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Op-ed

Deal or No Deal, a US Downgrade Is Deserved

by Carmen M. Reinhart
and Vincent R. Reinhart, American Enterprise Institute

Op-ed in the Financial Times
August 1, 2011

© Financial Times


Negotiations between President Barack Obama and congressional leaders found a sliver of common ground this weekend. Legislation to raise the debt ceiling now seems likely, giving the government headroom to operate until 2013. But a temporary ceasefire in this fiscal war will not address the country's longer run problems. The rating agencies are therefore justified in reconsidering America's triple-A credit rating.

The presumed deal now seems likely to trim spending by about $2.4 trillion over the next decade. The participants will doubtless hail this as a historic compromise. Yet if one puts the high decibel histrionics to one side, it becomes clear that this breakthrough marks, at best, the end of the first act of a drama that will rival the Ring of the Nibelung in length and complexity.

The biggest surprise in the opening act was the false sense of drama. On the evening news the default clock ticked down ominously. Yet the long history of sovereign defaults tells a different story. Nations do not stop payment on a whim. Indeed, they go to great lengths to avoid the sizeable disruption and long lasting stigma associated with nonpayment. Politicians accept unpalatable compromises, while fiscal authorities reach deeply into their bag of accounting tricks. Protestations up and down Pennsylvania Avenue notwithstanding, US officialdom was always likely to follow that script.

Yet even if this deal is done, the United States will continue to feel considerable external pressure, in the first instance from the rating agencies, unless more progress is made. Even by Washington standards, $2.8 trillion sounds like a big number, but the underlying budgetary arithmetic remains slippery. Most of the spending cuts are to be decided later. They also rely on the untested mechanisms of a new committee, tasked with agreeing to a package of cuts, with the threat of across-the-board cuts in entitlement programs if it fails. This sounds plausible, but we should remember that hope flickered for a moment back when Mr. Obama's deficit reduction commission was appointed. That light failed quickly.

This week America must wait nervously to find out whether the deal will be enough to save its credit rating. The rating agencies recently laid out two important vulnerabilities that might lead them to mark it down. Given the deal does little to address either, the agencies are likely to make good on their threat to downgrade.

The first concerns the true nature of America's overextended government, which stretches well beyond the $14.3 trillion public debt that is currently subject to limit. Here the federal sector is on the hook for a number of liabilities. Some are well known, and based on legislated promises, such as the underfunded social safety net. Others are unacknowledged, but will soon hit the national balance sheet.

In particular, unfinished business lingers from the financial crisis of 2007–09, mostly related to bad mortgages. Those are troubling for those institutions that hold the debt, as well as being a considerable burden for the one in five mortgage owners whose houses are now worth less than their debt.

This unfinished business has damaged the housing market and slowed growth, while also hitting state and local governments. Authorities splurged in the good years of the housing bubble, but did nothing to prepare for leaner times. Widespread deleveraging is thus still the order of the day. And when so many want to spend less than their incomes, an economy sputters.

This poor performance is what we should expect from history, where post-crisis economies grow more slowly, and unemployment stays high, in the decade after a major financial crisis. Economic data last week confirmed this, with the S&P/Case-Shiller home price index declining again, and gross domestic product expanding by less than 1.5 percent over the past four quarters.

Such a subpar performance makes it much hard to overcome America's balance sheet problems. These future liabilities also make more palpable the second risk identified by the rating agencies: the fact that almost half of all Treasury securities are now in the hands of foreigners. Here, demand for US debt has increased as emerging markets try to keep their bilateral exchange rates steady. Yet foreign official accounts want to get repaid as much as other investors—and if foreigners focus on the standoff, not the settlement, their doubts may grow about the United States' role in global markets. Any decision to slow foreign exchange intervention would tend to weaken the dollar, while also making the Treasury's task of funding large budget deficits much more difficult.

The rating agencies are not likely to be impressed by this weekend's drama, and rightly so. Yet a downgrade would still be a shame, if only because this deal ought to open up a further opportunity for US politicians. US tax policy is shambolic and spending discipline nonexistent. If Republicans could accept that the average tax rate has to rise, Democrats could perhaps appreciate that this may not be best accomplished by raising marginal tax rates in the existing system. Both could agree to discipline spending.

Such steps could arrest the steady increase of debt-to-GDP ratios, even after addressing those looming contingent liabilities. The nation would be better off. If moves are made quickly, there is much good that can now be done. But the chances are that stalemate will return, and any declarations of victory over a debt downgrade are likely to prove premature.


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