So, When Will S&P Downgrade the US Again?

♠ Posted by Emmanuel in at 6/24/2012 07:14:00 AM
Friends, there are certain certainties in life: Germany will do well in whatever international football (soccer) competition it enters, Lucy will pull the football before Charlie Brown can kick it; and the United States will inevitably get fatter and more indebted. Unless you read too many Paul Krugman op-eds--or Dan Drezner USA#1 cheerleading blog posts for that matter--you probably get the idea that deficits do matter.

Recently, S&P--which famously did the first deed in downgrading the bedraggled US of A among the three major credit rating agencies--issued an updated outlook on its sovereign credit risk. You will be unsurprised to hear that it remains likely to be knocked down a further peg or four in the near future. This also takes into consideration that no fiscal consolidation takes place alike the discontinuance of the infamous Bush tax cuts (as if the country has done so much better with them). From S&P, then:
Instead, our current (and previous) base-case fiscal scenario assumes that the 2001 and 2003 tax cuts, due to expire by the end of 2012, remain in place indefinitely and that the alternative minimum tax is indexed for inflation after 2011. On the expenditure side, our base case assumes Medicare's payment rates for physicians' services stay at their current level, although we also assume that BCA11 remains in force. (This includes both the original caps on discretionary appropriations and the automatic spending reductions applicable in light of the Supercommittee's failure to reach an agreement.) Our base-case fiscal scenario also assumes annual real GDP growth of 2%-3.5% and consumer price inflation near 2% through 2016. Finally, this fiscal scenario presumes near-zero (nominal) short-term Treasury borrowing rates until 2015, at which point the rates climb by just more than 100 basis points, as well as a slower rise of about the same magnitude in long-term Treasury yields from their 2011 level of just less than 3%.
I am highly distrustful of credit ratings in general, believing that they are no substitute for conducting independent evaluation. For instance, assuming that the country grows in the 2-3.5% range is a stretch--which in turn implies that a credit downgrade is more imminent if it fails to reach this range up to 2016 (which is absolutely certain IMHO). At any rate, we get to the dirty business of assigning probabilities:
The outlook on our 'AA+' long-term rating is negative, reflecting our view that the likelihood that we could lower our long-term rating on the U.S. within two years is at least one-in-three.

Pressure on the rating could build if, in our view, elected officials remain unable to agree on a credible, medium-term fiscal consolidation plan that represents significant (even if gradual) fiscal tightening beyond that envisaged in BCA11 [the deficit reduction supercommittee]. Pressure could also increase if real interest rates rise and result in a projected general government (net) interest expenditure of more than 5% of general government revenue.

On the other hand, the rating could stabilize at the current level with a medium-term fiscal consolidation plan, or if the U.S. government makes faster progress toward reducing the general government deficit than our base case currently presumes.
So here are the takeaway points for you: (1) To maintain its AA+, S&P requires that the US tighten its belt beyond the measures the deficit reduction supercommittee believes is necessary, which in any case are not being implemented due to partisan deadlock. (2) Growth assumptions of 2-3.5% are wildly optimistic IMHO based on recent growth figures Stateside, making debt-to-GDP figures look even worse going forward.

End result? Based on S&P's stated criteria compared to America's economic realities and political limitations, I would think that a credit downgrade in the next two years is an odds-on possibility. Even if the US is remarkably progress-free already, the momentum is on the downward path. And I believe that, given its fundamentals (or more accurately, the lack thereof), the pace of Americarnage should accelerate. Recall that as late as May 2010, Spain--yes, Spain--had a AAA rating.

It should be exciting to watch--as long as you fully divest yourself of Sammy's IOUs.