Warren Buffett said Friday that Standard & Poor’s was wrong to downgrade the U.S. government and if it were up to him, he would give the United States a “quadruple-A” rating, even higher than the “AAA” that our country had before it was downgraded to “AA+.” Unfortunately, Mr. Buffett is forgetting that credit ratings reflect not only a borrower’s ability to pay, but also its willingness to do so.
There is a certain logic to Mr. Buffett’s position and it is shared by many others who view the credit of the United States the way they might view the credit of a large corporation. The capacity of the U.S. to pay its debts is enormous and in the corporate world it would be inconceivable that a company with so much debt-paying capacity would not, therefore, repay them on time as they come due. Failure to do so is, of course, called a “default” and it is the likelihood of a company (or country, city, state, etc.) NOT defaulting that is embodied in its credit rating. The lower the likelihood of default, the higher the credit rating. Triple-A credits (and, to be honest, double-A-plus credits too) have virtually zero likelihood of defaulting.
This may sound simple, but what complicates it, especially in the case of non-corporate entities (like the USA) is that “likelihood of default” contains two distinct but equally important elements: (1) the capacity, or ability, to pay one’s debts and (2) the willingness to do so. In the case of a corporation, willingness to pay is assumed to be virtually automatic, since it would be a highly irrational company that was capable of paying its debts but still chose not to do so, since that would invite bankruptcy and corporate dissolution. Few corporate managements would choose to kill the goose that was laying their golden eggs, so to speak, by letting their company go bust by failing to pay debts if they had the wherewithal to do so; and if they did, the shareholders would likely step in and replace them with more rational management.
Until recently, a version of this same logic applied to most sovereign debt, especially that of the United States. Since it is clear that the U.S. has the capacity to pay its debts – a huge economy, broad tax base and compliant citizenry (i.e. while we may grumble about it, Americans overwhelmingly pay the taxes levied upon them; not the case in many other countries) – the assumption has long been that the powers that be in Washington would take whatever steps were required to tap our national revenue base and/or cut expenses sufficiently to meet our expenditures. In other words, the assumption was that the willingness to pay our country’s debts was always there, along with the capacity.
Events of the past few months have shaken the belief that our nation’s willingness to pay matched its capacity to pay. The statements by various members of Congress that they would in some cases be willing to allow a “small default” or “selective default” in the payment of the government’s bills, or by some Republican presidential candidates that they would not support an increase in the debt ceiling under any circumstances, send a clear message that the assumed willingness to pay debt when due does not enjoy the universal bipartisan support that it traditionally did. Indeed, when one sees how the willingness to reach political compromise has now been made into a liability in some political circles and is already being used to disparage politicians who sought to arrive at consensus in order to prevent default, it is easy to understand how Standard & Poor’s could conclude that the nation’s willingness to pay its debts, quite separate from its capacity to do so, has been compromised.
Similarly at the local level, we have seen where attempts by states to tighten their fiscal belts by asking state employees to take cuts in medical and pension benefits viewed as relatively minimal by most private sector employees whose benefits are more modest have been met with resistance and even civil (and not so civil) disobedience. All of this – regardless of which side of the fence you are on politically – suggests that the nation’s political willingness to take the hard steps necessary to deal with our fiscal problems and avoid default – long term and short term – may be lacking.
Putting all this together suggests that our nation may indeed be suffering from a lack of political will to compromise and solve our fiscal problems, both at the grassroots level and in Washington, DC. This lack of will is what I believe led S&P to take the action it did, not any concern about the underlying capacity of the nation to pay its bills, once it makes up its collective mind to do so.
New York Times columnist Tom Friedman wrote many years ago that the way to win a game of “chicken” (where two cars drive straight at each other to see who will “blink” and swerve out of the way first) is to wave a steering wheel out the window (hopefully one you bought at a junk yard and NOT your real one), hoping the other car’s driver will think you have disconnected your steering wheel and have no control of your car. In other words, you convince the other driver you’re crazy and he better swerve, since you have no intention or ability to do so. Watching the debt ceiling debate of the past month, many observers, including the rating agencies, may have concluded that one or both of the opposing sides at times resembled the driver holding the steering wheel out the window. The rating downgrade reflects the reality that there may be fewer responsible “hands on the wheel” of the fiscal car in Washington and across the country than there used to be.
Disclosure: I am long MHP. Besides being a banker and journalist, the writer spent 15 years at Standard & Poor's and still has a position in its parent company McGraw-Hill.