Thoughts on the S&P Downgrade

Well, everybody’s offering their thoughts on the S&P downgrade, so I might as well mention some of the reactions and offer my own.

Remember, earlier this year the ratings agencies said they were thinking about downgrading the U.S. if they didn’t come up with a plan to get their deficits in line. There was lip service in Washington about the need to reduce the debt, and Obama even appointed a commission to come up with ways to fix things, but no one ever did anything about their recommendations (known as the Bowles-Simpson plan), probably because the solutions were so balanced that both political parties found them unacceptable. But Republicans took the agency warnings as proof that they needed to cut spending before they raised the debt ceiling again. Of course, when the debt ceiling got closer and no agreement was being reached, the ratings agencies then warned that if they didn’t reach a deal they might downgrade the country, too. Then they warned that even if they reached a deal, if the cuts weren’t big enough, they might still downgrade us:

The major credit rating agencies have warned that if a big enough deficit-reduction plan of about $4 trillion is not agreed on — even if the debt limit is raised — they could still downgrade America’s coveted triple-A rating.

We only came up with a plan to cut $2-something trillion. The agencies wanted 4, we gave them 2, boom, they downgraded. Simple as that. Naturally, Republicans are using this as proof that we need to reduce the deficit even more. Of course, to them that only means cutting spending, and no tax increases at all. Tyler Cowen thinks the GOP will regret their stance, because they could have had $4 trillion with Obama’s “grand bargain” that was mostly spending cuts but still had some tax increases. But Cowen doesn’t think the markets will care too much, as “the facts on the ground did not change today… Still, years from now today may well be seen as a turning point of significance.” Megan McArdle thinks the GOP will take the share of the blame for this too, and she also wonders if the stock market was dropping all week due to rumors of the downgrade. (I think I side with Arnold Kling’s theory that the markets were dropping on concerns of the economy anyway, and the debt ceiling deal just accelerated the flight to Treasury bonds by making investors less nervous about holding Treasuries.)

But is it the GOP’s fault for resisting a $4 trillion deal that included revenues, or Democrats for not agreeing to $4 trillion in pure cuts? There’s enough spin to go around here. GOP presidential candidates, including Michelle Bachmann and Mitt Romney, have wasted no time in blaming the downgrade on Obama, which to me is starting to feel as silly as the way many on the left have unilaterally blamed everything on Bush. I think Obama deserves more of the blame for the deficit than the left wants him to take, but Bush deserves some of the blame that the right wants to dump entirely on Obama.

Paul Krugman, of course, never wastes an opportunity to blame “the madness of the right,” although his primary point is a little more substantial, taking us back to the economic reasons for the downgrade: “In short, S&P is just making stuff up — and after the mortgage debacle, they really don’t have that right. So this is an outrage — not because America is A-OK, but because these people are in no position to pass judgment.” (He’s referring to the way the ratings agencies had mortgages rated AAA even as they were found to be completely insolvent when the housing bubble burst and the financial crisis hit in 2007-2008. If they got that wrong, who cares what they think the US debt rating should be?)

There was an interesting back-and-forth with S&P and the Obama administration about an apparent $2 trillion error in S&P’s budget math, which they conceded but did not change the downgrade. I don’t think that’s really a big deal either way. The government is projected to spend over $40 trillion in the next decade, and considering the past woeful inaccuracies of such projections, I expect we will actually end up trying to spend far more than $2 trillion over the projections anyway, so who cares if S&P’s math-errored projections were different than the too-optimistic-anyway baseline projections?

But there are in fact some reasons to question the economic rationale for S&P’s downgrade – why was $4 trillion the magic number anyway? In addition to the math error, there is the inconsistency of the timing – S&P was apparently projecting worse numbers for the country in the past than it is today but it didn’t downgrade it until now.

This leads credence to the idea that, $4 trillion statements aside, the downgrade didn’t have as much to do with the U.S. economy as it did with U.S. politics, summed up in this statement from the S&P downgrade press release: “The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed.” Congress fought so much trying to increase the debt ceiling – and the GOP have now vowed that the days of clean debt ceiling increases are over – that it sounds like S&P just doesn’t trust the U.S. government very much to handle the increasingly large debt in the future – whether it will grow so fast that it won’t be able to pay it back or whether deficit hawks will essentially force a refusal to pay it back. It’s just “less predictable than what we previously believed.”

So who knows why they downgraded the United States? I don’t really care if it was for economic or political reasons or both. We increased the debt by almost $10 trillion in the last decade, and we were actually originally projected to reduce it in that decade. So I don’t care what kind of projections they have for this decade – it’s projected to go up by $7-10 trillion more in this decade already, depending on who’s doing the math and how many “cuts” will actually happen, and it’s likely to end up being far worse. And if you believe like I do that the deficit is in far worse shape then the projections say – though I hesitate to be too overly pessimistic – then you don’t believe the US deserves a AAA rating anyway.

How do we fix that form here? Dave over at Classical Values is skeptical about the value of the GOP being more open to tax increases. I’m breaking from pure libertarian form here, but I do think that a real reduction plan would have to include some tax increases. To look at it one way, the debt problem we have now was almost entirely caused by new spending – but the “Bush tax cuts” (that now should have Obama’s name on it too) definitely contributed something. I would be OK with a rollback to 2001-ish levels of spending AND taxes. The economy seemed all right with those still historically low levels in the 90′s, and it would stop the liberals from talking about the “Bush tax cuts.”

Additionally, while I would still personally prefer to slash spending enormously and not raise any taxes, those who share that ideology with me do not control all of Congress, and I think a 80-20 or so (spending cut to tax increase ratio) compromise still looks pretty good. The GOP has been so opposed to raising any revenue that they’ve opposed ending various tax credits. Even if you don’t want to raise tax rates, it’s silly to be opposed to ending poorly-targeted lobby-induced incentive-distorting tax credits like those for corporate jets or even mortgages. Besides, the Bowles-Simpson plan actually recommended lowering rates in exchange for ending a bunch of poorly-targeted lobby-induced incentive-distorting. Of course, many in the GOP are wary of the old Democrat trick of “tax hikes now, spending cuts later,” and then the spending cuts never actually happen: 80-20 becomes 0-100. But that’s just a matter of the GOP forcing any revenue increases to be proportional time-wise to the spending cuts. Either way, I just don’t think 100-0 is economically or politically feasible.

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