The US can’t put off tackling its debt much longer, says Simon Wilson.
What’s happened?
Credit ratings agency Standard & Poor’s (S&P) has warned that there’s a one-in-three chance that the US will lose its ‘AAA’ sovereign credit rating within two years. The overall outlook for America’s long-term credit rating has shifted from “stable” to “negative”. Its report, which caught the markets completely by surprise this week, is on the face of it pretty shocking. Despite some core strengths (such as a flexible and a highly diversified economy), S&P believes that America’s fiscal prospects could soon be “meaningfully weaker” than those of peer ‘AAA’ sovereigns with more credible fiscal plans, such as Britain, France and Canada.
Why is Standard & Poor’s worried?
Mainly due to the question mark over America’s political will and/or ability to rein in its government finances. Between 2003 and 2008, the government’s deficit ranged between 2% and 5%. Already larger than that of similar nations, it ballooned to more than 11% in 2009 and has yet to drop. As for the cumulative national debt, it’s near $14.3trn, almost as much as last year’s GDP. Despite the need for action, notes S&P, “we believe there is a material risk that US policy-makers might not reach an agreement on how to address medium- and long-term budgetary challenges” in the immediate future or even by 2013 (after the next presidential election).
Is it time to panic?
Not just yet. The timing of the report may come as a shock, but S&P isn’t saying anything the market didn’t know; recent IMF reports and Pimco warnings have also concentrated minds. S&P’s intervention is clearly intended as a warning shot to US politicians. Even the author of the report expects doom-laden warnings of a US fiscal meltdown to become a self-defeating prophecy: “some compromise that achieves agreement on a comprehensive budgetary consolidation programme – containing deficit reduction measures in amounts near those recently proposed, and combined with meaningful steps toward implementation by 2013 – is our baseline assumption and could lead us to revise the outlook back to stable”. This is the bit in the report that explains why US Treasury yields actually fell after it was released, and stocks recovered quickly. As Société Générale’s Fidelio Tata put it: “The best way to make Washington actually do something is to tell politicians there is something they cannot do.”
What’s Washington doing?
Just two weeks after the US government narrowly avoided a shutdown due to the inability of Republicans and Democrats to reach agreement over setting a budget, the next big battle looms. This time the issue is the imminent need to raise the federal debt ceiling (see below). With the government’s overall debt expected to hit it within weeks (around 16 May), Treasury Secretary Timothy Geithner has said he will take temporary measures to push the deadline to 8 July. But by then Congress needs to approve a rise, or risk fiscal paralysis and an all-out slump in confidence in America’s stability. “If you allow people to start to doubt whether the USA will meet its obligations, that would be catastrophic,” said Geithner.
How much are we talking about?
According to figures from the Congressional Budget Office, US law-makers will have to raise the limit by $2.2trn under the spending plan President Obama submitted in February, or by $1.9trn under the more austere plans favoured by House Republicans. That would cover fresh debt up to October 2012, a month before the next presidential election. All sides understand that to fail to pass the necessary legislation would invite economic catastrophe by increasing America’s borrowing costs. But many on Capitol Hill feel it’s time to take a stand. “It’s not just Republicans,” said Joe Lieberman last week. “A lot of Democrats, including myself, are not going to vote to raise the national debt ceiling unless there is something concrete, real tough, done to guarantee that the debt itself will be reduced in the coming years.”
So what’s the plan?
The Republicans’ Paul Ryan is leading the party’s programme for fiscal retrenchment, with a plan to cut the deficit largely through deep spending cuts and Medicare reform. Last week President Obama outlined his own plan to reduce the debt by $4trn over 12 years via more modest cuts and tax rises on the very wealthy (people earning over $250,000). As ever, the mixture of spending cuts and revenue rises forms the core political battlefield. Next year, the Bush-era tax cuts are due to expire. Currently, Democrats want to extend them for people earning below $250,000. Republicans want them extended for everyone, even the wealthy. For now, the tax side of the debate has been secondary to the spending side: expect this to change if America’s fiscal mess deepens.
What is a debt ceiling?
Unlike most nations, America puts a legal limit on its national debt, which is currently $14.3trn. For it to go any higher, Congress has to vote in favour. The power to approve all federal borrowing has been in place since the founding of the States. The introduction of an overall “debt ceiling” dates from 1917, when Congress agreed an overall limit to give the Treasury more flexibility as America entered World War II.
Raising the debt ceiling is usually a perfunctory matter: it has happened at least nine times since 2001. This time it’s different, partly because so many of the 87 newly elected Republicans were voted in on a pledge to cut up the national credit card; and partly because the debt (relative to GDP) is at its highest level in five decades.