The Simple Reason Why S&P Was Right To Downgrade U.S. Debt

obama

Photo: www.flickr.com

Standard and Poors has downgraded U.S. debt, but Treasuries have gone up in value. Another sign of incompetence by one of the ratings agencies that played a critical role in the Collapse of 2008? I don’t think so.Many of the people buying Treasuries are planning to sell them within the next few years. Believing that the U.S. will default 20 or 30 years from now can be consistent with a belief that the U.S. will not default before today’s buyer wants to sell them and buy assets in one of the world’s fast-growing economies.

The U.S. almost surely will default on some of its currently acknowledged obligations. The only question is whether it will be public employee pensions, Social Security, Medicare, or bonds. (If the U.S. were the world’s only place to do business, in theory a big tax increase would suffice to close the gap, but in a competitive economy where a hedge fund and its managers can move to Singapore or Switzerland and a factory can move to Mexico or China, there probably is no way to raise rates without strangling whatever growth has been forecast.) So the S&P rating makes sense from that basic point of view.

The S&P rating also makes sense from the point of view of arithmetic. Politicians and newspapers talk about “spending cuts”, but they are really talking about cuts to planned spending increases that could not possibly be afforded by the actual U.S. economy. It would be like me saying that I have cut my personal spending by deciding not to buy a $50 million house┬áthat I could never have afforded in the first place. After the so-called “cuts”, federal spending will continue to grow and continue to grow at a rate that is faster than the overall GDP.

A deeper reason that the S&P downgrade is justified is that the U.S. political system has proven itself incapable of long-term fiscal management. Although a lot of headlines are consumed by legislation regarding a variety of social issues (gay marriage, medical marijuana, etc.), given that government spending is 40 per cent of GDP, the most important function of politicians is deciding how to spend money. At the federal level, the politicians themselves have decided that, after more than 200 years, our Constitutional system of a House and Senate can no longer perform this fundamental function. The important decisions have now been delegated to an unaccountable “supercommittee” of 12 legislators. At the state level, politicians work around state constitutions that require balanced budgets by promising defined benefit pensions to public employees and then not putting aside enough cash even to meet the funding due under “we will earn 8 per cent returns” assumptions that are not supported by any market.

The U.S. has some of the world’s most sophisticated politicians who are exquisitely skilled at advancing their personal interests. One of the ways that a U.S. politician can gain personally is to borrow money without regard to who is going to pay it back or whether paying it back is even feasible. This fact combined with the world’s glut of savings has led us to the current pass in which approximately 40 per cent of federal spending is of borrowed money. Standard and Poors is right to add a little notch of concern that a future generation of Americans might not be able or interested in paying it back, at least not in dollars that haven’t been greatly inflated.

[One could argue that the supercommittee is accountable because its members could be defeated in the next election. However, it is unclear that individual votes will be recorded from this committee and the committee’s deliberations might be held in secret, unlike with the standard legislative process. For example, one of the 12 will be long-time incumbent Massachusetts Senator John Kerry. Would the predominantly Democrat voters in the state turn against Kerry because of something that he might or might not have done during a secret meeting of the supercommittee? How would a voter know what he had advocated?]

NOW WATCH: Briefing videos

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.