Saturday, August 13, 2011

Questions of character.

One week after the downgrade of the United States bond rating, the markets have returned a verdict of sorts. In a week of staggering volatility, stocks declined by 2% while money flooded into the downgraded U.S. Treasury market, reducing yields on the 10-year by 0.30%. While the S&P action certainly amped up the already-white hot political climate, the actual report offered little new insight. By the end of the week it was evident that the correction in the equity markets that had been underway since July was continuing, as was the global flight to quality that continues to favor U.S. Treasury bonds.

The dramatic rally in bonds was more notable than the stock market decline. After all, S&P's pronouncement was supposed to cast a pall over U.S. Treasuries and send investors scurrying to the sidelines. Of course, if global investors have learned nothing else, it is that there are no sidelines. The near-death experience of the world financial system in 2008 showed that in a pinch the United States Federal Reserve remains the back-stop and liquidity source of first and last resort, and since 2008 the universe of "risk-free" investment alternatives has dwindled. The very concept of a united Europe is under assault, much less the notion that the euro would emerge as the reserve currency alternative to the dollar. Even keeping holding cash in a bank has become problematic for institutional investors, as banks are beginning to charge fees for accepting large deposits rather than paying interest.

At the end of the day, the markets shrugged off the S&P downgrade because it was a non-event. Is the United States facing significant financial challenges? Certainly. Was this news? Certainly not. Does U.S. sovereign debt now rated AA+ constitute a greater default risk that any number of triple-A rated corporate bonds? That would seem to be a silly question, yet S&P seemed to be saying yes, while the markets this week said no. In the world today—a world where risks abound—the U.S. Treasury remains the benchmark for very simple reasons. In a crunch, there is nowhere else to go.

But in S&P's view, there was a material change. In the old rating agency adage, bond ratings reflect both an issuer's ability to pay and its willingness to pay. What had changed was the casual willingness of some debt ceiling combatants to embrace default as an acceptable outcome, even as others wielded the threat of default for leverage. This Friday, a senior director for S&P confirmed that the factor that led to the downgrade of the U.S. credit rating was not a material change in the financial circumstances as much as evident changes in the willingness to pay, or, more frankly, the willingness to not pay. “People in the political arena were even talking about a potential default... That a country even has such voices, albeit a minority, is something notable. This kind of rhetoric is not common amongst AAA sovereigns.”

It did not used to be this way. In fact, until recently such rhetoric was inconceivable—in old Yankee terms, credit was a point of moral character. This dramatic shift in acceptable political speech emerged earlier this year when Newt Gingrich advocated the use of bankruptcy by states as a strategic option. Gingrich's argument—which sent the municipal bond market reeling—established the principle that it is now acceptable for national political figures to disavow our moral and legal obligation to pay our debts, if it serves the interest of the pursuit of partisan political advantage.

A lingering question about our political system has been whether we are able to face up to long-term fiscal challenges and make needed changes in advance of market pressures forcing the issue. In some respects, we would seem to be making progress. After all, for the first time in the twenty years since the creation of the Concord Coalition, the issues of the long-term fiscal health of the United States and the affordability of entitlement programs are now active subjects of debate in the public square. The problem evidenced by the debt ceiling debate, however, is that for all of the debate and sense of urgency, there appears to be almost no willingness in Congress to taking the next step: Owning the problem, and doing something about it.

The debt ceiling bill that finally emerged—with the oxymoronic title The Budget Control Act of 2011—was a perfect Congressional compromise: It cut no spending and raised no revenues. For the only fiscal year over which this Congress has authority, Fiscal Year 2012, it reduced the deficit by a grand total of $21 billion. After talk of $4 trillion here and $2 trillion there, the final legislation—with apologies to Everett Dirksen—did not even add up to real money. The rest was in the out-years. Or kicked over to a debt commission which may or may not achieve its purpose—time will tell.

Congress has a well-established tradition of being long on rhetoric and short on action when it comes to dealing with budget issues. Dating back to the Gramm-Rudman-Hollings Act a quarter century ago, Congress prefers to set out-year targets but never actually specify what and how to cut. It is notable that Gramm-Rudman had the same 50-50 automatic cuts in defense and non-defense programs in the event targeted cuts were not achieved. It is also notable that none of those spending cuts ever materialized.

Now, once again, the arguments are high on rhetoric and devoid of substance. As a follow-up to the debt ceiling debate, John Boehner and Eric Cantor are pushing for a balanced budget amendment. Yet—like so many demagogues before them—neither Boehner nor Cantor have proposed how they would balance the budget—which, it is important to point out, the Paul Ryan Plan did not do. And this week, at the Republican presidential debate, Michele Bachman reasserted her stance in opposition to raising the debt ceiling, but none of the moderators saw fit to ask how Bachman would have proposed to allocate the limited federal resources if the debt ceiling bill had not passed.

At the Republican debate, only Ron Paul made a substantive point on this issue, when he advocated ending our war policy and spending. But every candidate, particularly if they choose to ride the balanced budget amendment wave, should be obligated to describe the specific choices they would make to actually balance the budget. It is not hard to do, as there is abundant data about choices and trade-offs readily available. The Congressional Budget Office provides detailed data for evaluating alternative policy choices, and weighing the long-term budget impacts. And earlier this year, this easy online tool was created that allows anyone to build their own budget solution.

We now have a window of several months before the commission created by the debt ceiling bill is obligated to put its recommendations on the table—and Congress is obligated to vote up or down—or automatic cuts are supposed to go into effect. The question is whether we ever get there, as both political parties are itching to make 2012 the showdown election, and both believe that they will be in a better negotiating position after that election. Republicans believe that Obama is beatable, and they can win the Senate with a continuation of the 2010 election trend. Democrats believe that the younger, more diverse electorate of 2008 will turn the tide away from the 2010 turnout that was uniformly older, whiter and richer. Therefore, both parties will be willing to kick the can a few more years down the road, and avoid once again making those choices that Congress has proven, time and time again, that it is loath to make.

The question remains whether this is our political system working as it should—as the more optimistic observers have concluded—or whether S&P's observation is correct, that our political rhetoric is evidence of a deeper weakness—that political imperatives now trump all other considerations—and that Congress is no longer be capable of making serious budgetary choices that are necessary for the long-term well-being of the nation.

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