Arnott: Inevitabilities - One Down, More To Come

August 09, 2011

The S&P downgrade was the first of a number of 'inevitabilities' for the world's largest economy.


Standard & Poor’s downgrade of U.S. government debt to AA+ from AAA is a wake-up call to a public weaned on credit - both governmental and personal credit. It is time to kick the “buy today, pay tomorrow” habit and look at policy options that, no matter how painful they appear today, are far less excruciating than the consequences of not taking action. In this special note, we take a close look at government finances and entitlement programs, and what can be done now to avert a true disaster in the future.

The Downgrade
Standard & Poor’s has downgraded the United States following the recent debt ceiling “debate.” The other credit agencies did not. Was Standard & Poor’s out of line? We think not. Consider, for example, how the United States would stack up relative to a corporation. In “corporate” terms, the United States

  • Delivers $1.4 trillion of operating losses on $2.2 trillion of revenues.
  • Recently altered its long-term strategic plan, trimming 5% of its current spending plans over the coming 10 years - mostly in the out years.
  • Carries a debt burden of $15 trillion, amounting to more than six years of annual gross revenues. Fortunately, its lenders do not currently charge much
    interest on these loans.
  • Has been generous in promising unfunded pension and post-retirement medical care to its constituents, amounting to more than 20 years of annual revenues.
  • Assumes a 3% real discount rate on the unfunded obligations, when long TIPS yields - as a truer discount actor - are not even half that. If we use the TIPS yields, these unfunded obligations consume well over 30 years of “company revenues.”


A company with these characteristics, not yet in default, would be in the lowest non-default rating category available - the junkiest of the junk bonds - a C. So, why all the fuss about a downgrade to AA+? It was inevitable.
This relatively small inevitability will be followed by other, substantially more significant, inevitabilities if we don’t tackle the tough issues now.1 Any high-yield manager will tell you C-rated companies do not stay C for long. The company either gets its act together pronto or goes into default.

Deficit Reduction: Inevitable
The deficit must be reduced. It’s inevitable, as status quo is unsustainable. We must, and therefore we will, have a balanced budget in 10 years. We have no choice. We do, at least for now, have choices in how to tackle the deficit. Do we reduce the deficit deliberately, or do we wait until the lenders say “no mas,” cutting up our credit cards?2 Consider four alternate paths:

  • Eliminate the deficit immediately by cutting 40% of all government spending, eviscerating all spending programs including entitlements, and watch 11% of our GDP evaporate instantly. We know that the private sector eventually steps in, so subsequent GDP growth can be quite splendid (see our Fundamentals from April 2011).3 But, first, we take the 11% hit. Of course, this 11% of GDP is phony GDP: it is pure debt-financed consumption. Still, neither party wants to be blamed for an abrupt 11% drop in GDP, no matter how impressive the subsequent recovery.
  • Eliminate the deficit immediately by boosting all tax rates by about two-thirds, and hope that the economy doesn’t collapse as a result. This option doesn’t permit the private sector to resume its role as the primary growth engine for the economy. So any GDP hit is probably both real and lasting.4
  • Trim the deficit from the 4% average since our last surplus in 2001 to 1% per year for 10 years.5 Of course, a smaller government might free the private sector to pick up the slack, so GDP growth might well be unaffected. But, under the static accounting of the Congressional Budget Office, this approach reduces future GDP growth by 1% to 2% per year until our budget is balanced. As a result, our debt soars to about 150% of GDP.
  • Continue the game of kick the can until no lender wants to buy our debt because they know our bonds are “certificates of confiscation.”6 We know the consequences, from countless examples drawn from history, not to mention current examples in Zimbabwe, Greece, Ireland, Spain, and Portugal. The depression is deep and the geopolitical consequences are dangerous.



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