General Economic Policy International Finance

S&P Comments Blame Administration more than Tea Party

A Politco story released this week regarding comments by S&P senior director Joydeep Mukherji is being used to suggest that Tea party intransigence is the root cause of the debt downgrade. However, I think the finger is really pointing at the Administration instead.

Joydeep Mukherji said the stability and effectiveness of American political institutions were undermined by the fact that “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,” he added. “This kind of rhetoric is not common amongst AAA sovereigns.”

It is worth noting that had the debt ceiling not been raised then it would have been up to the Treasury under Secretary Geithner, in consultation with the President and Congress, to decide which bills would be paid and which would be suspended. Tea Party Republicans, like Michelle Bachmann, assumed that the government would never default on our debt obligations. It was accurate to say that the government would not have to default since there were plenty of revenues coming in to cover all principal and interest repayments. Instead, the government could have suspended payments on discretionary programs and the effect would be much like a partial government shutdown. These effects would not be small or inconsequential but they would not amount to a default on debt.

However, this isn’t what the administration was saying. In Timothy Geithner’s Jan 6, 2011, letter to Majority leader Harry Reid he implores Congress to reach a deal to raise the debt limit.

He says in paragraph two, “Failure to raise the limit would precipitate a default by the United States.” He also says in the letter that failure to raise the debt ceiling would not be the same as a partial government shutdown. He wrote, “Those government shutdowns, which were unwise and highly disruptive, did not have the same long-term negative impact on U.S. creditworthiness as a default would, because there was headroom available under the debt limit at that time.”

In other words, the reason things would be different this time, is because we would fail to make our interest payments. At the end of the letter, he describes likely economic impacts of failure to raise the debt limit, most of which would clearly be the consequence of an actual default on US debt repayment. Thus, Geithner is strongly suggesting that the US might be inclined not to make some debt repayments if the debt ceiling were not raised.

Or listen to Obama’s Economic advisor Austen Goolsbee in January. He talks about default as if we would not make repayment of our principal and interest and does not make the distinction between discretionary spending and repayment of debt. Clearly he describes as catastrophic the impact of debt default.

But then listen to President Obama later in June. In this clip President Obama seems to equate the term default with not paying some government bills. So, for example, if the government did not pay some social security obligations, one might say the US had defaulted. So maybe when he says default he doesn’t really mean a debt default. However, at the end he asks whether we really would choose to send interest payments to China to avoid default on the debt rather than sending out social security checks. He doesn’t answer the question, but if I had to infer what his preference was based on the way he presented it, I’d have to say he’d prefer to pay the SS checks. The inference is that had the debt ceiling not been raised, the President may have been inclined to “really default” on some interest payments.

These are the voices S&P is more likely referring to, especially since these are the individuals who are empowered to administer the payment of government obligations. The administration could have avoided this criticism by saying throughout the crisis that the full faith and credit of the US would not be impaired EVEN IF we hit the debt ceiling. They then could have explained the serious repercussions if we were forced to go through a partial government shutdown. However the administration didn’t do that. Instead they told the default implication story over and over again and did not accurately reflect the true situation. That is …. unless it really WAS President Obama’s intention to default on debt to avoid a reduction in social security and other government payments!!

About

Steve Suranovic received his B.S. in mathematics from the University of Illinois at Urbana/Champaign and his M.S. and Ph.D. in economics from Cornell University. He has been a faculty member at the George Washington University since 1988. He has served several terms as the current Director of the International Trade and Investment Policy M.A. program at the Elliott School of International Affairs.

4 Comments

  • You're right that the administration was using “we're going to default, and you're to blame” as a political message in order to spur action. Anon is also right, however; Congressionally authorized and appropriated spending is just as much an obligation of the USG as bond payments. You can't pay one and not the other and consider yourself not in default.

    The real issue here is this: had we reached 8/3 without a deal the administration would have had to deal with two conflicting mandates: cease borrowing, and continue spending. Annual budget appropriations, as passed by Congress and signed by the President, are just as much a legal obligation on the Executive as a debt limit.

    The simple solution would've been to declare the debt limit unconstitutional (due to the 14th amendment) and to continue spending at the mandated levels. If someone doesn't like that, they can sue. Meanwhile tell Congress that if they don't want the government to borrow more they should pass balanced budgets.

    Statutorily, a debt limit makes no sense, and it should be eliminated.

