Is S&P’s Deficit Warning On Target?

An article from The Baseline Scenario

Posted: 21 Apr 2011 05:26 AM PDT

By Simon Johnson

On Monday Standard & Poor’s announced that its credit rating for the United States was “affirmed” at AAA (the highest level possible), but that it was revising the outlook for this rating to “negative” – in this context specifically meaning “that we could lower our long-term rating on the U.S. within two years” (p.5 of the report). This news temporarily roiled equity markets around the world, although the bond markets largely shrugged it off.

While S&P’s statement generated considerable media attention, the economics behind their thinking is highly questionable – although, given the random nature of American politics, even this intervention may still end up having a constructive impact on the thinking of both the right and the left.

It is commendable that S&P now wants to talk about the U.S. fiscal deficit – one wonders where they were, for example, during the debate about extending the Bush-era tax cuts at the end of last year.

The main problem is that S&P did not lay out even the most basic numbers or even point readers towards the nonpartisan and definitive Congressional Budget Office analysis of medium- and longer-term budget issues.[1] This matters, because the CBO numbers definitely do not show debt exploding upwards immediately from today – if you’ll take the time to look at Table 1.1 in the latest CBO report, the line “debt held by the public at the end of the year” (meaning private sector holdings of federal government debt; excluding government agency holding of government debt) makes it clear – debt as a percent of GDP rises to 75.5 percent at the end of 2013 and then increases very little through 2019.

There are two serious budget issues made clear by the CBO’s analysis. First, the big increase in debt in recent years has been primarily due to the financial crisis. To see this, compare the January 2011 CBO forecast (cited above) with its view from January 2008 (see page XII, Summary Table 1), before the seriousness of the banking disaster – and ensuing recession – became clear. At that point, the CBO expected federal government debt relative to GDP to reach only 22.6 percent (compare with 75.3% for the same year, 2018, from the 2011 projections.)

In other words, the financial crisis will end up causing government debt to increase by more than 50 percent of GDP over a decade. This is the major fiscal crisis of today and our likely tomorrow (for more on this, see this column).

S&P does mention this issue, but somewhat elliptically, when it says “the risks from the U.S. financial sector are higher than we considered them to be before 2008” (p.4). And S&P does put “the maximum aggregate financial sector asset impairment in a stress scenario at 34% of GDP, compared with our estimate of 26% in 2007” (p.5).

But there is no indication of where these numbers come from – and no sense that S&P is focused on the likely medium-term fiscal cost of financial disaster (as seen in the CBO numbers), as opposed to any kind of “up-front” commitment by the government (part of which would not constitute ultimate losses).

A future financial crisis, given the nature of our economy, could well cause a debt increase of more than 34% of GDP – just look at what happened this time in the US or the way in which Ireland was ruined by big banks and the relevant politicians gone mad. There is no way that the S&P’s stress scenario is sufficiently negative.

To be fair, the CBO also does not present a realistic stress or alternative scenario along these lines; this is a problem with current CBO scoring methods that needs to be addressed. The International Monetary Fund is already pressing, for example in its latest Fiscal Monitor (see Appendix 3, particularly the web of risks shown on p.84), for all countries to recognize more fully the probable future fiscal costs implied by contingent liabilities of all kinds arising from large and reckless financial sectors.[2]

There is of course a longer run budget issue – beyond 2020 – which is mostly about healthcare costs. S&P follows the current consensus by flagging the Medicare component of this and the CBO’s own projections on this front are undoubtedly scary (see this CBO webpage; or jump direct to the document and study the picture on its front page).

But the real threat to the economy is healthcare costs more broadly, not just the Medicare component. For more on this see the analysis by James Kwak (my co-author) writing about an important letter from Doug Elmendorf (head of the CBO) to Congressman Paul Ryan on the latter’s budget proposal. In James’s words, “The bottom line is that the Ryan Plan increases beneficiary costs more than it reduces government costs.”

The real danger to the United States economy – and to its federal budget – is that we will somehow derail growth, either by letting too big to fail banks become irresponsible again or by allowing healthcare costs to continue to rise on their current trajectory or in some other way.

It is disappointing to see S&P miss the opportunity to bring clarity to this issue. The organization still seems hampered by some of the same weak analytics that contributed to their misreading of subprime mortgages and associated derivatives.

Will their broad brush and somewhat indiscriminate warning spur politicians to sensible debate and eventual action – both with regard to the financial system dangers (the medium-term issue) or with regard to healthcare costs (the longer-term issue)?

Perhaps, but this sort of “warning” may also whip up debt hysteria of a kind that can quite easily lead to policies that quickly undermine growth.

An edited version of this post appears this morning on the NYT.com’s Economix blog; this material is used here with permission. If you would like to reproduce the entire column, please contact the New York Times.

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[1] Disclosure: I’m on the Congressional Budget Office’s Panel of Economic Advisers. This Panel meets twice a year to discuss economic forecasts. Attendance at the panel is paid.

[2] Disclosure: I attended a Fiscal Forum at the IMF last week where these issues were discussed. I was paid an honorarium.