Straight Talk from the S&P Woodshed

America got called to the S&P Principal’s Office to receive our punishment for not doing our homework.  In the ‘good old days’ the principal would have told us to bend over and put the cane to our backside.  These days there are often no consequences for falling behind so we got a ‘good talking to’ and our credit allowance was cut one notch.  That was just enough to sting worse than the caning but not enough to do any lasting damage—-unless we don’t learn our lesson from this first in history wood-shedding of the world’s greatest economy.

In one stroke, S&P cut America’s credit rating to a level not seen since 1917. The words of the credit opinion are a stinging rebuke of our political leadership and their endless game of scoring points rather than fixing problems.  But this is a blame we share as citizens.  After all we have sent the same people back to Congress over and over despite bad behavior.  The only glimmer of change we can believe in came from the TEA Party caucus members who voted against the debt deal calling it a bad deal just as they has promised the voters they would do.  The Democrats called them ‘terrorists’ and the Republican leadership called them obstructionists behind their back.  When buyers’ remorse set in after the deal was done, the TEA Party caucus looked more like winners than the deal makers.

America Needs Bipartisan Leadership Now. The S&P Credit Report words remind politicians that the patient is bleeding red ink and that waiting until after the 2012 election to fix it is not an option. Unless a credible solution is forged both parties could face responsibility for further downgrades before the 2012 election.

“In our view, the difficulty in framing a consensus on fiscal policy weakens the government’s ability to manage public finances and diverts attention from the debate over how to achieve more balanced and dynamic economic growth in an era of fiscal stringency and private-sector deleveraging (ibid). A new political consensus might (or might not) emerge after the 2012 elections, but we believe that by then, the government debt burden will likely be higher, the needed medium-term fiscal adjustment potentially greater, and the inflection point on the U.S. population’s demographics and other age-related spending drivers closer at hand.”

Standard & Poor’s takes no position on the mix of spending and revenue measures that Congress and the Administration might conclude is appropriate for putting the U.S.’s finances on a sustainable footing. The act calls for as much as $2.4 trillion of reductions in expenditure growth over the 10 years through 2021. These cuts will be implemented in two steps: the $917 billion agreed to initially, followed by an additional $1.5 trillion that the newly formed Congressional Joint Select Committee on Deficit Reduction is supposed to recommend by November 2011. The act contains no measures to raise taxes or otherwise enhance revenues, though the committee could recommend them.”

“The act further provides that if Congress does not enact the committee’s recommendations, cuts of $1.2 trillion will be implemented over the same time period. The reductions would mainly affect outlays for civilian discretionary spending, defense, and Medicare. We understand that this fall-back mechanism is designed to encourage Congress to embrace a more balanced mix of expenditure savings, as the committee might recommend.”

MEMO TO CONGRESS: You have promised more than you can deliver and the American public knows it so quit denying it and fix the problem before it is too late.  S&P said the plan laid out cuts spending alright but not nearly enough to make a material difference, And the “spending reductions” really are just in discretionary spending rates of growth and do not even attempt to tackle the entitlement issues that are the heart of the problem:

“We note that in a letter to Congress on Aug. 1, 2011, the Congressional Budget Office (CBO) estimated total budgetary savings under the act to be at least $2.1 trillion over the next 10 years relative to its baseline assumptions. In updating our own fiscal projections, with certain modifications outlined below, we have relied on the CBO’s latest “Alternate Fiscal Scenario” of June 2011, updated to include the CBO assumptions contained in its Aug. 1 letter to Congress. In general, the CBO’s “Alternate Fiscal Scenario” assumes a continuation of recent Congressional action overriding existing law.”

“We view the act’s measures as a step toward fiscal consolidation. However, this is within the framework of a legislative mechanism that leaves open the details of what is finally agreed to until the end of 2011, and Congress and the Administration could modify any agreement in the future. Even assuming that at least $2.1 trillion of the spending reductions the act envisages are implemented, we maintain our view that the U.S. net general government debt burden (all levels of government combined, excluding liquid financial assets) will likely continue to grow. Under our revised base case fiscal scenario- which we consider to be consistent with a ‘AA+’ long-term rating and a negative outlook–we now project that net general government debt would rise from an estimated 74% of GDP by the end of 2011 to 79% in 2015 and 85% by 2021. Even the projected 2015 ratio of sovereign indebtedness is high in relation to those of peer credits and, as noted, would continue to rise under the act’s revised policy settings.”

“Compared with previous projections, our revised base case scenario now assumes that the 2001 and 2003 tax cuts, due to expire by the end of 2012, remain in place. We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act. Key macroeconomic assumptions in the base case scenario include trend real GDP growth of 3% and consumer price inflation near 2% annually over the decade.”

