly become problematic even though the underlying economic situation hasn’t changed.

Greek 10 Year Borrowing Cost

Normally the complacency is misguided, not the sudden realization that debt levels are too high. Greece is a poster child of this phenomenon. Throughout most of the decade ending in 2009, the Greek government had to pay less than 6% to borrow money for 10 years. At the end of 2010 it was over 12% and today it is well north of 17%.

The jump in borrowing costs was partly triggered by a downgrade from A to A- on 1/14/09. This innocuous change in rating made the market realize that Greece is bankrupt.

The increasing frequency of outlook downgrades signals a growing awareness that the current trajectory of government finances in the US and parts of Europe is unsustainable. And as usual, Washington is missing the big picture.

In 2010, the US paid approximately $200 billion in interest

If this were to double to $400 billion, a fairly modest increase given the low current interest rates, it would require saving $200 billion on other programs.

Effectively this amounts to a $200 billion a year cut in government spending that does nothing to reduce public debt or provide any other benefit. The effect of these cuts would far exceed the economic impact of any credible program to right out public finances.

A more reasonable program

A reasonable program to bring out public finances under control would probably preserve our credit rating, which keeps borrowing costs relatively low, it would put the US on a path of sustainable grow, and it would have much less economic impact than letting the situation deteriorate until the the bond market treats the US like it did Greece. The details of this program are far less important than whether or not one is implemented.

Of course passing such a program would require politicians form both parties to behave like adults and work out a compromise. We all know that this isn’t going to happen. So, Brace for Impact!

Posted by Martin Gremm (Pivot Point Advisors)

About the author

Marc Schindler, CFP®

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