S&P Negative U.S. Debt Outlook Really Is A Big Deal

April 2011

Last week, credit rating agency Standard & Poors changed its outlook on U.S. government debt to negative. The stock market had a bad day in response, but the markets and news media seem to have already forgotten the warning. For the most part, commentators have indicated that the S&P warning describes what everyone already knows. This is true, but that does not make the warning any less bothersome.

S&P indicated a one in three chance that it would downgrade U.S. debt in the next two years. S&P cited two primary reasons for its negative outlook: (i) ballooning deficits and (ii) lack of agreement on how these deficits will be reduced. As for the first reason, S&P’s news release stated:

“In 2003-2008, the U.S.’s general (total) government deficit fluctuated between 2% and 5% of GDP. Already noticeably larger than that of most ‘AAA’ rated sovereigns, it ballooned to more than 11% in 2009 and has yet to recover.”

As for the second reason, S&P states:

“…we see the path to agreement as challenging because the gap between the parties remains wide. We believe there is a significant risk that Congressional negotiations could result in no agreement on a medium-term fiscal strategy until after the fall 2012 Congressional and Presidential elections.”

As part of its outlook, S&P projected three scenarios for the U.S. economy by 2013. S&P’s “optimistic” scenario projects 4% real growth, but estimates that debt will be 80% of U.S. GDP. Its pessimistic scenario includes a mild double dip recession and pegs debt at 90% of U.S. GDP. These debt levels are surpassed only by U.S.’s peak debt level during World War II. Further, the optimistic scenario shows deficits reaching 4.6% of GDP by 2013.

Moody’s, also a credit analysis agency, disagrees with S&P’s negative outlook. However, Moody’s recognizes the problem, noting:

“The US stands out from other major countries as not yet having a plan for reversing its upward debt trajectory.”

Moody’s disagreement with S&P occurs because Moody’s thinks that political common ground is likely. Its press release specifically cites President Obama’s April 13, 2011 speech as indicating progress. This presidential speech basically was in response to plans passed by the House of Representatives for the Republicans’ “path to prosperity”. The House proposal would cut $4.4 trillion from the deficit over the next ten years. However, the House bill is a long way from getting the Senate and presidential approval expected by as Moody’s.

It is difficult to understand how the President’s speech represents progress on the two issues that S&P cites. For example, details of the President’s proposed spending cuts are not clear. Much more time was spent indicating what would NOT be cut. Here is what the President proposed for spending cuts:

“The first step in our approach is to keep annual domestic spending low by building on the savings that both parties agreed to last week – a step that will save us about $750 billion over twelve years. We will make the tough cuts necessary to achieve these savings, including in programs I care about, but I will not sacrifice the core investments we need to grow and create jobs. We’ll invest in medical research and clean energy technology. We’ll invest in new roads and airports and broadband access. We will invest in education and job training. We will do what we need to compete and we will win the future.

The second step in our approach is to find additional savings in our defense budget…. I intend to work with Secretary Gates and the Joint Chiefs on this review, and I will make specific decisions about spending after it’s complete.

The third step in our approach is to further reduce health care spending in our budget. … But let me be absolutely clear: I will preserve these health care programs as a promise we make to each other in this society. … That includes, by the way, our commitment to Social Security.

The fourth step in our approach is to reduce spending in the tax code…. The tax code is also loaded up with spending on things like itemized deductions. And while I agree with the goals of many of these deductions, like homeownership or charitable giving, we cannot ignore the fact that they provide millionaires an average tax break of $75,000 while doing nothing for the typical middle-class family that doesn’t itemize.”

President Obama’s speech indicated that he proposes a mix of $3 in spending cuts for every $1 in tax increases claims to reduce the deficit by $4 trillion over the next twelve years. Interestingly, the above fourth and last step of spending cuts described above is really a tax increase. So, the ratio of spending cuts to tax increases is NOT the 3 to 1 ratio that the President stated.

Similarly, S&P’s concern about the various political parties not being able to obtain agreement is supported by the lack of bipartisan comments contained in President’s Obama’s speech. See if you think the following comments about the House bill speak to conciliation and bipartisanship:

“One vision has been championed by Republicans in the House of Representatives and embraced by several of their party’s presidential candidates. … But the way this plan achieves those goals would lead to a fundamentally different America than the one we’ve known throughout most of our history.

