Moody’s provides criteria for U.S. Triple-A rating

February 19, 2013

The credit rating agency Moody’s is in a very delicate position. Its arch rival, Standard & Poor’s, was recently charged by the U.S. Department of Justice alleging that S&P committed mail and wire fraud by defrauding investors with faulty ratings. Moody’s was not charged, but there are a lot of questions about why it was left out of the investigation. At the same time, Moody’s is responsible for judging the creditworthiness of the U.S. government’s debt. There is little wonder that the rating agency is being very transparent in the benchmarks it is using.

Moody’s current rating for U.S. debt is Aaa (negative), which means that it could be downgraded. Unlike Paul Krugman and others who want the nation to issue more debt to attempt to spur economic activity, Moody’s wants the U.S. to reduce its debt-to-GDP ratio to improve its credit quality. In a detailed analysis, Steven A. Hess, Moody’s Senior Vice President, lays out what the agency is watching and the metrics it will use to judge the actions of Congress and the President.

First Hess describes how the recent tax increases on those earning $400,000 per year or more does not raise enough revenue to square up fiscal issues:

The American Taxpayer Relief Act (ATRA), passed on 1 January, was the first significant fiscal measure of the year. We expect the various tax measures in the act, including an increase in the income tax rate for individuals with annual income of $400,000 and above, to raise government revenue by more than $600 billion over the next 10 years. However, we do not expect this amount to be sufficient to ensure a decline in the ratio of federal government debt to GDP. The Congressional Budget Office (CBO), for example, projects that this ratio, after falling somewhat in the middle of the decade, will begin to rise again at the end of the decade. Therefore, further measures are required to ensure a downward debt trajectory.

Moody’s reminds us of how the basic procedures for developing a budget have not been followed:

February: The Obama administration was to release its budget proposal for fiscal year 2014, which begins on 1 October. However, the administration has indicated its preparation of a budget proposal has been delayed and the date of the release is uncertain. In past years, the administration’s budget proposal has not been passed by either house of Congress. However, it is likely to form the basis for the Democratic position, as outlined at a high level in last week’s State of the Union address, in any negotiations over spending and revenue measures that would affect deficits and debt levels. The Republican position will most likely come in the form of a budget passed in the House of Representatives.

On March 1 the sequester kicks in:

1 March: Cuts in discretionary spending mandated by the Budget Control Act of August 2011 and delayed for two months by the ATRA, go into effect (the sequestration). After the first year, in which spending is actually reduced in nominal terms, discretionary spending growth would be constrained at a very low rate of growth over the next 10 years. Half of the $1.2 trillion in spending reductions would come from cuts in the defense budget.

By late March, Congress faces the need to authorize continuing government spending, since no budget for the current fiscal year has been approved:

27 March: The “continuing resolution” that authorizes the government to spend expires. Continuing resolutions are used when there is no budget in place, and the one that expires 27 March became effective at the beginning of the current fiscal year (1 October 2012). The last time the government’s spending authority expired, in late 1995, all “non-essential” parts of the government shut down, and many federal employees were furloughed. This lasted for two periods totaling 28 days. Such a development does not affect mandatory programs (including Social Security and Medicare) or interest on government debt, so the absence of a budget or new continuing resolution by 27 March would not affect the government’s ability to service its debt. However, the prospect of a government shutdown would provide a strong incentive for action on a budget.

On April 15, a fire gets lit under the feet of members of Congress. Their salaries will be escrowed if they do not pass a budget resolution:

15 April: If either the House of Representatives or the Senate has not passed a budget resolution by this date, the salaries of the members of that house will be put into escrow and not paid until a budget passes. Included in the most recent debt-limit suspension bill, this provision seeks to incentivize both houses to pass budgets. However it does not necessarily mean that they will pass the same budget. As such, while this requirement creates another incentive for action, it is not necessarily decisive.

In May is the return of the dirty words, “debt limit”:

19 May: The debt limit, currently suspended, will be reinstated at the level of debt outstanding on this date. This means that, in the absence of action to raise the debt limit, the Treasury would once again be in the mode of using “extraordinary measures” to continue financing government operations. These could last for approximately two months, after which expenditures would need to be reduced to the level of incoming revenue. The expenditures that would be reduced are not specified.

In our opinion, the debt limit is not a fundamental factor in terms of the US rating, although it provides a low level of event risk. While the debt limit will be reached on 19 May if no further measures are taken, we believe that interest payments on Treasury debt are very likely to continue even if the debt limit is not raised. The government has the ability to continue meeting its debt obligations, in that interest on Treasury bonds and notes averages about 6 percent of government expenditures.

And now Moody’s gets to the heart of the issue: the economy must grow at a healthy clip or more spending reductions will be needed to reduce the debt-to-GDP ratio:

[…] the economic projections used as the basis for the budget figures show strong rates of increase in real GDP for the 2014-18 period, higher than the average of private-sector forecasts and, at least in 2015, higher than the top of the Federal Reserve’s range. If these high rates of growth do not materialize, the modest reduction in the debt ratios in the middle of the decade will not occur, and the rising trend will be more pronounced in later years. Therefore, further fiscal policy actions in coming months would be needed to ensure a decline in the debt ratios. Any rating action in coming months will be predicated on the expected debt trajectory, which in turn will result from fiscal policy and the expected path of economic growth.

I know that many pundits don’t consider the credit rating of the U.S. to be of any importance. But it is the anchor of fixed income markets. U.S. Treasury securities are used as a store of global wealth. More importantly, it is a signal to domestic and foreign investors of the stability of the government and the economy. When Standard & Poor’s downgraded the U.S. credit rating from AAA (outstanding) to AA+ (excellent)  in August of 2011, it cited political dysfunction as their primary motivation:

More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011. Since then, we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics any time soon.

Moody’s appears to be following a very similar playbook by putting as much emphasis on U.S. political process as on debt load. Note to our leaders: please put your noses to the grindstone. Your lack of comity is becoming costly.

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