Standard & Poor's chief economist discusses entitlement cuts and federal spending

Apr 20, 2011

A recent poll shows that while Americans want to decrease the federal deficit, they do not want to cut entitlement spending. Standard & Poor's Chief Economist David Wyss answered your questions about what this means and how Standard & Poor's recent warning to the government will play a role. Ask your question now!

Read Today's Article: Poll shows Americans oppose entitlement cuts to deal with debt problem

Related:Standard & Poor's financial storm warning

Hi - This is David Wyss, Chief Economist at Standard & Poor's, to comment on the US debt and how to fix it. Polls show that Americans all favor cutting the deficit - as long as it doesn't involve cutting spending or raising taxes. Unfortunately, the real world doesn't work that way.

Good afternoon, Dr. Wyss.  What would the impact of a tax increase (or more specifically, a return to Clinton-era tax rates) be on the US, both from the perspective of S&P's credit worthiness and on the U.S. economy as a whole?

The sunsetting of the Bush tax cuts is scheduled for 2013. There are some questions about details - including dividend and capital gains taxes, but on the major issue, higher taxes will raise more revenue but also slow the economy.  My feeling - and understand I speak for myself, not necessarily for S&P, is that we need to reduce the deficit more urgently than we need to spur growth, and tax hikes have to be part of any budget balancing process.

Why didn't S&P talk about Bush deficits when Bush was president? Aren't the Bush tax cuts for EVERYONE set to expire on January 1st, 2013? Won't that have a major effect on the deficit when they do expire if Congress does nothing?

We did talk about the Bush deficits and the introduction of both tax cuts and Medicare part D. However, back then no one was paying attention. We started in 2006 pointing out that the US budget was on an unsusatainable course and that either spending had to be cut or taxes increased to keep debt within realistic bounds. The difference now is that we are running out of time. In 2006, we had 8 years to fix the problem; now we have 2 or 3.  The deficit now is three times the last Bush deficit, but the tax cuts and spending increases in the last administration were also unaffordable. 

I'm confused as to all the noise relative to social security. It seems that with a couple of tweaks, the program will have little difficulties, particularly as the social security trust fund can serve as a giant financial buffer - or can it? The cynical side of me says that if the federal government actually has to redeem the IOU's owed to the social security trust fund, very substantial additional revenues will be required from other federal taxes and levies. From my jaded perspective, that would say that revenues from FICA (fifteen percent roughly including the employers' contribution) were used to keep the income tax low to minimize public unhappiness with the cost of the Iraq invasion and to make possible the Busch tax cuts.

Have FICA revenues (the most regressive tax we have) been "embezzled" to facilitate other political objectives? If so, I would assume the odds of them ever being used for social security benefits are low to non-existent. BillSecure

The problem with the trust fund is that the only thing in it is a giant IOU from the US Treasury. This may be important morally, but you can't spend it.  Social security can be fixed relatively easily with some further increase in the retirement age or with a reduction in price escalation, but it does need to be fixed. The last fix was in 1984, when President Reagan raised the social security tax rate and also raised the retirement age (now 66 and scheduled to go to 67).  Social security is the minor entitlement problem; the major one is Medicare.

The social security revenues were borrowed by the government. We have the moral promise from Congress that they will be paid back. Ignoring the oxymoron of political morals, that still requires either higher taxes or spending cuts.

Why did the S&P make this announcement immediately after President Obama announced his deficit reduction plan? This is highly suspicious to say the least. In my opinion, this clearly shows bias by the S&P board members. They do not want a tax increase for the wealthy. Americans can read between the lines on this one. I for one will be researching S&P board members and its practices very closely from here on out. America can no longer afford low tax rates for the top 1% of our nation. They have clearly squandered their tax cuts that have been in place for the last decade. It is just irresponsible to borrow from China to pay for these tax cuts.

It's funny that the other side is accusing us of playing politics by putting out the announcement to support the President's call for deficit cuts. As a firm, we take no stand on whether the deficit should be cut through lower spending or higher taxes. As an individual, I think it has to be a combination of the two. I think you are being self-contradictory in accusing us of supporting lower taxes through calling for deficit cuts. The opposite is closer to the truth.

Can we really not touch entitlement spending and still expect to reduce the deficit? Or is that impossible?

I don't see how. At this time, enititlement spending is over 40% of the budget, and rising fast. Nondefense discretionary spending is only 15% of the budget, and shrinking. The deficit is about 30% of the budget. Even is we eliminate all nondefense discretionary spending, the deficit would remain too high. By 2050, entitlement spending alone will cost more than the US tax system raises. That means we either have to make major cuts in entitlement spending or we have to have major increases in taxes.

