08 Aug 2011

HBS Faculty on Downgrading US Debt


When Standard and Poor's Rating Services lowered its long-term sovereign credit rating on the United States from AAA to AA+ on August 5, it was a shot heard 'round the world. Stock markets plummeted, investors covered their eyes, consumers' confidence and pocketbooks took another beating, and the blame game engulfed politicians and S&P itself. In the midst of all this angst, four Harvard Business School faculty members offer their views on what went wrong and what needs to be done to right the US ship of state.

Bo Becker, Assistant Professor of Business Administration

Much anger and criticism have followed Standard & Poor's decision to downgrade America's credit rating. However, the real story is about how unsustainable the massive US government deficits are, and how difficult they will be to close.

The deficits were largely incurred to stimulate the economy in the wake of the financial crisis, but they may be hard to get rid of. The Washington political system struggles to deal with this gigantic fiscal challenge, and--no surprise--large tax increases and large expenditure reductions are not high on politicians' wish lists. Those facing tough re-election campaigns are hesitant to vote for such proposals. Add to this the ideological divisions about whether to emphasize taxes or spending when closing the budget gap, and we have a difficult and volatile fiscal outlook for this country.

Given these problems, S&P's call can be questioned, but only on the margin. No one disagrees with the fact that the United States faces a severe fiscal challenge. Anger with S&P, therefore, is much like anger directed toward a referee who has made a difficult call--frustration with the result expressed as criticism of the messenger.

It's been a tough couple of years for S&P and its rivals, Fitch, and Moody's. Recently, these agencies have faced considerable criticism over their sovereign ratings--in Europe, for example, over their downgrades of Greece and several other economies. They are accused of being too negative and downgrading countries unfairly. This is ironic, given that in 2008 and 2009, they were given a hard time for issuing excessively positive ratings of structured products based on home mortgages that turned sour. Whatever they do, someone gets mad.

That said, the mistakes on structured products were a historic blunder by the raters, and they likely contributed to the great recession by inflating the housing and credit bubbles in 2005-2007. But when it comes to sovereign risk, they are getting it right. Across the world, there are many serious threats to the long-term ability to repay national obligations like government bonds, and the United States is no exception. So rather than focus on whether S&P called the downgrade a little too soon, let's focus more on figuring out how to get the US fiscal house in order.

Robert Steven Kaplan, Professor of Management Practice

It would be tempting to join those who are criticizing Standard and Poor's. Unfortunately, it won't do us much good. The damage has been done. This downgrade was probably bound to happen once Speaker Boehner and President Obama failed to agree on a "grand bargain" of $4 trillion in deleveraging. The question now is the same as several weeks ago--how can we deleverage our government and still foster growth in the economy?

This downgrade is unlikely to have a material negative impact on Treasury rates, at least in the short run. The real danger is to the psychology of businesses and consumers, who are likely to be far less willing to spend, invest, and take risks on hiring. The US economy was already slowing, and this downgrade is likely to reinforce that trend. Unfortunately, slower growth makes deleveraging dramatically more difficult. Reducing debt results in deleveraging only if growth continues at a reasonably healthy level.

This, I believe, is why we saw the stock market sell off so dramatically on Monday. Investors fear a global slowdown in growth and a resulting negative impact on corporate profits. We won't know for several months the extent of the damage. GNP, employment data, and third-quarter corporate earnings will tell us more as we move into the fall. In the meantime, chances are we can expect a significant amount of market volatility.

So what do we do now? For starters, I believe that the federal government must focus on entitlement reform, new revenues, and some new spending intended to foster growth. This new spending may involve continuation of the payroll tax holiday as well as improvements in this country's infrastructure.

Politicians' pledges to resist restructuring entitlements or to rule out raising revenues are the antithesis of what is needed. Since this is such an enormously complicated challenge, lawmakers need to be open to asking the tough questions, engaging in real debate, searching for solutions, and making compromises. Pledges to rule in or rule out various policy options are likely to preclude sensible solutions.

This is an historic leadership moment. Can our leaders work together, face reality, engage in real debate and help solve our nation's problems? As citizens (and voters), I believe we must insist on it.

William A. Sahlman, Dimitri V. D'Arbeloff - MBA Class of 1955 Professor of Business Administration

I don't know how most Americans feel these days, but I haven't felt so frustrated since Richard Nixon left office in the throes of the Watergate scandal in 1974. Our so-called political leaders have just completed a grand game of chicken, and the United States is the loser.

