Moody’s warns of downgrade from AAA without budget deal

Moody’s Investors Service on Tuesday warned that it will downgrade the U.S. government’s AAA credit rating if Congress and the newly installed president next year fail to produce a major budget agreement that stabilizes and reduces the U.S. debt.

The announcement reflects widespread sentiment among global investors who provide much of the financing for the U.S. debt that the beginning of the next Congress and next administration present perhaps the last and best opportunity for the United States to get its debt under control and maintain its standing as one of the world’s best-managed economies.

The Moody’s announcement also represents a call by the nation’s creditors for presidential and legislative candidates this fall to seek a fresh mandate from voters in the elections to get the government’s house in order, and then take action on that mandate upon taking office.

Without such action soon, financial experts say the U.S. appears likely to head down the same path as Italy, Spain, Greece and other debt-strapped European countries that waited too long — for political reasons — to gain control over their debts and now face the double hardship of both spiraling debt burdens and deep economic recessions and social upheavals brought on by the severe budget cuts needed to belatedly impose budget discipline.

“If policies remain unchanged, the debt will explode, which clearly is not sustainable,” said John E. Silvia, chief economist at Wells Fargo Securities “The U.S. economy would, in a best-case scenario, face a period of slow growth. More ominously, the United States could face a deep downturn if financing for the federal government completely dried up as the recent example of Greece readily demonstrates.”

Time to act

Moody’s stressed that while the clock is ticking on the U.S. debt bomb, the U.S. still has some time to tackle its debts, which are equal in size to some of the worst-hit European countries. It called for the gradual phase-in of the estimated $4 trillion to $5 trillion of spending cuts and tax increases needed to reduce the debt to manageable levels without bringing on a recession or imposing severe hardship on U.S. taxpayers or citizens dependent on the government for support.

Congress already essentially scheduled a monumental budget and tax battle at the beginning of next year by setting up the “fiscal cliff” when all of President Bush’s tax cuts are due to expire at the same time $1 trillion in defense and domestic spending cuts are scheduled to take effect.

Moody’s, like many Wall Street observers, expects that deadline to be pushed further into next year, giving the president and Congress time to negotiate a compromise solution. And in a nod to the reality that compromise on major tax and entitlement matters is politically difficult and will take time, Moody’s indicated that it expects it will take months for Congress and the administration to hash out a plan to tackle the debt next year. It said it would wait to take action on the U.S. credit rating until after the outcome of the political battle is clear.

Fitch Ratings Service also recently said it expects action in the first six months of next year, warning that U.S. political leaders must adopt “sensible” measures to reduce the debt during that time period, or they will face a downgrade from Fitch, which is the smallest of the Wall Street credit agencies.

’Sensible’ reforms sought

“They need to set out some kind of plan to address the deficit and debt in a sensible way,” Fitch Managing Director David Riley told Bloomberg Television last month. “We are not looking for slash and burn; we are talking about a sensible reduction. If they can’t really put that together in the first half of 2013, there is a significant threat to the loss of the triple-A rating from Fitch.”

A downgrade to AA from Moody’s or Fitch means the U.S. would no longer have a claim to the top-notch rating that made U.S. Treasury bonds the safest and most sought-after investment in the world in the last century. Wall Street’s other top rater, Standard & Poor’s Corp., already downgraded the AAA rating of the U.S. government last year and has warned it may take further action if more debt reduction measures are not enacted next year.

To avoid a downgrade, Moody’s said Congress will need to adopt a deficit reduction program that stabilizes the burgeoning U.S. debt and begins to slowly reduce it to manageable levels. Budget experts say such a program would prevent the public debt from rising much from the 70 percent of economic output level where it is today, and it would need to include at least $4 trillion to $5 trillion in spending cuts and tax increases while addressing looming insolvencies in entitlement programs such as Medicare and Social Security.

Moody’s also said it is concerned about the anticipated expiration of the national debt limit around the end of the year, and would like to see an “orderly resolution” that raises the debt limit without the threat of default as occurred last summer. If the budget negotiations are prolonged and contentious and threaten to lead to a default on the U.S. debt, Moody’s said it would accelerate its review of the U.S. rating at that time.

Wall Street analysts say the U.S. has only escaped the debt trap that is engulfing Greece and other European nations because it prints the world’s reserve currency, the dollar, and remains a relatively safe haven in a troubled global economy. That makes foreigners more willing to provide the U.S. with low-cost credit than other nations. Because of the long-running debt crisis in Europe, global investors have flocked to U.S. markets despite the S&P downgrade last year, even driving the interest rates Treasury pays on its debt recently to record lows.

“While the metrics in the U.S. appear worse [than European countries such as France], the fact it issues the world’s trading currency has so far placated investor concerns,” said Richard Batty, global investment strategist at Standard Life Investments. The U.S. has “an overall ability to engineer policies in aggregate to arrest a lurch into a debt trap” because of that, he said.

Putting Washington on notice

The move by ratings agencies essentially puts both presidential candidates as well as members of Congress on notice that the financial dangers of the mounting debt are growing, while it heightens the importance the upcoming elections hold in deciding the future direction of the government. Signs already had emerged that the elections are more focused than usual on the question of the national debt and how to control it.

Many Wall Street analysts credit Republican presidential candidate Mitt Romney’s selection of running mate Rep. Paul Ryan — the champion of the House’s spending cut plan, which would radically reform the fast-growing Medicare and Medicaid entitlement programs — for putting the crucial issue of entitlement reform before voters.

“Like his proposal or not, unlike anyone else in Washington, Ryan deserves credit for having the political courage to have a budget plan that addresses difficult issues,” said Ward McCarthy, chief economist at Jefferies & Co.

“This will drive much of the campaign and debate rhetoric to topics that need public dialogue and debate. Ideally, this campaign should revolve around the economy and fiscal policy, as those are the two most important issues for this country at this point in time.”

Joseph G. Carson, economist at AllianceBernstein, agreed that much is riding on the outcome of the elections, in which Mr. Romney has called for far-reaching entitlement reforms like those proposed by Mr. Ryan, coupled with increases in defense spending and further tax cuts. President Obama, by contrast, wants to avoid radical changes in the entitlements, while cutting defense and raising taxes from wealthier Americans to maintain a higher level of domestic spending.

“The U.S. electorate is being offered two different fiscal visions for the future,” Mr. Carson said. “In fact, we think that there probably has not been such a wide gap between the federal budget platforms of a sitting president and a candidate since the 1980 elections, when Republican presidential nominee Ronald Reagan committed to a major, long-term defense buildup, in contrast with Jimmy Carter’s policies of staying with the status quo.”

“The central theme in the Ryan budget is that controlling mandatory spending is critical to reducing the size of government and deficits. Obama’s budget assumes that the general public wants to maintain the size of current social programs and extract more revenues to pay for them,” Mr. Carson said. “Whoever wins the election must ensure that under any plan, a long-term budget should seek to balance the government’s books, meet the needs of its citizens, and stop draining resources from the private economy, in order to help promote economic growth.

The White House was silent on the Moody’s announcement, but House Speaker John A. Boehner, Ohio Republicans, and other Republicans hailed the move.

“Today’s warning by Moody’s underscores the point we have been making all year,” said Mr. Boehner. “We need to fundamentally reform our tax code, reduce spending, save Medicare, and reform other critical programs that are heading toward bankruptcy. Republicans have consistently put forth budgets that achieve these pro-growth goals.”