A 70% cut to clean energy. A 25% cut in education. A 30% cut in transportation. Cuts in college Pell Grants that will grow to more than $1,000 per year. That’s what they’re proposing. These aren’t the kind of cuts you make when you’re trying to get rid of some waste or find extra savings in the budget. … These are the kind of cuts that tell us we can’t afford the America we believe in. And they paint a vision of our future that’s deeply pessimistic.

It’s a vision that says if our roads crumble and our bridges collapse, we can’t afford to fix them. If there are bright young Americans who have the drive and the will but not the money to go to college, we can’t afford to send them. … It’s a vision that says America can’t afford to keep the promise we’ve made to care for our seniors. … This is a vision that says up to 50 million Americans have to lose their health insurance in order for us to reduce the deficit. … That’s not right, and it’s not going to happen as long as I’m President.

…the difference with the House Republican plan could not be clearer: their plan lowers the government’s health care bills by asking seniors and poor families to pay them instead. Our approach lowers the government’s health care bills by reducing the cost of health care itself.”

Expected Tax Increases

Many analysts believe that a tax increase is inevitable. President Obama’s plans for increased taxes are much clearer. In his April 13 speech, the President reiterated plans for tax increases proposed as part of his recent budget proposal. Not counting the increased taxes the President calls “tax spending”, the increased taxes total $1 trillion.

President Obama consistently repeats his desire to end the Bush-era income tax cuts for higher-income individuals. Generally, the President defines these as single individuals with incomes over $200,000, and married couples with incomes over $250,000. The primary changes would be as follows:

1. The top individual income tax rates would increase to 36% and 39.6% after 2012. Absent a change, for 2011 and 2012, the top two individual income tax rates are 33 percent and 35 percent.
2. Capital gains and dividend taxes would be increased for higher-income individuals. After 2012, higher-income individuals would pay capital gains and dividend taxes at 20 percent rather than at 15 percent.
3. The tax benefit of itemized deductions of higher income individuals would be limited to 28%, even though the same taxpayers’ income would be taxed at a higher rate.

After 2012, the President proposes to return the federal estate tax to 2009 levels; meaning, a maximum estate tax rate of 45 percent and a $3.5 million exclusion.

Despite the President’s talk to the contrary, the President’s fiscal 2012 budget does not include a cut in the U.S. corporate income tax rate. Any cut in overall corporate tax rates would likely be accompanied by corporate tax increases by eliminating not-yet-specified “loopholes”. In addition to corporate “loopholes” not yet specified, numerous corporate tax increases already proposed in the fiscal 2012 budget include the following:

1. International taxation - An estimated $129 billion in additional revenue is projected over 10 years pertaining to items such as limiting income shifting through intangible property transfers, and changes to the foreign tax credit rules.
2. LIFO - The last-in, first-out (LIFO) inventory accounting method would be repealed for federal income tax purposes. Taxpayers that currently use the LIFO method would be required to write up beginning LIFO inventory to its first-in, first-out (FIFO) value in the first tax year beginning after December 31, 2012. This proposal would raise an estimated $52.8 billion over 10 years.
3. Fossil fuel tax preferences – The Tax Code includes a number of tax incentives for oil, gas and coal producers, most of which would be eliminated. These proposals would raise an estimated $46.1 billion over 10 years.
4. Financial institutions – A new tax would be imposed on large U.S. financial institutions, labeled as a financial crisis responsibility fee. The fee would raise an estimated $30 billion in additional revenue over 10 years.
5. Carried interest – This investment-related income would be taxed as ordinary income (vs. as capital gains). This would raise an estimated $14.8 billion in additional revenue over 10 years.
6. Insurance companies - Insurance companies are subject to technical tax rules which would be altered. These changes would raise an estimated $14 billion over 10 years

Even if passed, the CBO states the President’s projections are not realistic

The Congressional Budget Office (CBO) released its initial assessment of President Obama’s 2012 budget. Generally, CBO concluded that the President’s deficit forecasts are too optimistic. The CBO wrote:

“CBO’s analysis of the President’s proposals is based on its own economic assumptions and estimating techniques (rather than the Administration’s) and incorporates estimates prepared by the staff of the Joint Committee on Taxation (JCT) for tax provisions. … Compared with the Administration’s estimates, CBO’s estimates of the deficit under the President’s budget are lower for 2011 (by $220 billion) but higher for each year thereafter (by a total of $2.3 trillion over the 2012–2021 period). That disparity stems from differences in the underlying projections of what would happen under current law ($1.3 trillion) as well as from differing assessments of the effects of the President’s proposals ($1.0 trillion).”

