Wednesday, November 12, 2008

Could the USA lose its AAA bond rating?

Some say that with rising debt levels – the financial bailout built up projected increases due to entitlement costs – the U.S. Treasury could eventually lose its AAA rating on government bonds, which would imply higher interest rates for the government and for all Americans. This story on CNBC discusses the issue. Analysts from the major bond rating agencies – Moody's and Standard & Poor's – raised the issue of sovereign debt downgrades even before the financial crisis hit, solely based on rising costs for Social Security and Medicare and the government's seeming inability to address them.

How would this matter? Two ways. On one hand, a bond downgrade might finally spur Congress to action, as the first concrete evidence of the cost of our failure to address rising entitlement costs in a timely way.

But on the other hand, if falling bond ratings imply higher interest rates, this would have a paradoxical effect on the measured Social Security and Medicare shortfalls: they would go down. The reason is that the Social Security and Medicare deficits are calculated as "present values," which means that future dollar deficits are discounted back to the present using the government bond interest rate. For example, at the current assumed long-term interest rate of 2.9% above inflation, a Social Security deficit in 2080 of $500 billion has a present value of $64 billion. Now let's assume that Treasury bonds are downgraded and must now pay a higher interest rate – say, 3.9% above inflation. In that case, the same $500 billion real dollar deficit in 2080 now has a present value of only $32 billion.

Now, this is only accounting make-believe – the deficits are what they are, and the fact that we discount them as government interest rates that may rise as a result of our fiscal profligacy can't possibly make them smaller. But given Congressional inclinations to make no hard choices for as long as possible, surely someone would grasp onto this accounting curiosity as a reason to continue to do nothing. This highlights the important role of how we measure entitlement costs, and how those measures affect what we see and what we do about it.


bubbleRefuge said...

The fact that the bond rating agencies do not realize that there is no SS insolvency risk is an outrage. The treasury can fund anything it wants to denominated in dollars. The only constraints are operational rules. Note these are the
same agencies who failed to identify the sub-prime mortgage risk properly. You and the rating agencies are out of paradigm. The fact that such a well respected agency could be so wrong about the economic fundamentals -with nobody calling them out on it but a few- is a testament to the dire situation the financial system and the economy is in. We need a new economic policy leadership that recognizes what a soft-currency floating-fx rate monetary system is and how to architect policy around it.

MS said...

Shouldn't we use risk-adjusted rates, which would be nearly equivalent to using AAA rates?

But then should we also risk-adjust the projections of returns on Social Security personal accounts. Would these adjustments change in any way your conclusions about PRAs still being a good idea? I guess if we were to risk-adjust the accounts they wouldn't look any better or worse than the shadow bond account.

Andrew G. Biggs said...

Bubble refuge: Two of the ratings agencies have said they will downgrade if debt continues to rise as predicted. If this debt increase were a certainty they should downgrade today, but they assume -- for better or worse -- that we'll find a way of balancing the books.

MS: I agree that we should generally use risk adjusted returns in comparing personal accounts to the current program, although a) that's not a big issue for this post, about a possible Treasury bond downgrade; and b) for the exercise using historical data it wasn't really the object. But in the abstract, I don't believe you should simply compare the average stock return to the average bond return without considering risk.

bubbleRefuge said...

but they assume -- for better or worse -- that we'll find a way of balancing the books.
Well certainly for worse. This conversation shouldn't exist. Again these dismal scientists are out of paradigm. We cannot and almost certainly will not decrease the deficit without bringing this economy to its knees because of the aggregate demand that the tax revenue would suck out of the economy(happened in 1999). Somehow, some-where, some-way, some-day, a leader has got to emerge and change our macro policy goals to use fiscal
policy for GDP, unemployment, and inflation targeting. Deficits don't matter. We've go to stop with this monetary policy bull-crap to which there is scant evidence as to its efficacy but plenty of evidence that it causes financial market volatility.

As far as SS. SS payroll tax should be eliminated as it is a regressive tax. The treasury could write checks to our SS accounts if it makes guys like you happy. If tomorrow congress were to pass an indefinite payroll tax holiday, we'd be out of this mess in a few weeks.

Thanks for the reply.

Anonymous said...

How would the fed, the issuer of currency, ever have a payments crisis? It makes no sense to even talk about a rating on govt bonds. There is no insolvency risk.

Andrew G. Biggs said...

Anonymous: Lenders care about the real return on bonds, adjusted for risk; the Fed can influence only the nominal return by printing money.

Anonymous said...

The historical after-tax real rate of return on U.S. treasuries is negative (see articles in Financial Analysts Journal).

I agree with anonymous that a govt can not have a payments crisis in its own currency unless it so chooses.

Since when does AAA ratings criteria have anything to do with the rate of return, real or not? Instead, it simply has to do with the borrowers ability to repay principal and interest.