Monday, September 5, 2011

The US credit rating: could we default?

Back to our regularly scheduled program. As per request, in this post I'll briefly touch on the implications of S&P's downgrade of the US credit rating. So, what exactly happened is that after the debt ceiling debacle of early August, S&P (officially a "Nationally Recognized Statistical Rating Organization") downgraded their rating of US debt from AAA to AA-. You might remember S&P as one of the credit agencies that were rating subprime mortgage-backed securities as AAA in the years leading up to the crisis of 2008. Yup, just a few years ago they were saying that those bonds based on subprime borrowers were safer than the bonds currently issued by the US government. The chart above shows the interest rate we've paid on our 10 year debt over the last few decades. As of the close of the markets on Fri Sep 2nd, we are paying 1.99% on money we've borrowed for 10 years. Does that seem high to anyone? Anyone? That is the kind of risk the market is assigning to US debt. But then again, the markets occasionally go barking mad; just look at the 1990s tech bubble.

Are we really headed down the path of Greece and Portugal? In effect, no. One major difference between us and them is that our debt is issued in our own currency. And not only our own, but the world's reserve currency. While Greece is straightjacketed because it's in the Euro, the US can print more money at will. Such a country is not at risk of defaulting on its debt. Uncle Sam, need to pay more debt? Turn on the presses, Bernanke. Of course, resolving the debt issue in such fashion would lead to inflation, but the debts would nonetheless be paid. Inflation is a risk that nominal bondholders have to live with; inflation-indexed bonds are another story. Being the holders of the world's reserve currency also helps to ensure that when the world gets jittery, people pile into dollar-denominated assets, which often mean treasury bonds, thus driving down our country's borrowing costs just when world events would make our debt seem riskier. Over the last several years, whenever the markets were especially worried about the economic outlook, US borrowing costs (as measured by the interest on the 10 year note) tumbled. This has happened over the last month (see the large drop here).

So, if we can't really default on our debt, why the downgrade from S&P? Well, Felix Salmon thinks it's related to our dysfunctional political atmosphere:

Any student of sovereign default knows that it is born of precisely the kind of failures of governance that we saw during the debt-ceiling debate. That is why the US cannot hold a triple-A rating from S&P: the chance of having a dysfunctional Congress in future is 100%, and a dysfunctional Congress, armed with a statutory debt ceiling, is an extremely dangerous thing, and very far from risk-free.

Yes, there’s a lot of fiscal math in the S&P statement. But at heart, any sovereign ratings decision is political, not economic: the economics is there to provide a veneer of empirical respectability to what is fundamentally a value judgment. We saw the values of Congress during the debt-ceiling debate, including various members of the House who said with genuine sincerity that they’d actually welcome a default. In that context, S&P’s judgment is hard to fault.

Essentially, while the US could always pay its bills, as long as there are politicians insane enough to take the economy hostage in order to score political points, there is some risk of default in buying US debt. Even if recent events only raised the interest rate on US debt by 0.05% (which is probably an underestimate), with an outstanding debt of $14 trillion that would increase our borrowing costs by $7 billion per year (.0005 * 14 trillion). It’s quite an ironic result seeing as how the politicians who caused the debt ceiling debacle were worried about US budget problems. For those of you in debt: it doesn’t help for you to raise the interest rate on your debt.

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