Risk and the government’s credit rating

Risk and the government’s credit rating

Inspired by Michael McConnell’s post and a comment by Charles Krauthammer on Special Report with Bret Baier, I offer a different way of thinking about the current budget battle. Let’s consider it in terms of tradeoffs among different types of risks.

The Tuesday deadline for budget negotiations is about liquidity risk (aka funding risk) – will the government have enough cash to pay its bills on time?

The government also faces solvency risk – will policymakers close the large and growing gap between spending and revenues? Will they cut spending and/or raise taxes enough to make the U.S. government a financially sustainable operation?

Both types of risk result from policy decisions made by our elected representatives. The short-term liquidity risk was created by conservative Members of Congress who refused to raise the debt limit without cutting spending. The solvency risk accumulated gradually as officials from both parties promised government benefits in excess of the taxes they were willing to impose.

Investors and credit rating agencies should care about both liquidity risk and solvency risk. Both threaten the U.S. government’s and the Nation’s financial and economic strength.

The current legislative situation creates a tradeoff between reduced solvency risk on the one hand, and reduced liquidity and political risk on the other.

The President is prioritizing the reduction or even elimination of liquidity risk between now and early 2013. He wants a debt limit increase or a process that ensures that Congressional conservatives cannot again threaten short-term government financing by blocking another debt limit increase. The President argues that the resulting reduced liquidity risk would be good for America’s credit rating. He is correct but incomplete in this point.

I suspect the President is driven at least in part by a desire to minimize his personal political risk. We have seen the political winds shift dramatically several times during the past few weeks’ battles, and everyone has taken political damage. I can understand why the political advisors to an incumbent President would want to avoid reintroducing that risk close to an election.

Fiscal conservatives in the House and Senate are prioritizing the reduction of solvency risk. They want another opportunity to force Congress and the President to address the imbalance between spending and revenues. They are demonstrating now that by holding the debt limit hostage and increasing liquidity risk, they can achieve some deficit reduction through spending cuts and reduce solvency risk a bit. Congressional Republicans could and should argue that the increased liquidity risk they have created is outweighed by the reduced solvency risk that will result. In other words, the spending cuts and deficit reduction we hope they will soon enact are worth the pain of this fight and the liquidity risk it created.

I see anecdotal reports suggesting that neither the Reid nor the House-passed bills reduce the deficit enough to affect the credit rating agencies’ determination of solvency risk. That reinforces my view that reducing solvency risk is even more important to our government’s credit rating than are marginal changes in liquidity risk. We need deeper spending cuts and more deficit reduction than Washington may enact in this round.

We are seeing now how legislatively difficult it is to cut spending and reduce the deficit. The next round will be even more difficult, and smart money would bet heavily against a signing ceremony next year. If credit rating agencies are most concerned with solvency risk, then any process which leads to another legislative battle next year is, on balance, good for the U.S. government’s credit rating. No battle means no change in law means no significant additional deficit reduction before 2013 beyond what is enacted in the next week.

Indeed yesterday the President did not say that he wants to “negotiate” or “work to reduce the deficit” in a second round. He instead said:

We agree on a process where the next step is a debate in the coming months on tax reform and entitlement reform –- and I’m ready and willing to have that debate.

In Washington “have that debate” is code for “Let’s argue about it next year, not resolve anything, and then let the voters decide.” The President may want only a debate, but I think Congressional conservatives want to change the law again next year.

Another round of deficit reduction next year will occur only if conservatives in Congress once again can block a debt limit increase. The process negotiation going on now is really a discussion about whether conservatives retain this power.

If they retain the procedural leverage to block another debt limit increase next year:

  • liquidity risk increases;
  • solvency risk decreases, because the chance of enacting more deficit reduction goes up; and
  • political risk for incumbents increases.

The President argues that the increased liquidity risk would be bad for America’s credit rating.

I place the highest priority on reducing solvency risk. I care less about marginally increased liquidity risk. I’m with the House freshmen in caring little about increased political risk for incumbents.

I think another opportunity to cut spending and reduce solvency risk would be good for America’s credit rating and would outweigh the cost of any increased liquidity risk. Otherwise everyone will just argue for 18 months while the underlying fiscal position continues to deteriorate.

I therefore support anything which would allow another round of this struggle next year. Yes, it’s unpleasant and ugly to watch. Yes, it would mean another round of worries about a short-term cash crunch just six months from now.

The best way to improve America’s fiscal health and credit rating is to force policymakers to address the underlying spending problem repeatedly until it is fixed. If the only way to cut spending in 2012 is to provoke another fight like this one and watch conservatives again hold the debt limit hostage, so be it.

(photo credit: Kevin Dooley)

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