Standard & Poor's Shot Across The Bow
Downgrade of U.S. debt should spur the government into serious action on debt, taxes, and spending, says finance professor Nejat Seyhun.
ANN ARBOR, Mich.—Standard & Poor's recently took the unprecedented step of downgrading the debt of the United States from AAA to AA-plus, despite passage of a long-awaited debt ceiling/spending bill. The ratings agency was not impressed by the acrimony displayed by Congress and President Obama, and it noted the deal didn't fully address long-term gaps in spending and revenue. The move was assailed by some experts who noted recent poor judgments by the ratings agency. But finance professor Nejat Seyhun says S&P made the right call, despite some problems with how the agency went about it. In the following Q&A, Seyhun, the Jerome B. & Eilene M. York Professor of Business Administration, characterizes the downgrade as the kick the government needs to begin the serious conversation on spending priorities and taxes it has avoided for far too long.
In your opinion, was this S&P downgrade justified?
Seyhun: Yes. Given the amount of debt, given the deficit, given the political gridlock and unwillingness to compromise, and given the budget forecast I think it was justified. There were some problems in the execution of the downgrade, however.
Speaking of that, a lot was made of the $2 trillion math error. Opponents of the downgrade also noted S&P's misjudgments on Iceland and mortgage securities. Is that sour grapes or do they have a point?
Seyhun: S&P and the other credit ratings agencies are typically a bit late and a bit easy on the debtors. They tend to wait until the picture is quite clear and then downgrade. Typically the market prices react before the credit agencies lower their ratings. We also have evidence that they lower the ratings slowly, as opposed to taking one big step. I think part of the issue here is S&P has been under some political pressure. Europeans have been putting pressure on S&P, saying it's been too hard on European sovereigns and as a result they may have wanted to get ahead of the game and downgrade the U.S. even though there was an agreement on the debt ceiling.
S&P didn't find that agreement satisfactory. Why not?
Seyhun: It averted the immediate problem but it didn't do much for the long-term problem. I agree with S&P that the agreement is only a little part of what's needed to solve the long-term sustainability of the U.S. budget situation.
Do you mean in terms of our long-term obligations versus what's expected to come in through tax revenue?
Seyhun: Correct. The U.S. has a current deficit of about 10 percent of GDP, the revenues are running around 15 percent of GDP, and expenditures are running around 25 percent of GDP. We're running about $1.5 trillion currently and that's likely to accelerate if we don't do anything about the current policy. The fact there's an agreement to cut $1 trillion over the next 10 years is really peanuts. They're just solving less than one year's problem with that agreement. There's a lot more to solve.
How come the other ratings agencies, like Moody's and Fitch, haven't downgraded the U.S. debt?
Seyhun: Good question. Again, the rating agencies tend to act slowly, all of them. It's possible Moody's and Fitch want to see what will happen with the super commission or they may want to see what's going to happen with GDP.
Do you think this could be a wake-up call for policymakers?
Seyhun: Yes and, fortunately, it's having that effect. The stock market reacted very strongly on the first day of trading after the downgrade. The Dow Jones Industrial Average was down 635 points that day. Even though a lot of people thought that there was no new information in what the S&P said, the markets took it very seriously. There was a global stock market decline — Europe, Latin America, and the Pacific Rim all declined. So I think it's signaling that we're sort of at the end of current policies, that we need to change.
Do you think that will happen?
Seyhun: It has to happen. We've pushed the envelope as much as we can in terms of trying to do everything and not prioritizing. The U.S. wants to be the world's police with defense expenditures running $700 billion a year and we want to run sort of a welfare state with Medicare, Medicaid, and Social Security. We have lots of other obligations and we can't do all of it. The U.S. needs to prioritize and decide which things we want to do and which we do not want to continue. So, yes, I think a solution will be forced if the government doesn't do it voluntarily.
It seems a lot of the argument centers on tax increases and whether they should be part of the solution. The S&P did chide the government for spending too much and also for not having a plan to raise revenue. Are we talking about a mix of tax increases and cuts?
