Nouriel Roubini's Global EconoMonitor

Wednesday Note: S&P Outlook Downgrade Reminds Washington to Do the Right Thing

S&P’s decision to cut its outlook for U.S. government debt from stable to negative—a historic first—sent markets tumbling: On April 18, the Dow Jones Industrial Average and the S&P 500 both recorded their biggest one-day drops in nearly a month (though U.S. Treasurys and the dollar did well). The landmark outlook downgrade reinforces what we have been saying since 2010: The United States is on an unsustainable fiscal path from which it cannot exit without political consensus. The key question is whether the gridlocked U.S. political system can respond in time to avert a bond market revolt.

The rise in public debt following a financial crisis is one of the main mechanisms by which a recovery may be supported in the short term. Typically, this happens via Keynesian consumption-smoothing across economies and income generation through the state’s redistribution of resources between economic sectors, financed by borrowing against future revenues and growth. But the flip side of this short-term recovery may be reduced post-recovery potential and actual growth: The larger public debt portends a future rise in taxes on wealth and/or income, which in turn weighs on growth and thereby on fiscal balance.

Since the precrisis leveraged asset bubble induced above-equilibrium public revenue, corporate profits and household income, wealth and spending, it is logical to expect a general reduction in net wealth, including a rise in net public debt. The capacity of the financial markets and the state to tolerate and manage that rising debt burden or adjust fiscally or structurally to reduce it will be the key to whether the markets buy the fiscal liabilities or sell them en masse.

A bond market revolt is not at all easy to engineer in the United States. There is no safer asset destination on the planet than the United States, which has the third-longest-running system of government in the world, despite being a young nation. Almost no other country’s structure of state—and hence property rights—have survived world and local wars (including defeats), economic depressions and financial and fiscal crises without major dislocations and arbitrary redistributions of wealth through inflation or more direct expropriation. The knee-jerk risk-off wave may well pass as people begin to recognize that this rating move will make little if any difference—and may even improve debt dynamics by cutting bond yields if risk-off persists. Unlike other debtor countries, the United States actually benefits from risk aversion, even domestic risk aversion, through a stronger dollar and lower bond yields, so the market impact will likely be transitory.

The United States has the most manageable fiscal issues of any major advanced economy because federal, state and local revenues as a share of GDP are very low, for cyclical and other reasons. Therefore, fiscal balance can be restored by fiscal adjustment without major economic difficulty in the near term. In the longer term, structural fiscal reform will be needed due to rising Social Security commitments. For the United States, debt sustainability is a function of political constraints. The political center has fractured as a result of the financial crisis, and healing it requires a consensus about the desired size of the state: Should the government bear the low level of responsibility of its 18-19th century libertarian predecessors or should it share the 20th century New Deal or Great Society vision of America?

The current shortage of consensus in Washington about the right balance between public and private responsibilities suggests no real action will be taken to address structural budget issues until at least after the 2013 presidential elections. On the other hand, there are now four potential plans to foster debate in Congress that would reduce the deficit by US$4-5 trillion over the next decade: the original Simpson-Bowles bipartisan proposal, the Republicans’ “Ryan Plan,” President Barack Obama’s new proposal and the impending “Gang of Six” proposal that potentially could have the most bipartisan appeal. So while formal progress will not be made until 2013, an agreement in principle that something will be done by 2013 could coalesce between 2011 and 2012.

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