The fiscal cliff and downgrading U.S. debt

Last Friday, the Peter G. Peterson Foundation held an event called “The Fiscal Cliff and Beyond.” The event both highlighted the results of the Solutions Initiative II (in which EPI took part) and convened discussion panels around the topic of the fiscal cliff as well as longer-term fiscal and economic issues.

I found a few comments from two different panels interesting. In one panel, Erskine Bowles, who co-chaired the 2010 fiscal commission and now is a big supporter of the Fix the Debt campaign,  said that if we go over the fiscal cliff, U.S. credit will be downgraded by rating agencies—for example Moody’s or Fitch. On a different panel, Douglas Holtz-Eakin, former John McCain adviser, CBO head, and now director of the American Action Forum, said that if we go over the fiscal cliff (a terrible metaphor), financial market reactions will be severe.

FULL ANALYSIS FROM EPI: Budget battles in the lame duck and beyond

Since “financial market reaction” to fiscal developments is going to be a big theme in coming months, it’s worth thinking a little more carefully about statements like these. 

Bowles’ invocation of a downgrade invokes memories of the U.S. credit rating being downgraded by Standard and Poor’s following the Aug. 2011 debt ceiling debacle. Recall that the GOP took what had historically been a pro forma vote to raise the statutory debt ceiling and turned it into a crisis by threatening inaction that would force the U.S. government to default on its obligations unless steep spending cuts were negotiated. The Obama administration unwisely chose to play the game of negotiating for a debt ceiling increase, and eventually was unable to get the GOP in Congress to agree to any revenue increases to pair with the spending cuts.

The resulting Budget Control Act provided for steep automatic cuts as well as setting up a new Congressional “Supercommittee” to hammer out additional deficit reduction measures. This bargaining over deficit reduction as a price to pay for passing an increase in the debt ceiling also solidified the shift from prioritizing job creation to prioritizing austerity measures. Additionally, the rating agency Standard and Poor’s downgraded the U.S. AAA credit rating for the first time in history in the wake of the debt ceiling negotiations; this was based on their politically-motivated judgment that the  U.S. government’s ability to manage fiscal policy was shown during the debt ceiling debate to be “less stable, less effective, and less predictable.”

Now we face a different deadline forcing action on fiscal policy—not a statutory debt ceiling increase, but a series of expiring tax reductions, expiring stimulus provisions, and legislated spending cuts—a fiscal contraction that would lead to negative GDP growth and higher unemployment in 2013. There are a number of points to make here in regards to whether allowing these tax increases and spending cuts to take place would lead to adverse financial market reaction. First, as Sen. Patty Murray (Wash.) argued Friday, the revenue stream that is expected once the Bush tax cuts expire (if no action is taken) and the steep spending cuts that kick in would actually substantially close budget deficits (to the detriment of economic growth, but it would still close budget deficits). Around $4 trillion in new revenue over 10 years would go a long way toward closing the deficits that Standard and Poor’s claims to be worried about. In fact, $4 trillion in deficit reduction is just the amount they wanted to see agreed to back in 2011. So, it would be odd indeed to see a credit downgrade from ratings agencies allegedly concerned about too-large deficits that was triggered by a sharp reduction in these deficits.

Secondly, one of the reasons Standard and Poor’s downgraded the U.S. credit rating is because they believed the lack of a fiscal consolidation plan threatens high interest rates. Bowles, who made the comment about being downgraded, predicted two years ago that we would see higher interest rates at this time. Interest rates have instead remained at extremely low levels, and as my colleagues note in a recent paper, until the output gap is closed, fiscal stimulus—were it to take place—would only negligibly accelerate inflation or push up interest rates.

Third, if we do see a credit downgrade if fiscal contraction does take place, the reason for it will be political, not economic. The last time around, Standard and Poor’s used their judgment that the government could not work well enough together to address fiscal issues to justify the downgrade; their economic argument was invalidated once it became clear that they persisted with the downgrade after a $2 trillion error was found in their math. If such a downgrade happens again, it will be based on political calculations and not economic ones—not a justifiable rationale for downgrading U.S. debt.

Lastly, there is one fairly predictable financial market reaction that would indeed be appropriate to the real problem inherent in approaching the “fiscal cliff”—a stock market decline. Stock prices are supposed to be moved by expectations of future profitability, and a sharp fiscal contraction that began dragging firmly on economic recovery in 2013 would threaten this profitability. But we need to be clear here as to what the stock market would be objecting to: too-rapid reductions in budget deficits.


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