Downgraded Outlook

When is bad news good?  It makes that transition when it alerts us of a problem that is resolvable.  On Monday, the rating agency Standard and Poor’s downgraded the outlook for the United States federal government from stable to negative because they believe that there is a significant risk that elected officials may not reach an agreement that addresses the country’s long-term fiscal imbalances caused by unfunded entitlement programs (“S&P Affirms US AAA Rating, Cuts Outlook to Negative”). 

Some believe that the political class is so polarized that compromise is impossible.  Others, knowing that voters to not like cuts in benefits nor increases in taxes and that any serious plan will require one or both, believe that any serious plan to resolve the problem offered by one party will be used as an effective campaign issue against the other.  Good politics usually trumps serious economic reform.

The Chinese government sees the problem.  As one of America’s biggest creditors with about 2 trillion in exchange reserves in dollar denominated assets “China Urges US to Protect Creditors After S&P Warning.”  China is as trapped by our debt as we are.  Any rush to sell dollar denominated assets, like United States Treasury bonds, will quickly lead to a collapse in price seriously damaging the value of remaining Chinese holdings. 

Of course, the impact on the federal government’s fiscal crisis would be monstrous as well. The Greek debt crisis may illustrate the worst case scenario of what we could face.  Greek debt currently has a yield of over 15% on 10-year bonds compared with the German rate of 3.27%, and the U.S. rate of 3.43% (“Greek PM: Ratings agencies running our lives”).  The average maturity of the U.S. government debt is approximately 5 years.  As a back of the envelope calculation, assume all debt is held in five years notes and the yield is 2.25%.  Interest payments comprise approximately 15% of all federal outlays.  If interest rates double to 4.5%, interest payments on the debt would rise to 30% of all current outlays.  If they rose to 10%, interest payments would rise to 60% of all outlays.  If interest rates rose to Greek levels of 15%, interest payments would rise to 100% of current outlays.   

Federal government outlays are currently 24% of GDP.  To maintain current levels of expenditures on all other programs, outlays would have to rise to 44% of GDP if interest rates rise to 15%.  Not to lose the main point, it is the projected growth in unfunded entitlements that threatens our country’s fiscal stability.  Rather than vote against a party that offers need reform, the wise voter will use time as a fulcrum to leverage future cuts in entitlements.