Tag: government debt

Liability Is ‘Wrong’ Solution for Rating Agencies

Last week, while America was occupied with elections, an Australian court found Standard & Poor’s liable for “misleading” local council governments by awarding AAA rating to derivatives that later lost value (more detail on the case here). Not surprisingly, after the financial crisis, dozens of suits were filed in the United States, Europe, and elsewhere claiming investors were “misled” by the rating agencies. Most of these suits were quickly dismissed or withdrawn. The Australian case is one of the few to find liability.

First, as I documented in a recent Cato Policy Analysis, the regulatory structure for the rating agency is fatally flawed and was without a doubt a contributor to the financial crisis. That said, subjecting rating agencies to legal liability would make the situation worse, not better. From that analysis:

[A] risk from subjecting rating agencies to liability for either their statements or processes is that, in order to protect themselves, the agencies would adopt a “reasonable man” approach. For instance, if the agencies used government forecasts of house prices in their mortgage default models, then it is likely that any court would deem such assumptions “reasonable”; after all, these are the assumptions that regulators rely upon. If such assumptions are, however, grossly in error, as were the housing price forecasts used by various federal agencies, then the value of information created by the rating agencies would also be reduced, if not compromised. A reasonable-man approach would also encourage rating agencies to utilize “consensus forecasts” of key economic variables. Yet the consensus could be dangerously off. The economic forecasting profession does not exactly have a great record at predicting turning points, and it also missed the decline in house prices. A system of liability would likely destroy whatever additional information the rating agencies bring to the market, as the agencies would face tremendous pressure to simply mimic widely held beliefs, which themselves would already be priced into the market.

Another problem would be that rating agencies would most likely face litigation risk from those being downgraded, especially by governments. Witness the abuse Standard & Poor’s received from the SEC right after it downgraded the U.S. federal government. Do we truly believe that we would have more accurate ratings if a Greek court were able to decide if a downgrade of Greek government debt was accurate? I would also go as far to argue that ratings of sovereign debt should be considered politically protected speech (but then I’m also for protecting most, if not all, speech).

US Has Already Been Downgraded

Lost in all the concerns over how Moody’s and S&P will view any deal to raise the debt ceiling and whether such a deal addresses our country’s long term budget imbalances is the fact that at least three rating agencies have already downgraded U.S. government debt.  One of these agencies, Weiss Ratings, treats U.S. government debt as barely better than “junk” or speculative grade.

It would be easy to dismiss these agencies as irrelevant and attempting to simply grab attention, but at least one of these agencies, Egan-Jones, has a track record of correctly predicting problems at such companies as Enron, WorldCom, Global Crossing, Bear Stearns and Lehman Brothers that the major rating agencies missed until it was too late.  Egan-Jones also employs a business model of having investors pay for its services, rather than the debt issuer.

The simple truth is that the U.S. government has made more future promises than it will have the capacity to pay, under almost any circumstances.  The fact that the major rating agencies downplay these long term imbalances is further testament to their entrenched monopoly status.  But then when the government provides you with some regulatory protections, its only natural to assume the government will expect one to return the favor.

For more on the issue, check out Cato’s latest daily podcast.

Bush Deception Points

Former President George W. Bush’s book Decision Points is apparently selling quite well. The book includes a defense of the president’s fiscal record, and a table on page 447 compares Bush to prior presidents on spending and debt (you can see the table on Amazon’s search inside feature).

One problem with the table is that Bush claims credit for the low spending and debt of President Clinton’s last year, fiscal 2001. The first budget Bush crafted was for fiscal 2002. Here are the data reported by Bush, and data recalculated to better reflect the budgets that each president had some control over. Figures are averages over the fiscal year periods, measured as a share of GDP:

Decision Points Comparison: Clinton (1993-2000) 19.8%, Bush (2001-2008) 19.6%.
More Accurate Comparison: Clinton (1994-2001) 19.4%, Bush (2002-2009) 20.4%.

The book makes Bush look better on spending, but a more accurate comparison shows Clinton to have a better record.

It’s true that Bush was not responsible for some of fiscal 2009 spending, and if we take that year out Bush would have average spending of 19.8%. But consider the direction of spending under the two presidents–spending fell under Clinton from 21.4% to 18.2%, but it increased under Bush from 18.2% to 20.7% by fiscal 2008 (and even higher in fiscal 2009). (Spending data are here). 

The table in Decision Points also shows Bush looking better than Clinton on public debt as a share of GDP, averaged over each president’s tenure. But the debt data has the same time period problem as the spending data. More importantly, Clinton delivered surpluses his last four years in office, which handed Bush a budget with very low debt and low interest costs. The low interest costs helped mask the spending-increase policies of Bush for a number of years. But Bush’s profligacy eventually became clear to analysts and the public alike, and this autobiography cannot undo his record as the biggest spender since LBJ.

