On Friday, August 5, 2011 the Standard and Poor’s (S&P) – one of the leading credit rating agencies in the world – had published a research update[1] titled “United States of America Long-Term Rating Lowered To 'AA+' On Political Risks And Rising Debt Burden; Outlook Negative”. On Monday, Aug. 8, 2011, in New York, the Dow Jones industrial average closed down 634 points, or 5.5 percent, to 10,809. It was the biggest one-day point drop since December 2008. In this article I will try to explain the key concept behind the downgrade, namely “debt burden” and elaborate on the S & P decision to downgrade the U.S. rating.

The general concept of debt is very familiar to every adult person. Debt is what you owe someone after taking out a loan. For example, your credit card debt is a short-term debt, while a mortgage is a long-term debt. Just like individuals and companies, governments have budgets and they must borrow if they wish to spend more than their current income allows. Debt itself does not constitute any problem, and we all benefit from routine borrowing from our credit card company. However, debt becomes a problem when it grows large relative to the income of the debtor. For example, if Bill Gates has a debt of one million dollars, it is considered negligible for him because he earns more than that every single day, and has no problem repaying the debt. But if a high school teacher has a debt of one million dollars, she might declare bankruptcy and her credit rating will surely be very low. We say that the debt burden = debt/income of the high school teacher is much higher than the debt burden of Bill Gates.

The U.S. credit rating was lowered because of the debt burden, which is measured as the ratio of General Government Net Debt to GDP (Gross Domestic Product), where the latter is considered the nation’s income. For example, in 2010 the U.S. debt was 9.5 trillion dollars, while France had a debt of 1.9 trillion dollars. Which country had a bigger debt problem (burden)? It turns out that the answer is France[2], with debt/GDP = 74.6%, while the U.S. debt/GDP = 64.8%. The debt burden of France was therefore greater than the debt burden of the United States last year (2010).

Why then did S & P let France retain its AAA credit rating, while the U.S. was downgraded to AA+? The answer is given in the S & P title of the report: “Political Risks And Rising Debt Burden”. In a nutshell, the researchers at S & P predict (forecast) the future debt burden for the next 10 years and try to assess how governments deal with it. They conclude that under the current political climate, the debt burden is not adequately dealt with since “Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures.” (page 3 of the report).

The next figure illustrates three scenarios for the future of the U.S. debt burden, as described in the S & P report. All 3 scenarios predict a rise in debt burden in the next 10 years. The base case scenario (neither optimistic, nor pessimistic), predicts a rise of net debt burden to 74, 79, and 85 percent of GDP in the years 2011, 2015, and 2021 (black line).

(Click to Enlarge)

Even the best case scenario predicts a modest rise in debt burden to 78% of GDP by the end of 2021. The worst case scenario predicts a rise of the debt burden to 101% of GDP by the end of 2021. For details on the assumptions behind each forecast, see the full report. Thus, the decision to lower the U.S. credit rating is motivated by what is likely to happen in the future, not solely what already happened in the past. This seems a bit unfair as we are not used to seeing somebody convicted for the crimes he is “likely” to commit in the next 10 years. But economics must attempt to predict the future, since all our important decisions depend on expectations about what will happen in the future (investment in education, saving for retirement, career choice, purchase of a home, getting married, having children, just to mention a few).

How severe is the U.S. debt burden problem? To answer this question, let’s use the personal debt example to get a better understanding of the numbers in the above graph. Suppose Bob earns $100K per year, and takes a mortgage of $500K. Then his debt burden is 500/100 = 5 or 500% of the annual income. It is not unheard of that individuals take a mortgage (assume debt) which is 5-times their income, but the highest debt burden in the world in 2010 was Japan’s and it was only 200% of GDP. Yet the U.S. approaching 100% burden is considered as a negative. The reason is that when Bob takes a mortgage, he can repay the debt by selling his house, provided that the housing prices are more-or-less-stable. The discussed debt burden for the government is the General Government Net Debt, and it is net of all assets that the government can use to pay its debt. Thus, to compare a net government debt burden of 100% to Bob’s mortgage debt, we need to consider a scenario in which the value of his house dropped to $400K, and even if he sells the house, he still owes one year of income to the bank. Now we see that in this scenario Bob would be in trouble, which is why many people like him in the recent housing crisis defaulted on their mortgages.

Debt burden is expensive. In 2010 the Federal Government spent about $200 billion in interest payments on its debt, which is 50% more than what it had spent on education. Thus, regardless of whether we agree with S & P rating, objectively speaking, the U.S. debt burden is considered high.

How to solve the debt burden problem? Is it necessary to reduce the debt itself? The answer to the last question is NO. Recall that the debt burden is the ratio debt/GDP. In a growing economy, a country can keep the debt stable or even increase it, while still enjoying a decline in debt burden, provided that the GDP (denominator) grows fast enough. Any debt is a result of past deficits, i.e. the difference between government income and expenditures. Every year since 2001, the U.S. government experiences a deficit, which means that each year the government has been increasing its debt. Thus, in order to reduce the debt, or at least reduce its growth, the government must reduce its deficit = expenditure – receipts. Thus to reduce the deficit, the government needs to (i) reduce spending, (ii) increase receipts (mainly taxes) or (iii) a combination of (i) and (ii). This is where the problem lies, and this is the reason why S & P report mentions “Political Risks” 7 times in their report. The two major parties cannot agree on the measures of deficit reduction, i.e. on (i), (ii) or (iii). The exact political and economic arguments of the political spectrum are beyond the scope of this article.

Looking at the bright side. The downgrading of the U.S. credit ranking has a positive aspect. I see the report as saying to our government that the debt burden problem is serious and must be addressed. S & P also issued an “Outlook Negative” verdict, which means that if not enough steps are taken to reduce the debt burden in the next 2 years, then the U.S. credit rating can drop further. Ironically, the negative report might force the politicians to take the debt burden seriously after the 2012 elections. I expect much more agreement on the debt issue in the 2012 campaign, in which case the S & P report can be seen as a unifying factor.