June 17, 2024

Economix: Behind the S.&P. Warning on the Deficit

Today's Economist

Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

Standard Poor’s announced on Monday 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, that was a warning “that we could lower our long-term rating on the U.S. within two years” (see Page 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 attention, the economics behind its thinking is highly questionable. Still, given the quirky nature of American politics, this intervention may or may not 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 United States fiscal deficit –- one wonders where it was, for example last year, during the debate about extending the Bush-era tax cuts.

In January, both S.P. and Moody’s Investors Service warned that the United States might tarnish its credit rating if its national debt kept growing. Though the latest S.P. report did not explicitly refer to the coming Congressional vote over raising the debt ceiling, it certainly added an element to the debate.

But S.P. did not lay out even the most basic numbers or point readers toward the nonpartisan and definitive Congressional Budget Office analysis of medium- and longer-term budget issues. This matters, because the C.B.O. numbers definitely do not show debt exploding upward immediately from today.

(Disclosure: I’m on the C.B.O.’s Panel of Economic Advisers, which meets twice a year, and I am paid for that role, though I did not take part in this analysis in any way.)

You can see the C.B.O. analysis clearly in Table 1.1 in its latest report, where the line “debt held by the public at the end of the year” (meaning private-sector holdings of federal government debt and excluding government agency holding of government debt) makes it clear: debt as a percentage of gross domestic product rises to 75.5 percent at the end of 2013 and then increases very little through 2019.

Two serious budget issues are made clear by the C.B.O. 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 C.B.O. forecast cited above with its view from January 2008 (see page XII, Summary Table 1), before the seriousness of the banking disaster — and the ensuing recession — became clear.

At that point, the C.B.O. expected federal government debt relative to gross domestic product to reach only 22.6 percent in 2018 (compared with the 75.3 percent for 2018 from the 2011 projections.)

In other words, the financial crisis will end up causing government debt to increase by more than 50 percentage points of G.D.P. over a decade. This is the major fiscal crisis of today and the likely one tomorrow. (I wrote more on this in a column this week for Bloomberg.)

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” (Page 4). And S.P. does put “the maximum aggregate financial sector asset impairment in a stress scenario at 34 percent of G.D.P., compared with our estimate of 26 percent in 2007” (Page 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 the financial crisis (as seen in the C.B.O. numbers): the loss of tax revenue from the economic slowdown, for example, or the costs of addressing cyclical problems, such as spending on unemployment.

Instead, S.P. talks about the upfront cost without explaining what it means. My educated guess is that this means such programs as the Troubled Asset Relief Program, or TARP — costs that could be recouped, at least in part, and thus 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 percent of G.D.P. — just look at what happened this time in the United States or the way in which Ireland was ruined by big banks and reaction by the politicians there. There is no way that the S.P.’s stress situation is sufficiently negative.

To be fair, the C.B.O. also does not present a realistic stress or alternative situation along these lines, because of a problem with its current methodology 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 Page 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. (More disclosure: I was paid an honorarium to attend a Fiscal Forum at the I.M.F. last week at which these issues were discussed.)

There is, of course, a longer-run budget issue — beyond 2020 –- that is mostly about health care costs. S.P. follows the current consensus by flagging the Medicare component of this, and the C.B.O.’s projections on this front are undoubtedly scary (see this C.B.O. Web page or jump directly to the document and study the image on its front page).

But the real threat to the economy is health-care costs seen broadly, not just the Medicare component. For more on this, see the analysis by my co-author on the Baseline Scenario blog, James Kwak, writing about an important letter from Douglas W. Elmendorf (the head of the C.B.O.) to Representative Paul D. Ryan, Republican of Wisconsin and chairman of the House Budget Committee, on Mr. Ryan’s budget proposal.

In Mr. Kwak’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 health-care 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 clarify this issue. The company still seems hampered by some of the same weak analytics that contributed to its misreading of subprime mortgages and associated derivatives.

Will its broad-brush and somewhat indiscriminate warning push politicians to sensible debate and eventual action –- with regard to both the financial system dangers (the medium-term issue) or health care 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.

Article source: http://feeds.nytimes.com/click.phdo?i=32447162cb0a9cba771637d9af0542d9

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