The Good News is the US has a Chance to Keep the AA+ rating if it Acts—otherwise DOWN to AA.  That was the blunt warning from S&P, don’t count on keeping the AA+ if all you give us in response is business as usual.  We don’t care if it is election season, the US economy is in intensive care and the patient can’t wait for the doctor to return from his fundraising or convention commitments.

“Our revised upside scenario–which, other things being equal, we view as consistent with the outlook on the ‘AA+’ long-term rating being revised to stable–retains these same macroeconomic assumptions. In addition, it incorporates $950 billion of new revenues on the assumption that the 2001 and 2003 tax cuts for high earners lapse from 2013 onwards, as the Administration is advocating. In this scenario, we project that the net general government debt would rise from an estimated 74% of GDP by the end of 2011 to 77% in 2015 and to 78% by 2021.”

“Our revised downside scenario–which, other things being equal, we view as being consistent with a possible further downgrade to a ‘AA’ long-term rating–features less-favorable macroeconomic assumptions, as outlined below and also assumes that the second round of spending cuts (at least $1.2 trillion) that the act calls for does not occur. This scenario also assumes somewhat higher nominal interest rates for U.S. Treasuries. We still believe that the role of the U.S. dollar as the key reserve currency confers a government funding advantage, one that could change only slowly over time, and that Fed policy might lean toward continued loose monetary policy at a time of fiscal tightening. Nonetheless, it is possible that interest rates could rise if investors re-price relative risks. As a result, our alternate scenario factors in a 50 basis point (bp)-75 bp rise in 10-year bond yields relative to the base and upside cases from 2013 onwards. In this scenario, we project the net public debt burden would rise from 74% of GDP in 2011 to 90% in 2015 and to 101% by 2021.”

Our revised scenarios also take into account the significant negative revisions to historical GDP data that the Bureau of Economic Analysis announced on July 29. From our perspective, the effect of these revisions underscores two related points when evaluating the likely debt trajectory of the U.S. government.

First, the revisions show that the recent recession was deeper than previously assumed, so the GDP this year is lower than previously thought in both nominal and real terms. Consequently, the debt burden is slightly higher.

Second, the revised data highlight the sub-par path of the current economic recovery when compared with rebounds following previous post-war recessions. We believe the sluggish pace of the current economic recovery could be consistent with the experiences of countries that have had financial crises in which the slow process of debt deleveraging in the private sector leads to a persistent drag on demand. As a result, our downside case scenario assumes relatively modest real trend GDP growth of 2.5% and inflation of near 1.5% annually going forward.

Long-term US Outlook is negative and America is falling behind in global competitiveness.  Waiting to fix the problem not only only weakens the dollar and growth prospects but undermines US national security and America’s global competitive position.  Even the Europeans will likely perform better than the US as things are going.

“When comparing the U.S. to sovereigns with ‘AAA’ long-term ratings that we view as relevant peers–Canada, France, Germany, and the U.K.–we also observe, based on our base case scenarios for each, that the trajectory of the U.S.’s net public debt is diverging from the others. Including the U.S., we estimate that these five sovereigns will have net general government debt to GDP ratios this year ranging from 34% (Canada) to 80% (the U.K.), with the U.S. debt burden at 74%. By 2015, we project that their net public debt to GDP ratios will range between 30% (lowest, Canada) and 83% (highest, France), with the U.S. debt burden at 79%. However, in contrast with the U.S., we project that the net public debt burdens of these other sovereigns will begin to decline, either before or by 2015.”

“Standard & Poor’s transfer T&C assessment of the U.S. remains ‘AAA’.  Our T&C assessment reflects our view of the likelihood of the sovereign restricting other public and private issuers’ access to foreign exchange needed to meet debt service. Although in our view the credit standing of the U.S. government has deteriorated modestly, we see little indication that official interference of this kind is entering onto the policy agenda of either Congress or the Administration. Consequently, we continue to view this risk as being highly remote.”

“The outlook on the long-term rating is negative. As our downside alternate fiscal scenario illustrates, a higher public debt trajectory than we currently assume could lead us to lower the long-term rating again. On the other hand, as our upside scenario highlights, if the recommendations of the Congressional Joint Select Committee on Deficit Reduction–independently or coupled with other initiatives, such as the lapsing of the 2001 and 2003 tax cuts for high earners–lead to fiscal consolidation measures beyond the minimum mandated, and we believe they are likely to slow the deterioration of the government’s debt dynamics, the long-term rating could stabilize at ‘AA+’. On Monday, we will issue separate releases concerning affected ratings in the funds, government-related entities, financial institutions, insurance, public finance, and structured finance sectors.”

We owe S&P a vote of gratitude for this tough love message.  It is not easy speaking truth to power even when they need to hear it.

Now it is our job as citizens to make sure they hear it and act on it. As Mark Twain said: ‘nothing concentrates the mind so well as the near term prospect of a hanging.’  And that is what every elected official from President Obama to every member of Congress must feel—because that is what we each of us feels about our precarious economic future.

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