  • I apologize if I came off to forceful. Anyway, I do however see that you have a background in trade – something I would like to know more about – here is my rambling theory on current events and trade:

    There are the three economic theories I am familiar with. The Classical theory, Keynesian theory, and Monetary theory. I would argue that the classical theory has become pretty much useless. That leaves Keynes and Friedman, right? However, since we are in a liquidity trap much of monetary theory can be thrown out the window because increasing the money supply has not done enough. That leaves Keynes. And if we are to follow his theory there are several ways to jumpstart the economy but direct government spending is the best way. If the US government were to embark on the road of direct stimulus how much would you have to overcompensate in the model because of our trade deficit? In other words if the government puts people to work doing something constructive the multiplier effect might not be as large when those new consumers spend a significant portion of their paychecks buying cheap Chinese goods? It seems to me that one of the many problems we have is the failure on the part of the Chinese to trust their domestic consumption (since they devalue their currency). It also seems to me that the world is in desperate need of rebalancing. How can we get the Chinese to lessen their tariffs a little and let their currency rise? How did the global system become this unequal in terms of trade? I suspect when China started opening up Kissinger and Crew were imagining how great another billion consumers and manufacturers (give or take) it would be to have in the global economy to trade with. It was good dream and I think in the long run that it is definitely a good thing. However now it seems like we have given them enough time to grow their economy at a rapid pace by selling artificially cheap goods. It seems like we have let the Chinese shield themselves with our overconsumption for too long. Isn't it time China took one for the team (by that I mean the rest of the world)? It seems to me that they should tax their imports from the rest of the world less through tariffs or let their currency rise? Why don't global summits focus on this issue and attempt to fix it? We as a global economy are in this together and the Chinese need to cooperate with the rest of us more. It seems like we have given them enough time so that they can build up their economy while shielding themselves. We need fair access to their consumers. What other options does the world have? Global debt restructuring I suppose (i.e. Bretton Woods all over again).

  • To continue:

    It is a default either way. Institutional investors would look at the fact that the US government decided to not pay up on their financial obligations to other investors (i.e. American citizens). What message would that send? From the perspective of institutional investors it would say “What’s to stop the United States government from paying their financial obligation to me next time?” The only difference in that situation between American citizens and institutional investors would be that institutional investors hold pieces of paper (called bonds) in a depository institution. Both American citizens (in the case of Medicare, Medicaid, and Social Security recipients) and institutional investors paid the American government a fee for a monetary benefit they would receive at a later date.

    I would like to address the domino effect that would take place after a spike in interest rates through the prism of your field of expertise, economics, as well as the field of finance:
    First I will start from facts I believe we both acknowledge to be true. First it would be a terrible idea to raise interest rates right now; Growth in the economy is anemic and unemployment is high. Raising interest rates would raise borrowing costs on government, businesses, and consumers. Raising borrowing costs discourages investment and consumption and thus would slow down the economy. So if you’re following me I think we would both agree that it would be ideal to let interest rates rise after a sustained recovery has taken hold. In the financial markets on-the-run treasury yields (the most recent) are viewed as the minimum interest rate on which an investor can borrow. All other bonds are valued by taking a spread above the on the run treasury yield curve. Let’s take two bonds that are similar in every way except for that one is a treasury bond and one is a corporate bond. So if the treasury yield curve is at 3% then a corporate bond maybe be offered at – let’s say 5% (3% from the treasury base plus an extra 2% for firm-based credit risk). So what happens when the treasury yields shoot up to 6%? Every bond in the market will need to be revalued at the same time. And the markets wouldn’t just add another 2% percent for the spread. They don’t raise the rates proportionally in creating that spread. This immediate and massive revaluation period would be chaos in the financial markets. The fact that the entire global economy is at a tipping point between the US’s oversupply of housing/high unemployment/lack of demand, Europe’s sovereign debt crisis, and the slowdown in emerging markets is very important here.
    Not only would this technical default you speak of cause a crisis of revaluation it would also cause a crisis of solvency in many other countries. Those European countries central banks hold many of our bonds. When yields on treasuries rise their value will fall (due to the inverse price/yield relationship). If the European central banks needed to sell those on the open market they would not get as much money for them and as a result those European countries may not be able to pay their creditors. There are many banks in the United States who hold bonds from those European countries. What happens when those US banks do not get paid what they are due? This is a downward spiral that threatens the entire global economy. This is why a technical default would be a cataclysmic event. You must zoom out instead of focusing on the fact that…uhh…well… it doesn’t really matter if we don’t pay others besides the bondholders.

  • That is a stretch my friend. It is true that if we had not raised the debt ceiling we would have had enough cash in the treasury to pay off the interest and the principal. However, we would have had a technical default. In other words we would not have had enough cash to cover all of the routine expenses of the federal government that had previously been promised to our citizens. We could not afford to meet social security payments, medicare payments, medicaid payments, and defense payments (not to mention countless other obligations) in addition to the interest and principal on the debt. Failing to meet these obligations would not just cause a downgrade but this would cause interests rates to rise. A technical default is still a default and would have been viewed as such by the financial markets.

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