Credit ratings, the U.S. government and you | Econ Matters

Amid all the discussion of the various plans to address the ceiling on the amount of United States Treasury debt — think of this as the credit card limit for the federal government — we see falling prices for a broad spectrum of assets. Both stock prices and Treasury securities saw their trading prices decline last week.

Although nettlesome, it is important to note that the debt ceiling is a legal restriction. The law dictates the maximum amount of debt that can be issued by the United States Treasury. At the time of this writing, a deal has been worked out that would raise the debt ceiling. This is absolutely the easiest part of the conflict.
The more troublesome concern was not resolved. As a share of gross domestic product, federal spending has been increasing for the past several years. This means the federal government has been commanding a larger fraction of the total resources produced within the United States. Some of this spending increase has been discretionary, and the rest has been entitlements. Meanwhile, tax revenues as a share of gross domestic product edged down during the contraction. This measure has been remarkably stable and averaged 20 percent for decades (more on this subject later).
Herein lies the problem: The planned path for future spending is greater than the planned path for future tax revenues. Not much work was done to address this imbalance.
By not addressing the imbalance, the United States has left itself open to changes to credit ratings. Credit agencies are notoriously slow in changing their ratings. This makes sense with private companies because the books are private information, but that is not the case with the United States accounting. Greater transparency means the ratings agencies can see the spending plans based on current law and project future revenues. As large deficits continue, ratings agencies update the risks that future default will occur. Eventually, a country cannot raise enough revenues to meet all of its obligations. A downgrade provides information to investors. Greater risk means higher interest rates.
Interest rates are fundamentally prices. They move around all the time to equate the demand for these instruments with the supply. Generically, the movement in interest rates is neither bad nor good. In this case, however, the cause of the interest rate movement matters. Rates are not increasing because of greater productivity or an outbreak of consumer spending that reduces worldwide savings. Here, the increase owes to change in risk of a sovereign nation. Every U.S. citizen bears this additional risk. It comes with being a citizen.
To make this more concrete, it is as if every U.S. citizen is rolling the dice, and he or she gets a payoff if the number four comes up. Instead of six faces on the die, a new one is introduced, and it has eight sides. The likelihood that you will see your payoff number has just decreased. On top of this, what you have to pay to play this game has not changed, and you are required by law to play. No one likes this outcome.
In my view, this is a spending problem. There will be talk of tax increases. Remember, the federal government has collected about 20 percent of gross domestic product for a long time. But years ago tax rates were 70 percent on Americans earning the highest incomes, and they have been as low as 33 percent. Despite the variability in tax rates, we see that revenues fluctuate only a little; in other words, federal taxes are almost invariably 20 percent of gross domestic product. The evidence suggests that there is nothing that changing the tax code can do to change this fraction. Thus, spending changes are the only means to address our future deficit path and its consequences. We will just have to wait a little longer to see how Washington will solve the problem. Until then, we will deal the riskier fallout.