Final note: yes, I understand that Congress plays a large role in federal budgeting, but so do presidents. Presidents propose annual budgets, they twist arms and use the bully pulpit to increase or cut programs, they support legislation to expand or contract entitlement programs, and they sign or veto appropriation and authorization bills.

Unions and Government Debt

In a recent bulletin, I argued that public-sector unions impose various costs and burdens on state and local governments. Here is some more evidence.

The chart below shows a scatter plot of the union shares in state/local government workforces and state/local government debt levels as a share of state gross domestic product. Each blue dot is a U.S. state.

The variables are correlated – as the union share increases, a state tends to have a higher government debt load. The chart shows the fitted regression line in pink dots (R-square=0.27; F-stat=18; t-stat on the union share variable=4.2).

The correlation is likely caused by the fact that unionized government workers are powerful lobby groups that push for higher government-worker compensation and higher government spending in general.

(Thanks to Amy Mandler for data help and Andrew Biggs for suggestions. Andrew’s work on state debt is here).

Fannie, Freddie, Peter, and Barney

Last week, after Rep. Barney Frank (D-MA) said that holders of Fannie Mae and Freddie Mac’s debt shouldn’t be expected to be treated the same as holders of U.S. government debt, the U.S. Treasury took the “unusual” step of reiterating its commitment to back Fannie and Freddie’s debt.

If ever there was case against allowing a few hundred men and women to micromanage the economy, this is it.

Fannie and Freddie, which are under government control, are being used to help prop up the ailing housing market. If investors think there’s a chance Uncle Sam won’t back the mortgage giants’ debt, mortgage interest rates could rise and demand for housing dampen. Therefore, Frank’s comments caused a bit of a stir. However, with the government bailing out anything that walks or crawls, investors apparently weren’t too concerned with Frank’s comments as the spread between Treasury and Fannie bonds barely budged.

As I noted a couple weeks ago, the Treasury is in no hurry to add Fannie and Freddie’s debt and mortgage-backed securities to the budget ($1.6 trillion and $5 trillion respectively). Congress certainly isn’t interested in raising the debt ceiling to make room. And as Arnold Kling points out, putting Fannie and Freddie on the government’s books would actually force the government to do something about the doddering duo.

All of which points to what an unfunny joke budgeting is in Washington. Take a look at what current OMB director Peter Orszag had to say about the issue when he was head of the Congressional Budget Office:

Given the steps announced by the Treasury Department and the Federal Housing Finance Agency on September 7, it is CBO’s view that the operations of Fannie Mae and Freddie Mac should be directly incorporated into the federal budget. The GSEs’ revenue would be treated as federal revenue and their expenditures as federal outlays, with appropriate adjustments for the manner in which credit transactions (like a mortgage guarantee) are reflected in the federal budget.

Note that Orszag wrote that statement less than two years ago. And since then, the bond between the government and the mortgage giants has only gotten tighter.

The same people that say Fannie and Freddie shouldn’t be on the government’s books are often the same people who once dismissed concerns that the two companies were headed toward financial ruin. In 2002, Orszag co-authored a paper at Fannie’s behest that concluded that “the probability of default by the GSEs is extremely small.”

Another one of those persons, Congressman Frank, has his fingerprints all over the housing meltdown. In 2003, a defiant Frank stated that “These two entities – Fannie Mae and Freddie Mac – are not facing any kind of financial crisis.” Frank couldn’t have been more wrong. Yet there he remains perched on his House Committee on Financial Services chairman’s seat, his every utterance so important that they can move interest rates.

Debt Aggravates Spending Disease

USA Today’s Dennis Cauchon reports that ”state governments are rushing to borrow money to take advantage of cheap and plentiful credit at a time when tax collections are tumbling.” That will allow them to “avoid some painful spending cuts,” Cauchon notes, but it will sadly impose more pain on taxpayers down the road.

When politicians have the chance to act irresponsibly, they will act irresponsibly. Give them low interest rates and they go on a borrowing binge. The result is that they are in over their heads with massive piles of bond debt on top of the huge unfunded obligations they have built up for state pension and health care plans.

The chart shows that total state and local government debt soared 93 percent this decade. It jumped from $1.2 trillion in 2000 to $2.3 trillion by the second quarter of 2009, according to Federal Reserve data (Table D.3).

Government debt has soared during good times and bad. During recessions, politicians say that they need to borrow to avoid spending cuts. But during boomtimes, such as from 2003 to 2008, they say that borrowing makes sense because an expanding economy can handle a higher debt load. I’ve argued that there is little reason for allowing state and local government politicians to issue bond debt at all.

Unfortunately, the political urge to spend has resulted in the states shoving a massive pile of debt onto future taxpayers at the same time that they have built up huge unfunded obligations for worker retirement plans.

We’ve seen how uncontrolled debt issuance has encouraged spending sprees at the federal level. Sadly, it appears that the same debt-fueled spending disease has spread to the states and the cities.