Gradual improvement of the deficit can be readily achieved in four, not necessarily successive, steps:

1. Increase the debt ceiling and honoring all of our financial agreements, including to the American people who have paid into maintaining our economic system for their entire working lives.

2. Not extending the Bush-era tax cuts for anyone

3. Reigning excessive speculation on Wall Street, to include all excessive speculation but especially and immediately on oil futures

4. Passing into law a requirement that our budget be based on a balance between spending and revenues. The revenue need to be based on a simple and straightfoward system of progressive taxation that requires that all Americans and Corporations contribute in proportion to their actual income.

I would appreciate Dr. Wyss' opinion on this proposal.

I would agree with your points in general, but the problem of entitlement spending would remain. Yes, passing a law to balance the budget is a good idea. We did that back in the late 1990s. however, any law can be overturned or ignored by the next Congress. The political problem that entitlement spending is unaffordable in its current form would remain, and the political support for keeping Medicare and social security and not raising taxes would still be the political contradiction that would face future Congresses.

Treasuries bonds are nominal debt contracts denominated in US dollars. The Fed and Treasury, as a technical matter, do not have any constraint on their ability to issue said dollars. Treasury yields looked at over say, the last 30 years, are exceptionally low. The US, in its entire history, has never defaulted on its debt unless you count its delinking from gold in the 1930s. Given those facts, why would you suggest the US might default on its debt?

We do not expect the US to default on its debt. I think it is extremely unlikely that the US would do so as long as it is capable of issuing debt in its own currency. However, especially for an international bond holder the prospect of getting paid off in devalued currency as the Treasury just prints more is a significant issue. This is why we downgraded Japan from its AAA rating 20 years ago, despite the fact that they had the same advantages as the US. A downgrade to AA+, the next step, still says that the US will pay its debts. We just aren't sure how.

Dear Dr. Wyss, With respect, I think S&P (and a number of other forecasting firms -- it's not as if there was a single sinner here) messed up in the last decade. Why should we suddenly start believing forecasts again?

There is plenty of blame to go around. But we aren't talking forecasts here, we're talking accounting. Double-entry bookkeeping still works, and it is showing a US debt posuition which is rapidly becoming unsustainable.

Your announcement drew very different reactions in the stock and bond markets, with the former appearing scared and the latter showing almost no reaction at all. Do you have any idea on why they reacted in those different ways?

There are a couple of possibilities. One is that people in the bond market already knew this, and therefore the warning didn't affect them Anyone in the bond market who didn't understand the US was running an unsustainable deficit shouldn't be trading.  Maybe stock traders weren't paying as much attention. The other possibility is that the amrket sees the warning as increasing the likelihood that something will be done about the deficit. Thart would be good for the bond market, since it implies fewer Treasury bond issues. It might be bad for the stock market if it implies higher taxes or slower GDP growth, which would translate to weaker after-tax profits.

Why do you lump social security and Medicare in the same "entitlement" bucket? Don't they have vastly different outlooks? Isn't the true issue health care costs?

Medicare accounts for about 75% of the problem. Social security has a problem too, but it is fixable with relatively minor tweaks (such as further raising the retirement age). The inexorable rise in health care costs is much harder to deal with, and Medicare costs will rise much faster than social security spending. In other words - you're right; the prospects are very different andthey shouldn't be as closely lumped together as they are.

Who has said anything about not touching entitlement spending? The health care reform law includes significant cuts to Medicare. Many of the Republicans who are supporting Ryan's plan to privatize Medicare (a plan that keeps all of those cuts in place) campaigned against those cuts. So, near as I can tell, the only people who have said we don't need entitlement cuts are the Republicans who voted and campaigned against the ACA, and their current policy position includes massive cuts to Medicare. So, again, who exactly has said we don't need any cuts in entitlements?

Most public polls, among otehr things. The cuts to Medicare spending in the health care reform measure are unfortunately too little to help the problem very much, and Congress is trying to overturn even that. The Ryan proposal basically transfers the risk of rising health care costs to retirees, which I don't think is likely to work either financially or politically (although some move in that direction is probably a good idea as part of cost control).  Health care is 15% of GDP, and the government now pays over half of that. Government in the US now pays a higher percentage of GDP for health care than the British government, which manages to cover everyone in the country for that amount.

Certainly Medicare is a major financial problem. What I can't understand is all the emphasis on "musical insurance alternatives". This is such an indirect way of controlling medical costs it seems useless to me. Why hasn't there been at least some focus on the costs and quality of actual medical services, the cost of procedures, medicines, tests, etc. ? Final illness medical expenditures might be another area to address. Other western countries seem to have excellent medical services at forty to fifty percent of what our medical services cost. BillSecure

Definitely, but 15% of Americans work in the health care sector, and politicians don't want to tell them that there will be fewer jobs or lower wages and profits. We haven't yet come to terms with the issue of whether health care is a right or a market good like any other. Until we do, cost control is not going to work.

