On August 5, the credit rating agency Standard & Poor’s (S&P) lowered the U.S. government’s debt rating, citing concern about the nation’s debt burden and spending trajectory. What does that mean? Let’s ask Rick Calhoun, a Little Rock investment banker with Crews and Associates and a board member of the Advance Arkansas Institute.
Previously on the Arkansas Project, Rick warned about how a downgrade could affect the federal government’s ability to service its debt, and how spending reform is urgently needed. We followed up with him after last week’s downgrade.
In a guest piece on the Arkansas Project last month, you argued that government spending needs to be brought under control. What was your take on the debt deal Congress passed and President Obama signed on August 2?
Rick: Most everyone agrees it was the best deal that could be reached in the present political climate, but really, it’s only the beginning of the political skirmishes to come. The debt deal did not bring spending under control; it only said, “we intend to bring spending under control in the future.” On the whole, it’s a good place to start, but doesn’t go nearly far enough. If we can’t cap spending, in 10-15 years we may end up looking more like Ireland and Greece. Nobody wants that.
Government debt ratings are pretty abstract. What does a debt downgrade mean?
Rick: S&P, Moody’s, and Fitch are rating agencies (actually, private companies) that rate the creditworthiness of an issuer’s debt, or bonds, which includes bonds issued by governments as well as corporations. Put another way, the rating agencies tell investors about an issuer’s ability to make principal and interest payments and avoid default.
S&P has 10 ratings in the “investment-grade” category. The lowest is BBB- and the highest is AAA. Any bond rated below BBB- is considered a “junk” bond and is highly speculative. To put things into perspective, Ireland was downgraded to BBB+ back in April, which is only two notches above the lowest rating. Greece was downgraded to CCC in June, which gives them “junk” status and a 73 percent probability they’ll default within the next five years.
When S&P downgraded U.S. Government bonds from AAA to AA+, that’s only one notch below the highest rating, but it’s still nine notches higher than all the rest in investment-grade range.
The rating will not affect the economy—rather the rating is a reflection of the economy and the government’s reduced ability to make future payments on its debt. However, a weak economy that produces less tax revenue while federal spending continues to grow is at the root of the problem. The average person will feel little in the short term, but the long-term consequences could be great.
One of the political responses has been an attack on S&P’s credibility. How reliable are S&P and other ratings agencies?
Rick: Attacking the accuser is an old political tactic—it’s like saying unkind things about the bank that won’t make you a loan because you already owe to much on your credit card. Yes, the rating agencies did make some bad calls in the past and that’s one of the reasons they’re now being extra cautious.
Federal regulators such as the Office of the Comptroller of the Currency and others mandate rating guidelines that must be followed by pension funds, investment managers, etc. How can government regulators tell banks and investment managers to follow their rating guidelines on one hand, and then tell the public to ignore the same rating agencies on the other, and still maintain their own credibility?
Or to put it another way, there was a great quote in the Wall Street Journal that sums it up: “The Obama administration needs to stop trying to disarm the fire alarm and start trying to put the fire out.”
This is uncharted territory, as there’s no precedent for a U.S. debt downgrade. What would it take to get the AAA debt rating restored?
Rick: Unless the federal government can address its long-term spending problem, U.S. debt will probably be downgraded again in the future. The problem didn’t happen overnight and it won’t be fixed overnight. In the 1930s, the government saw spending as a way to tackle many of our social problems, and it has only gotten worse over the years. As my grandmother used to say, “The chickens have finally come home to roost.”
It will be painful, but the only solution is to reduce spending. The revenue component will take care of itself as the economy recovers. The U.S. Treasury has never collected more than about 19 percent of GDP, during periods of high tax rates and periods of lower tax rates—so raising taxes is not the answer. The answer is to stop spending and encourage economic growth.
What should we expect to happen next?
Rick: Hang on to your hat, because it’s going to be a wild ride in the financial markets. Contrary to common thinking, U.S. Treasury rates have fallen even lower. “U.S. debt is the comely girl at the homely girl dance” is how one trader compared U.S. debt to the debt of other countries. The stock market was looking for an excuse to sell off; the downgrade provided that excuse. Next month, the stock market will use unemployment, housing starts, or some other excuse to go up or down.
Right now, the economy is looking to Washington for encouragement and getting little. For the long term, do we want to use a balanced budged amendment to the U.S. Constitution, or do we want to follow Greece or Ireland down the path of economic ruin? Call your congressman and ask for his answer.