I won't dwell on the inanity of the negotiations or final resolution about spending, revenues, and debt limits. Suffice it to say that cutting a little over $2 trillion from the projected ten-year deficit is akin to losing seven pounds off a starting weight of 350. We will still have accumulated deficits over that time frame of $7 trillion, and we still confront total debt and vested liabilities of perhaps $90 trillion.

One side argues that we can't raise revenues, while the other asserts we can't cut entitlements. Both sides are wrong. Entitlement costs, especially healthcare, will eat us alive. Without real reform of affordable health delivery, not just reform of access to health insurance, the US economy is doomed. More generally, at all levels, government has given away the future to buy votes in the present—a truly bipartisan effort over decades. On the revenue side, we will need to increase taxes, broaden the tax base, and reform the tax code or we are also doomed.

Because the negotiated settlement of the debt crisis was so lame, Standard & Poor's has downgraded the country. Instead of asking whether we are in greater danger of long-term financial difficulties, everyone is blaming the bearer of bad news, pointing out that they weren't exactly prescient in the recent financial crisis. That is true but irrelevant. You don't need a crystal ball to see that we have an unsustainable business model and no political process for change.

What we need is simple—growth. We need the economy to expand. We need people to feel that they can get a job, that their children will be better off, that tomorrow will be a better day. Where does growth come from? The answer is equally simple. Business, especially new business, creates jobs and prosperity.

We need to stop arguing about how to slice a shrinking pie and start working to grow the pie. We need lots of investment in research and development. We need a better educated and trained workforce. We need talented immigrants to work their magic in the economy. We need to use existing government and private dollars to fix infrastructure and create opportunities. We need more venture capital and more entrepreneurs. We need more competent CEOs of major companies who will invest wisely to create new valued products and services.

Private action can overcome partisan haggling and incompetence. America is a great country, because it has citizens who constantly search for new ways to improve the world. We have willing investors. We view crises as opportunities. We, the non-politicians, need to accept responsibility for fixing the country and get on with it.

Matthew C. Weinzierl, Assistant Professor of Business Administration

A common take on the S&P downgrade is that it is a wake-up call, forcing us to sit up and face the dire condition of the US government's finances. In fact, it's time to press snooze.

First, the fiscal stress on the United States is not imminent. Borrowing costs for the government are at historic lows. Bond markets, which not only reflect the opinions of investors with money and careers at stake but which, more to the point, are S&P's customers, appear to have ignored the agency's opinion entirely. Revealingly, S&P simultaneously "affirmed the 'A-1+' short-term Rating" for the United States, suggesting that the agency itself sees no risk in the near term.

Second, acting as if there is an imminent fiscal crisis would risk a severe slowdown in the economy. With high unemployment, anemic growth, and faltering confidence, the US economy is not in a position to absorb fiscal austerity. The consequences of a second downturn could prove disastrous for millions of American families and businesses. Whether a new fiscal stimulus is merited or even possible is up for debate, but a fiscal retrenchment in the near term is likely to make things worse.

Third, alarms about the long-term fiscal challenges facing the United States have been sounding for decades, and we know what the options are. In 1996, the director of the Congressional Budget Office testified: "Financing the entire expected growth in spending on these entitlements through borrowing is not a long-term option because it would risk substantial damage to the economy." Fifteen years later, the story is the same. The threat is real, the costs will be large, and we must act. But what we must do is well understood: Reform entitlements and the tax code to spend less, raise more, or both.

Fixing the long-term fiscal problem will require political courage. S&P may have meant their downgrade as an attempt to awaken that political will, but by issuing it during the heated debates over the debt ceiling and short-term policy, S&P risks prompting fiscal austerity over the wrong time horizon.


Jim Aisner

About Harvard Business School

Founded in 1908 as part of Harvard University, Harvard Business School is located on a 40-acre campus in Boston. Its faculty of more than 250 offers full-time programs leading to the MBA and PhD degrees, as well as more than 175 Executive Education programs, and Harvard Business School Online, the School’s digital learning platform. For more than a century, faculty have drawn on their research, their experience in working with organizations worldwide, and their passion for teaching, to educate leaders who make a difference in the world. The School and its curriculum attract the boldest thinkers and the most collaborative learners who will go on to shape the practice of business and entrepreneurship around the globe.