No Runny Eggs

Less than 2 months after Standard and Poor’s cut its federal government credit outlook to negative, Moody’s announced on Thursday that it expects to place its federal government credit rating under review as there still is no agreement on whether to live within the government’s revenue limits or to raise the debt ceiling. To wit, this is the set of implications from Moody’s:

1) The likelihood that Moody’s will place the US government’s rating on review for downgrade due to the risk of a short-lived default has increased. Since the risk of continuing stalemate has grown, if progress in negotiations is not evident by the middle of July, such a rating action is likely. The Secretary of the Treasury has indicated that the government will have to drastically reduce expenditure sometime around August 2 if the debt limit is not raised; the initiation of a rating review would precede this date.

2) If a debt-ceiling-related default were to occur, Moody’s would likely downgrade the rating shortly thereafter. The extent of and length of time before a downgrade would depend on how factors surrounding the default affect the government’s fundamental creditworthiness, including (a) the speed at which the default were cured, (b) an assessment of the effect of the default on long-term Treasury borrowing costs, and (c) measures put in place to prevent a recurrence. However, a rating in the Aa range would be the most likely outcome. Any loss to bondholders would likely be minimal or non-existent, as Moody’s anticipates that a default would be cured quickly.

3) If default is avoided, the Aaa rating would likely be affirmed after any review. Whether the outlook on the rating would be stable or negative would depend upon whether the outcome of the negotiations included meaningful progress toward substantial and credible long-term deficit reduction. Such reduction would imply stabilization within a few years and ultimately a decline in the government’s debt ratios, including the ratio of debt to GDP.

Allow me to translate the last item. If the only thing that is done is a short-term solution, either a “clean” debt-ceiling increase or a massive spending cut that doesn’t affect interest (or a combination thereof), Moody’s is going to join S&P in having a negative outlook on debt.

I’ll borrow a couple of the slides my Congressman, Paul Ryan, included in his series of April listening sessions to illustrate why a short-term solution, regardless of what it is, won’t work. The first shows the trajectory of publicly-held debt from 1940 to 2080 (click for the full-size graphic):

Do note how soon the publicly-held debt crosses the 100% of GDP threshhold (sometime between 2020 and 2030). I could also point out where it ends up, but one thing Ryan pointed out in the listening sessions is that the CBO cannot project what the economy does after 2037 because the computers crash when trying to model that.

The second one focuses on the projected yearly spending on just the “Big Three” of the entitlement programs, Social Security, Medicare, and Medicaid, versus projected federal revenues, again as a percentage of GDP (click for the full-sized graphic):

I really wish Ryan had included interest on the debt in the chart because it would better illustrate just how much entitlements and debt crush the life out of the rest of the federal budget. Indeed, in a floor speech on Thursday, Ryan pointed out that by the end of this decade, 20% of the total tax revenue would be dedicated to interest. That brings the entitlement plus interest share of the tax revenue to somewhere around 85%.

The unsustainable trend is undeniable. Once revenues stabilize at the historic 18% (give or take a couple tenths of a point) of GDP, just the entitlements will rapidly approach 100% of the revenues, hitting somewhere around 90% by the aforementioned 2037 GDP model crash date, and crossing 100% around 2050.

The bond ratings agencies are making it crystal clear that simply saying the government can borrow more isn’t going to cut it. Similarly, as much as many people don’t want to hear it, thinking we can avoid default just by cutting spending isn’t going to cut it. Indeed, given the current tax collection rate (due to the collapsed economy, not to the Bush tax cuts; though that’s an argument for another post), Congress could zero out all discretionary spending, and we’d still run a deficit and thus increase the debt.

Revisions/extensions (6:15 pm 6/6/2011) – James Pethokoukis, who just returned from China, says the Chinese want a long-term fix.

Another item in James’ piece is that some of the “smart money” seems to think the Treasury will prioritize debt service and Social Security checks. Without specific instructions from Congress, I wouldn’t put my money on that.