Why the S&P Downgrade of U.S. Debt was Right on the Money

The S&P downgrade of U.S. debt from AAA to AA+ reminds me of the Christian Bale’s character (Dicky Eklund) in the movie, The Fighter. We’ve been walking around like we’re the “pride of Lowell,” but now we’ve been slapped down to reality. If there’s any doubt about this, check out what China had to say about the downgrade:

China, the largest creditor of the world’s sole superpower, has every right now to demand the US to address its structural debt problems and ensure the safety of China’s dollar assets.

To cure its addiction to debts, the US has to re-establish the common sense principle that one should live within its means.

S&P has already indicated that more credit downgrades may still follow. Thus, if no substantial cuts were made to the US gigantic military expenditure and bloated social welfare costs, the downgrade would prove to be only a prelude to more devastating credit rating cuts, which will further roil the global financial markets all along the way.

(Source: Xinhua news agency)

And here’s the sad thing. China is absolutely right! We need to cure our addiction to debt. And if we don’t do it, the world’s financial markets will. How? Higher interest rates.

But back to the question at hand. Was the S&P right to cut its rating on U.S. debt? To put that question into perspective, let’s look at the spending cuts recently passed by Congress

A $2 Trillion Hocus Pocus

Recall that our friends in Washington spent months bickering over spending cuts. The eventual deal, which triggered the raising of the debt ceiling, “cut” spending over the next ten years by $2 trillion. That sounds austere, until you consider that the good folks in Washington use what’s called baseline budgeting.

As reported by Peter Ferrara of Forbes, The Congressional Budget Office tells us we are still on track to increase the debt over the next 10 years by $8 trillion. So while the $2 trillion “cut” slowed the craziness by a fraction, we are still borrowing and spending money like a drunken lotto winner.

So let’s review. Our representatives in Washington fought with each other right up to the debt ceiling deadline over a deal to slow spending by a measly $2 trillion, which will result in $8 trillion in additional borrowing over the next decade. We still have the Medicare problem. And we still have the Social Security problem.

The S&P’s Rationale

The battle of just $2 trillion in spending cuts paved the way for S&P’s rating downgrade. According to the S&P,

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. We also believe that the fiscal consolidation plan that Congress and the Administration agreed to this week falls short of the amount that we believe is necessary to stabilize the general government debt burden by the middle of the decade.

(Source: S&P Press Release (pdf))

I highlighted two key phrases in the S&P’s rationale. S&P focused on the government’s prolonged fight concerning a meaningful agreement on reductions to entitlement programs, increases in taxes, or both. In other words, the S&P was careful not to blame either party. Instead, it viewed the government’s epic battle over relatively minor spending cuts as an indication that the political divide will keep the U.S. from meaningful spending and tax reform.

Now, at first I thought this rationale was a bit thin. Let’s face it, the U.S. can always print money to pay its debts (at least to a point). But then I read the political reaction to the downgrade.

The Blame Game

Following the downgrade, both parties immediately blamed the other party.

Senator Reid of Nevada offered this explanation to the rating cut:

The action by S&P reaffirms the need for a balanced approach to deficit reduction that combines spending cuts with revenue-raising measures like closing taxpayer-funded giveaways to billionaires, oil companies and corporate jet owners. This makes the work of the joint committee all the more important, and shows why leaders should appoint members who will approach the committee’s work with an open mind – instead of hardliners who have already ruled out the balanced approach that the markets and rating agencies like S&P are demanding.

At first glance, this statement seems reasonable. Use the phrase “balanced approach” enough, and what’s not to like? But there are several problems with Reid’s statement: (1) the S&P did not call for an increase in taxes; it took no position one way or the other; (2) the “taxpayer-funded giveaways” Reid speaks of show just how unbalanced Reid’s approach is. “Taxpayer-funded giveaways” makes for a great sound bite, but it completely ignores real tax reform that this country needs. The fact is that the “rich” already pay a fortune in taxes. Should they pay more? Maybe. But Reid’s diatribe doesn’t move us closer to a solution.

The Republicans were just as bad. House Speaker John Boehner had this to say about the downgrade: “It is my hope this wake-up call will convince Washington Democrats that they can no longer afford to tinker around the edges of our long-term debt problem.” Now I agree completely that spending is out of control in Washington. But that’s just part of the problem. Let’s face it, the Bush tax cuts are a big part of our current debt problem. Yet Boehner and other Republicans won’t even discuss an increase in revenue.

And that brings us back to the S&P downgrade. If anything, the reaction of Reid and Boehner underscores why the S&P downgrade of U.S. debt was right on the money. Politicians are talking past each other, not with each other. They need to stop trying to score political points, and start a real dialogue aimed at solving the fiscal crisis.

Published or Updated: August 9, 2011
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Comments

  1. Money Beagle says:

    I disagree only because the purpose of the credit ratings is to judge whether we have the ability to pay our debts back. Regardless of how much debt we have, we have never failed nor is there anything to suggest the future failure ability to pay our debts off.

    Besides, if it was such a warranted move, then investors would have rushed away from the treasuries, right? Yet, treasuries and gold were the two things that people moved into. If treasuries are so ‘bad’ then the opposite should have happened.

    • Cyber Tech Zone says:

      Your opinion is right. I agree with you.

      Signed,

      Cyber Tech Zone

  2. jim says:

    I think they were wrong. Like they’ve been wrong many many many times in the past. Remember these are the guys that rated bundled sub prime mortgages as AAA until the real estate crash.

    S&P made a $2 trillion dollar error in their calculations on the US debt and then failed to even step back and rethink after that was pointed out. Frankly thats just stupid.

    • DR says:

      Jim, I had the same initial response to the $2 trillion dollar error. But as sloppy as it is, the downgrade wasn’t technically about the amount of debt. And frankly $2 trillion over 10 years as compared to GDP is peanuts. That said, I totally agree with you about S&P’s history. Of course, ratings are at best an educated guess.

  3. Annie Mack says:

    It isn’t S&P’s place to rate anyone based on politics. Had they downgraded the USA based on failure to pay debt, then I could see their point. However, math error aside, S&P had no basis on which to downgrade the USA and the timing is very suspect. I believe our allies are aware of what a sham this is and the race to buy treasury bonds should be an indicator of the faith that still remains in our country. I wish our citizens were as loyal! Wanting a president out of office is no reason to take down an entire country!

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