Seyhun: Most likely. I think a serious, credible solution to the deficit problem will have to take a very broad approach. This is an approach the Bowles-Simpson Commission took. The Gang of Six, as it was called, showed you can balance the budget and get the deficit down to zero using realistic assumptions. They called for a combination of lower marginal tax rates yet higher revenues by eliminating deductions — including some favorite deductions like mortgage interest — and at the same time cutting the growth rates of Social Security, Medicare, and other health care expenditures like prescription drugs. That's a balanced approach to eliminating the deficit. They did not suggest some other ways of raising taxes, such as a value-added tax (VAT), which could raise huge amounts of revenue. They showed you could get to a balanced budget with as low as a 23 percent highest marginal personal tax rate (and 26 percent for corporations) by eliminating all deductions.
When you talk about the revenue side, things like eliminating our favorite deductions and a VAT have been non-starters in Congress. Also cutting Social Security is fraught with political danger. Do you think those are on the table now?
Seyhun: I think what S&P is saying is that we're coming to the end of one policy tool. Until now, to get out of our current funk with respect to growth and unemployment we've been trying to spend money to stimulate the economy. S&P is saying we're reaching the end of that policy tool. We are not going to be able to spend our way out this particular funk. Now the remaining policy tools are to cut back on expenditures and to raise revenues. In that sense, the downgrade is certainly contributing to the policy tools.
How do you think the downgrade will affect Federal Reserve policy? Will it prevent the Fed from launching another quantitative easing program?
Seyhun: There are constraints on what the Fed can do now. Certainly the downgrade is going to be something they'll have to take into account, but really they've done as much as they can. The Federal Reserve increased its balance sheet from $600 billion to $2.8 trillion. They flooded the market with as much liquidity and credit as they could. The problem is, given the state of the economy and the expected future state of the economy, neither borrowers nor lenders are interested in using this credit to make investments.
Corporations are sitting on $1 trillion of liquidity. They're not interested in borrowing more money. A lot of individuals aren't able to get loans because they're not deemed to be prime borrowers, and banks don't seem to be interested in making additional loans. I looked at the total loans the banks made since 2008 and bank lending has declined from $1.5 trillion to $1.2 trillion. So they've cut back 20 percent over the last three years on lending activity while at the same time the Fed has flooded the market, giving banks all this credit to make loans. But the banks are not doing it. What could additional easing do? It could be counterproductive at this time. Bernanke himself said that monetary policy is not panacea. So I think they reached the end of their policy tools.
We just had a very acrimonious debate with this recent debt-ceiling bill. How do we get the same people involved in a national conversation like that to reach a more broad-based deal?
Seyhun: It's a very serious problem. A lot of policy choices are available to solve the deficit problem. But at the same time, we do not want to hurt the economy. How do we on one hand address the deficit problem and on the other hand don't make the current long-term prospects of growth worse? Bowles-Simpson showed we cannot really raise the marginal tax rates on corporations or individuals. That's going to have an undesirable effect of making the GDP growth worse. That means we're going to have to lower the marginal tax rates both on corporations and individuals.
Corporations are facing much lower marginal tax rates abroad than in the United States. As a result, they keep a lot of their profits outside the U.S. So Bowles-Simpson envisions a corporate tax rate of about 26-28 percent, down from the current 35 percent. If we're going to bring marginal rates down yet raise more revenue, the Democrats are going to have to give up a little of their priority that tax rates shouldn't be regressive. A regime where everyone is taxed the same would be regressive and it would lower marginal rates, but it would raise a lot of revenue without hurting economic growth.
We also have to address the expenditure side. The population is aging so the burden on Social Security, Medicare, Medicaid, and prescription drugs is going to increase. Almost all the growth in the deficit comes from these healthcare expenditures. Social Security is actually less of a burden. You also can deal with the Social Security situation by raising the retirement age, which they've done in the past.
Bowles-Simpson showed there can be bipartisan agreement on credible policy tools to reduce and eliminate the budget deficit. Unfortunately we missed that opportunity. When Bowles-Simpson came out with its report in December 2010, President Obama basically ignored it. Another problem I see is none of the Bowles-Simpson members are on the "super committee." Nevertheless, I think there's an opportunity to take elements of the Bowles-Simpson recommendation of a broad-based approach.
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