Earlier this month, Moody’s Investors Service – citing increases to the U.S. public debt created by this month’s tax deal between the Obama Administration and congressional Republicans – said the United States could be placed on a negative credit outlook in the next two years, increasing the likelihood that the country’s credit rating could actually be downgraded from its coveted triple-A level in the 12 to 18 period after a negative outlook was issued. 1
Not the First time Moody’s Has Warned on the U.S.’s Sovereign Credit Rating
Moody’s has previously made rumblings about the possibility of negative movement in the U.S.’s credit rating. 2. In the past, I’ve dismissed these concerns because they don’t account for the fact that other nations with big deficits already have much higher taxes than the U.S., so those countries have already expended their reserve of unused taxing power. I’ve also suggested that the political leadership the U.S. provides in maintaining international peace and security, creating a climate where business can flourish, heightens U.S. creditworthiness.
Why Now More Risk of a Downgrade to the U.S. Credit Outlook or Rating?
My perspective on the United States’ sovereign credit rating has changed because a confluence of factors suggests that the major credit rating agencies – Moody’s (MCO), Standard & Poors (owned by McGraw Hill (MHP)) and Fitch (majority-owned by Fimalac SA (FMLCF)) – will seriously consider the prospect of a U.S. downgrade in the coming years:
- Inclusion of a payroll tax cut for 2011 in the recent tax compromise. Extending the Bush-era tax cuts and federal long-term unemployment insurance benefits was not a surprise since that basically just maintained the status quo. But the fact that the U.S. would lower taxes to fund one of its key financial vulnerabilities, Social Security retirement benefits – at a cost of $111.65 billion over ten years3 – can be seen as a gratuitous barb in Europe, where governments are taking painful austerity measures.
- The sheer size of the U.S. budget deficit. Even before the new imbalances created by the tax package, the U.S. budget deficit was already beyond historical norms. Adjusted for inflation, 2010′s deficit was twice the size of the U.S.’s biggest World War II deficit in 1943, and three times the biggest inflation adjusted figure at the height of the Reagan administration’s arms buildup.4
- Continued high defense spending. Recent obstacles to U.S. efforts to wind down military operations in Afghanistan portend that any significant peace dividend accruing from a U.S. withdrawal from Afghanistan or Iraq is still years away. 5
- The credit agencies’ conflicting political interests. As I’ve previously argued, the major credit agencies are already motivated to more aggressively question the U.S. credit rating to fend off threats of increased regulation stemming from the agencies being too soft on big players (like Lehman Brothers). While they will be cautious to lower the U.S. credit outlook or rating itself for fear of market disruption, this conflicting political interest may tempt the credit agencies to depart from this careful path.
Barring strong U.S. economic growth in 2011 and serious action to reduce spending in the upcoming budget cycle – including letting the one-year payroll tax cut expire – these factors could eventually persuade the credit agencies to take negative action.
Consequences if a U.S. Credit Downgrade Occurs: More Debt and Political Fallout for President Obama in the 2012 Election
The immediate economic effect of a lowered U.S. credit outlook or rating would likely be a higher cost of borrowing for the U.S. Government, pushing the deficit even further. But a U.S. credit downgrade could also have broad political implications, further galvanizing the movement to control spending and providing Republican presidential contenders with fresh ammunition to challenge President Obama in the 2012 election.
Disclosure: The author does not hold a securities position in Moody’s (MCO), McGraw Hill (MHP), or Fimilac SA (FMLCF).
Disclaimer: The information provided in this post does not constitute professional investment advice, and should only be used in consonance with all available information, including the opinion of a professional adviser, to make an investment decision.
- See “Moody’s: U.S. Credit Rating Outlook Could Be Affected By Tax Package,” Dec. 13, 2010, http://www.huffingtonpost.com/2010/12/13/moodys-us-credit-rating-o_n_796101.html. [↩]
- See, e.g., “Moody’s Says U.S. Debt Could Test Triple-A Rating,” Mar. 16, 2010, http://www.nytimes.com/2010/03/16/business/global/16rating.html [↩]
- See “Package Adds Fuel to Fights Over Spending, Tax Policy,” Wall Street Journal, Dec. 18-19, 2010, A5 [↩]
- See the outstanding chart provided by Dave Manual at “A History of Surpluses and Deficits in the United States,” http://www.davemanuel.com/history-of-deficits-and-surpluses-in-the-united-states.php. Dave Manual also notes that the current deficit is much lower in percent of GDP (9-10%) than the World War II figure (30.3%). However, the total public debt as percent of GDP has now just equaled the maximum World War II level of 94%. See “United States Public Debt, Wikipedia.org, http://en.wikipedia.org/w/index.php?title=United_States_public_debt&oldid=403760797. [↩]
- See “U.S. Delays Afghan Moves,” Wall Street Journal, Dec. 16, 2010, A1. [↩]