Adults in the room? The recent brinksmanship over the debt ceiling has ended in a "compromise". No one is claiming victory in this unseemly debate and justly so. Nothing was accomplished. The Standard & Poor’s downgrade of the US credit rating from AAA to AA+, despite ruffling some feathers, has had little to do with the recent market turmoil. In fact, US Government securities have strengthened after the downgrade. Let’s look at some facts.
In mid July, Standard & Poor’s announced that they would maintain the AAA credit rating on the US "If Congress and the Administration reach an agreement of about $4 trillion"…and that it be credible. The announced $2.4 trillion deal, well short of the $4 trillion proposal by the Senate’s "Gang of Six", is composed of two parts: 1) $917 billion reduction in discretionary spending over 10 years, and 2) $1.5 trillion to be agreed by a joint committee of Congress. To begin with, the $917 billion does not represent an actual reduction in spending from current levels, but a reduction from planned increases. The Office of Management and Budget estimates that the plan will reduce future deficits by at most 0.5%. The reduction in 2012 is a mere $21 billion. Most of the cuts are in the out years. Experience has taught us that unless those cuts are very specific, they do not materialize. A reduction of $21 billion will hardly constitute "fiscal drag", which some fear would slow the economy.
It might be helpful to put the US debt in context. Mary Meeker, a former Morgan Stanley technology analyst and currently with Kleiner Perkins Canfield and Byers – a venture capital firm, thought it would be interesting to do an analysis of the United States as if it were a publicly traded company. This hypothetical analysis was presented earlier this year with high praise from George P. Shultz, Paul Volker, Michael Bloomberg, Richard Ratvich, and John Doerr. Of the $14.3 trillion of US debt, approximately $4 trillion is the amount theoretically owed to entitlement programs. Mary Meeker’s analysis more accurately casts those liabilities at $66 trillion at "net present cost" (Medicaid $35 trillion, Medicare $23 trillion, Social Security $8 trillion). While it may be encouraging to be discussing the nation’s liabilities, we have yet to do anything to address this daunting issue. The changing conversation in Washington and the artificial crisis surrounding the debt ceiling debate is in anticipation of an eventual market crisis.
In Europe, on the other hand, we are seeing market forces at work. What began as seemingly manageable problems in smaller peripheral countries are becoming increasingly serious as larger countries, such as Italy and Spain, are having to pay more to refinance their maturing bonds. Credit defaults swaps for France, still a AAA credit, are three times more expensive than they are for the United States. The unknown consequences of a slow motion train wreck in Europe – recession, potential break-up of the euro, and stresses to the European banking system, have spooked the market much more than the debt ceiling negotiations and the Standard & Poor’s downgrade of the US.
In Europe, more so than in the United States, there seems to be a calculated interest in protecting the banks and bond holders. While there may be some benefit to buying time to implement a debt reduction and reorganization policy, it is impossible to emerge from a credit induced recession without recognizing credit losses. The business cycle is an integral part of the regenerative process of capitalism. The fact that the European Central Bank has expressed a willingness to absorb more sovereign credit risk by purchasing Italian bonds may be a short term palliative to the markets, but it does not address the underlying imbalances in the euro-zone. The next year or so will prove to be an increasing challenge until truly difficult measures are taken.
In the United States, economic indicators point to continued anemic growth with an increasing probability of a recession. Consumers, for better or worse, are taking measures to reduce their debts, either by paying off credit or undergoing foreclosure. Corporations have used their cash flow to pay down loans and increase their cash positions. States and local municipalities, some better than others, are making adjustments to bring their budgets into balance. However, until the Federal Government addresses its daunting budget problem, we can expect low growth, high unemployment and subpar equity performance.