The politics of U.S. debt rating
Standard & Poor’s downgraded U.S. long term debt from AAA to AA+ on Friday. The release outlines two related issues of concern. First is the issue of political gridlock and the ensuing policy uncertainty. The second is the sheer size of projected unfunded liabilities of the United States. This is from the S&P release:
“[T]he prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially entitlements, or on reaching an agreement on raising revenues is less likely that we previously assumed and will remain a contentious and fitful process…The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed.” [Emphasis mine.]
Business is really concerned about the political brinksmanship on Capitol hill. Couple of days before the deal, amid uncertainty about whether or not a deal would happen on the debt ceiling, Wall St panicked and mobilized a giant campaign to pressure Congress. The Economist has a decent article on the debt deal that outlines most of the obvious issues.
Underlying these concerns is the elephant in the room.
The real fiscal problem
Despite the advantage the United States enjoys from the reserve currency status of the dollar, it cannot pay for its burgeoning entitlement liabilities by printing money alone. Bill Gross, the long time boss of Pimco, the trillion dollar gorilla of the bond market, estimates unfunded U.S. liabilities at 65 trillion dollars; as did Mary Meeker in a well researched booklet on the issue called USA Inc. Of these, $58 trillion, or about 90%, are just Medicare and Medicaid. If these entitlement programmes remain unfunded, U.S. debt/GDP ratio will cross the 90% threshold in a decade and reach a truly unsustainable 150% in twenty years, according to the Congressional Budget Office. This is the only non-trivial issue–military spending, social security, discretionary spending are all small change. Every American economist worth his salt has been harping on this ad nauseam.
The political impasse
Pundits have been talking about the political gridlock in Washington ever since the Clinton administration, if not earlier. On cable, this is usually presented as partisanship on both the left and the right–that both the liberal democrats and the conservative republicans have fled the center. This picture is so inaccurate that there is no need for further comments.
Another position; say that of Paul Krugman and the editors of the New York Times et cetera; is that the GOP has become the party of No. That they have abandoned all efforts to reach compromise with the ruling party to solve real problems together. While this has some semblance of truth, it is also not an accurate picture of American political reality. Let me explain.
There is a structural reason for increasing partisanship–gerrymandering. This is an important article about congressional redistricting and how it distorts the electoral system. I want to focus on more fundamental factors so I will move on, trusting the reader to read this at her pleasure.
The political economy of Washington
As I have outlined before in the context of sharply rising inequity and the dominance of the financial sector, U.S. policymaking has undergone a dramatic shift since the 1970s. Robert Reich has argued that the computer, telecommunications and transportation revolutions altered the underlying economic fundamentals of the post-war economy. International capital mobility and global supply chains undercut labor union power and working class mobilization. The consequent decline in the bargaining power of labor coupled with increasing financialization of almost all the dynamic sectors of the US economy tipped the scales towards capital and investors. The creation of the World Trade Organization and the spread of neoliberalism under the auspices of the IMF after the collapse of the U.S.S.R. added a significant new structure to the international economy. To participate in international trade and gain access to much needed Western technology, countries now had to accept comprehensive treaties. To call GATT, WTO, and NAFTA free trade agreements is to miss their essential content–these are better thought of as investor rights agreements.
This power shift has had major effects on electoral politics–who gets elected, how they frame the issues, and how they vote on Capitol hill–depends increasingly on campaign finance. In the 2006 cycle for instance, the average winning candidate for the senate spent 9.6 million dollars. Of course, the most expensive campaign was run by Hillary Clinton who spent an astounding $40 million. Presidential races have become obscenely expensive. Obama spent three quarters of a billion dollars for his election and is widely expected to raise a billion for 2012. House races are somewhat cheaper–the average winner in 2008 spent about $1.4 million. Of course, we have not even talked about indirect spending by interest groups and the giant spigot that opened up with the Supreme Court ruling on political spending by corporations. Thomas Ferguson proposed an “investment theory of politics” in his book Golden Rule, which regards elections as occasions when groups of investors coalesce to control the state, by essentially buying the elections. It is a very good predictor of policy over a long period, as he has shown.
Returning to the point at the beginning of this section, perhaps more significant than the monetization of electoral politics is the relationship between Washington and capital markets. Policymakers have to conduct what has been called stock market diplomacy. State policy cannot deviate too far from the demands and expectations of investors, otherwise we have a loss of investor confidence with disastrous effects on the real economy–not something policymakers can stomach. The markets thus impose very narrow bounds on policy. Watch what happens on Monday. Its going to be a bloodbath and Washington is going to run helter-skelter to placate investors.
The emerging consensus
Following the comments made above, it is clear that there are fairly narrow options available to policymakers in Washington. The unfunded liabilities can only be fixed by either raising taxes and revenues, or slashing welfare spending, or a mix of both. A brief survey of business literature is enough to confirm what we already suspect. The business elite have unsurprisingly converged to the position that the lion’s share of the pain has to be borne by the poor. President Obama has suggested that a small part of the burden should fall on the elite in the form of marginally higher taxes, to howls of protest from the Republicans and the business elite. Depending on the composition of Congress in the coming few years, the contribution from higher taxes on the rich is either going to be almost zero, or marginal at best.
The Business press has been talking about reducing the cost of labor in the First World to make it competitive with the emerging economies. That is, working class wages and benefits–real incomes of the mass of the populace–have to decline further. It is a fair bet that this will be achieved within a generation. The constraints and incentives of the political system guarantee that no significant force will emerge in Washington to contain this trend.
Before closing there is one more point that needs to be made. Everyone knows that U.S. treasury bills are still risk-free, and that this is unlikely to change without a dramatic decline in American power. That is why this is best seen as Business scolding Washington. So ironically, the downgrade is going to lead to a giant flight to safety as markets panic–to U.S. treasury bills, of course.
Now, watch the bloodbath on Wall Street.
[Update @ Monday 2PM: As predicted, investors have fled to U.S. treasuries–the benchmark 10-year note yield was down to 2.35% from 2.56% on Friday. Recall that bond yields drop when there is a surge in demand.
My girlfriend thought I was being too dramatic in my conclusion. Now it seems I was not dramatic enough. Wall Street is in panic mode. The Dow has plummeted 6% in intra-day trading. Bank of America is down 18% and Citibank is down 10% as investors fret over the ability of the U.S. government to bail them out if they implode. Its time to buy stocks, especially financials.
Noam Chomsky makes similar points at TruthOut, much more eloquently than I can muster of course.]
[Update @ Wednesday 1PM: the yield on the benchmark 10-year U.S. treasuries is down to 2.14%, a hair’s breath away from the record low of 2.13% in December 2008.]