QE1&2 hasn't done much to stimulate the economy, unless you are really worried about the bank's balance sheet. When the Fed has to soak all the money back out of the system it will be equally as devestating to the fragile economy that has begun. I keep thinking however that as bad as Treasuries look right now, there isn't a lot of better options. I'm waiting on rates to go up and the real pain to start. We haven't seen anything yet. The american standard of living now is unsustainable, especially in this global economy that transfers tech and jobs looking for equilibrium.

I think you are contradicting yourself here. I agree QE2 didn't do much to the economy or to financial markets, but that also implies it won't do much when it is withdrawn. I do expect interest rates to rise after midyear. They should, since they are far below any "normal" rate. I think the private economy is strong enought o withstand that.

Serious deficit reduction will require spending cuts and additional revenue.  Since no one in Washington wants to raise taxes, why not impose a one time "deficit reduction fee" of $10 on everyone who pays federal income tax?  Another one-time fee could also be paid by businesses and corporations.   It would generate billions in revenue earmarked for deficit reduction without raising taxes.  This one-time additional revenue in combination with meaningful spending cuts could have a real impact on the deficit.

There are about 150 million tax returns filed. Such a tax would raise about $1.5 billion, or 0.1% of the budget deficit. Sorry, but we need a lot more money than that

Should the "nationally recognized statistical ratings organizations" be stripped of their legislative imprimatur and forced to compete in a free market? Didn't the legal requirements that certain entities hold AAA credit instruments fuel the degradation in standards that permeated the market pre-crisis?

There are very few entities that have to hold AAA securities. Dodd-Frank does effectively remove most of the legislative needs for a rating. We started as a purely private firm with no regulatory requirements for ratings. We are happy to go back to a competitive environment for ratings.

Dr. Wyss, Don't you inadvertantly tip your hand when answering the (granted, partisan) pointed question about the timing of S&P's announcement? When you answer "the other side," it seems to me that you make it very clear you are "on the other side" from someone else.

I was referring to "the other side" realtive to the person asking the question, not relative to me.

90% of the prime & alt-A MBS & CDO's that were rated as 'AAA' by S&P from 2005-2007 have either defaulted or are now rated 'CCC' or below. How could S&P rate mortgages the same as debt issued by a country that can make more of their own currency (with the Fed's agreement)? Bond market credit default swaps were much quicker in identifying credit problems on mortgages than S&P. Why should we now believe S&P rather than the bond market on US sovereign debt risk?

With all due respect, your numbers are wrong by an order of magnitude. Despite the panic, actual defaults on AAA mortgage-backed securities have been rare. We do publish that data, but I can't give you exact number off the top of my head. I will point out that when the Fed bought in these securities from AIG they were at about 15 cents on the dollar; that portfolio is now worth about 85 cents on the dollar.

Given that the ratings agencies gave tens of thousands of AAA credit ratings to the super senior tranches of junk mortgage CDO's, which subsequently plummeted in value, why should you guys still have any credibility?

If we don't have any credibility, why are you even bothering to ask the question? The fact is that outside of the mortgage arena, bonds and consumer debt instruments have performed pretty much as would be expected given their ratings and the economy.  I'm not arguing we got the mortgages right; although we wrote articles about the housing bubble starting back in 2005, we underestimated the impact on mortgage defaults, losses, and financial markets. That is a different topic than today's, however.

A bit of a sacred cow issue, but it heeds to be asked. What role does the Pentagon spending have in all of this, and wouldn't it significantly reduce the deficit by reducing it's budget?

That's how we balanced the budget back in the 1990s, as defense spending dropped after the cold war. Today, defense spending is about 20% of the budget. I think it needs to be examined along with everything else as part of balancing the budget. Again, even eliminating defense completely wouldn't be enough to balance the budget, so you can't do it just by cutting back on defense.

Thank you for participating in the forum. I am signing off now.

In This Chat
David Wyss
David A. Wyss is chief economist at Standard & Poor’s, based in New York. Dr. Wyss joined Data Resources, Inc. in 1979 as Chief European Economist in London, which was acquired by McGraw-Hill. He came back to the United States in 1983 as Chief Financial Economist for DRI/McGraw-Hill, and became chief economist for Standard & Poor’s in 1999. Before joining DRI, Dr. Wyss was Senior Staff Economist with the President’s Council of Economic Advisers, Senior Economist at the Federal Reserve Board, and Economic Advisor to the Bank of England. Dr. Wyss holds a B.S. from MIT and a Ph.D. in economics from Harvard. He was named one of the “100 Most Influential people In Finance” by Treasury and Risk magazine in 2009.
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