However, whether the President’s or CBO’s estimates are believed, the President’s budget provides a staggering amount of deficit spending. Generally, economists believe that a deficit of around 3% of the total economy (GDP) is sustainable. This is premised on continuing economic growth of approximately the same 3% rate. However, these levels of deficit spending never come close to being achieved under the President’s 10-year forecast. The CBO writes:

“According to CBO’s projections, if all of the President’s budgetary proposals were enacted, they would add $26 billion to the baseline deficit for 2011. As a result, the 2011 deficit would total $1.43 trillion, or 9.5 percent of gross domestic product (GDP).”

These large deficits are driven by further spending increases. The deficits occur despite significant tax increases. Again, according to the CBO:

“The President’s policy proposals mostly affect the revenue side of the budget. … Revenues would rise relative to GDP: from 16.2 percent in 2012 to 19.3 percent in 2021. … Total outlays under the President’s budget would equal 23.6 percent of GDP in 2012, decline slightly as a share of GDP over the following two years, and then rise for the rest of the 10-year projection period. They would equal 24.2 percent of GDP in 2021.”

Investing geniuses are also sounding the alarm

William Gross is one of the world’s smartest investors alive. Mr. Gross has made his living managing bond investments. He co-founded PIMCO in 1971, and runs multiple mutual funds that focus on bonds. His largest fund, PIMCO’s Total Return fund is the world’s largest bond fund and fifth largest mutual fund. Yet, he now realizes that bonds are a lousy place to be invested. He has been actively writing about the need for government policy change for quite some time, but his writings are getting more agitated.

Mr. Gross recently wrote one of his most blunt articles. Here are some quotes:

“75% of the budget is non-discretionary and entitlement based. Without attacking entitlements – Medicare, Medicaid and Social Security – we are smelling $1 trillion deficits as far as the nose can sniff. Once dominated by defense spending, these three categories now account for 44% of total Federal spending and are steadily rising. … After defense and interest payments on the national debt are excluded, remaining discretionary expenses for education, infrastructure, agriculture and housing constitute at most 25% of the 2011 fiscal year federal spending budget of $4 trillion. You could eliminate it all and still wind up with a deficit of nearly $700 billion!

…The situation is almost beyond repair. Check out the Treasury’s and Health and Human Services’ own data for the net present value of entitlement liabilities shown in Chart 2.

The incredible reality is that the $9.1 trillion federal debt that constitutes the next-to-tiniest ball in our chart is nothing compared to unfunded Medicaid and Medicare. It is like comparing Pluto to Saturn and Jupiter. The former (the $9.1 trillion current Treasury debt) does not even merit planetary status in our solar system of discounted future liabilities. It’s really just a large asteroid. …

Previous Congresses (and Administrations) have relied on the assumption that we can grow our way out of this onerous debt burden. Perhaps we could, if it was only $9.1 trillion, as shown in Chart 2. That would be 65% of GDP and well within reasonable ranges for sovereign debt burdens. But that is not the reality. … This country appears to have an off-balance-sheet, unrecorded debt burden of close to 500% of GDP!”

The world’s even better-known investor, Warren Buffet (Chairman of Berkshire Hathaway), is voicing similar concerns. Buffet continues to be negative on investing in fixed rate securities because of inflation concerns. Buffet was recently reported as saying:

I would recommend against buying long-term fixed-dollar investments. … If you ask me if the U.S. dollar is going to hold its purchasing power fully at the level of 2011, 5 years, 10 years or 20 years from now, I would tell you it will not.”

Since the S&P warning, some have suggested that S&P is being silly, since the U.S. can raise the money necessary to repay its debt by printing more money. That is certainly true, and is also true for every other sovereign nation. But, that does not mean that every nation’s debt is equally safe and worthy of holding. Printing money to pay debt causes inflation. The more insidious way that a nation can default on its debt involves diminishing the value of its repayments through inflation. Ultimately, S&P’s warning is not a warning on a default; it is a warning about high inflation and all that it brings.

Fulcrum inquiry performs economic analyses for litigation, business valuations, and forensic accountings.