Should the US Government’s Sovereign Credit Rating be Downgraded to Junk?
(Where are the Credit Rating Agencies?)

by Eric Englund
by Eric Englund

Would you loan money to an entity that can legally print as much money as it desires? When you "purchase" a U.S Treasury bill, note, or bond, you are loaning money to the federal government – which possesses that ever-menacing printing press. Of course, the federal government is duty-bound to repay you, the lender, as prescribed by the debt obligation. Few people are willing to consider the possibility that the U.S. government would default on its debt obligations. Nevertheless, when examined objectively, one could make the case that Uncle Sam’s sovereign credit rating should be downgraded – perhaps even to "junk." So where are the credit rating agencies? Are they going to miss this one just like Enron?

Today, there is a widely-held perception that the U.S. government is the safest credit risk on the planet – heck, mathematical economists even deem the yield on a U.S. Treasury bill to be the "risk-free rate of return." If the aforesaid perception met reality, then the U.S. government would have, among many things, a sound monetary system (look out for that printing press), a laissez-faire approach to business, excellent control over its budget, honest financial reporting, along with top-flight internal accounting and control systems. If this doesn’t sound like the U.S. government you know, then it makes sense to question the conventional wisdom that Uncle Sam is the safest credit risk on the face of the Earth.

Both Moody’s Investors and Standard and Poor’s have granted the U.S. the highest sovereign credit rating possible (Aaa and AAA respectively). Most other countries are less fortunate and have lower credit ratings – which can affect such a country’s interest rates and access to the credit markets. The lower the credit rating, it is believed, the higher the chances are for a country to default on its sovereign debt obligations. Be aware S&P downgraded Japan’s sovereign credit rating to AA– on April 15, 2002 (more about this later). No one wants to lend money to a party that is likely to renege on its duty to repay with interest.

So what comprises a sovereign credit rating system? In the Federal Reserve Bank of New York’s October 1996 issue of its FRBNY Economic Policy Review, Richard Cantor and Frank Packer sifted out eight key variables that S&P and Moody’s use to determine a country’s sovereign credit rating. In addition to studying these eight important rating variables, Messrs. Cantor and Packer conveyed an incredibly important aspect of such ratings:

Sovereign ratings are important not only because some of the largest issuers in the international capital markets are national governments, but also because these assessments affect the ratings assigned to borrowers of the same nationality. For example, agencies seldom, if ever, assign a credit rating to a local municipality, provincial government, or private company that is higher than that of the issuer’s home country. (emphasis added)

This presents quite a conundrum for the rating agencies. In other words, is the United States becoming a banana-republic borrower with top-flight companies domiciled on its soil? (I’m referring to companies whose balance sheets haven’t been raped and pillaged by Ivy League MBAs.) For example, if the U.S. government had its rating lowered to a "junk" grade, such as BB+, would Berkshire Hathaway lose its AAA rating? The ramifications for downgrading Uncle Sam would be enormous. Thus, one must wonder if there is the courage necessary, among the major rating agencies, to properly assess the U.S. government’s credit worthiness.

What follows are descriptions of the eight key sovereign rating variables reflecting verbiage exactly as provided by Messrs. Cantor and Packer (variables 1 though 8). Directly, after each variable, I provide analysis as to how the U.S. government measures up in light of the specific variable at hand. Please note that my analysis includes readily available research, commentary, and other information. I liberally use quotes from the likes of James Grant, Bill Gross, Hans-Hermann Hoppe, Doug Noland, Kurt Richebacher, Murray Rothbard, Hans Sennholz, and others – which demonstrates that much credible information is available to support a case for downgrading Uncle Sam’s sovereign credit rating. Consequently, when tallying how poorly the federal government measures up to each variable, one must conclude that the U.S. government’s sovereign credit rating should be revised dramatically downward – unquestionably to a level lower than Japan’s.

Variable #1 – per capita income: The greater the potential tax-base of the borrowing country, the greater the ability of a government to repay debt. This variable can also serve as a proxy for the level of political stability and other important factors.

Analysis: Dr. Kurt Richebacher and Tony Allison make the grim points that personal incomes are not growing and that Americans, thanks to easy credit, are living well beyond their means. Not only does this bode ill for Uncle Sam’s tax base, a heavily indebted populace is not one that provides a foundation for social and political stability.

The following commentary came from Dr. Kurt Richebacher as found in the January 4, 2005 edition of The Daily Reckoning:

A "self-sustaining" U.S. economic recovery urgently needs accelerating employment and income growth. Just the opposite is happening. During the six months up to last November, real disposable personal income grew just 1%, or 2% annualized. This is down from 3% in the first half of 2004 and 4.8% in the second half of 2003. Taxes and higher inflation rates are taking their toll. Debt-financed spending went to new records. During the third quarter, private households increased their spending by $139.4 billion, while their earnings increased only $81.6 billion.

What follows is an excerpt from Tony Allison’s December 17, 2004 "Market Wrap Up" as found on Financial Sense Online:

In recent years, consumer incomes have not kept up with expenditures. This is clearly shown in the personal savings rate that has plunged to near zero. The recurring charges at the grocery store, dentist, gas station etc. will continue to add up. As interest rates rise, these household expenses will become painfully high if not paid off. Imagine how balances for mortgage and income tax payments will grow over time. This is the "magic of compounding" in reverse. "Survival debt" grows into financial suicide when credit limits are breeched.

On the whole, America’s taxpayers are in poor financial shape – they are emulating Uncle Sam’s reckless borrowing habits. For instance, the average American household has $8,000 in credit card debt while total consumer debt is nearly $2 trillion. Additionally, total household mortgage debt is approaching $7.8 trillion. Thanks to the Federal Reserve, there is a debt bubble in the United States. When combining stagnant personal income growth with aggressive personal debt growth, America’s tax base is built upon sand. It stands to reason that a country’s sovereign credit rating will eventually reflect the financial health of its citizens. This being the case, a downgrade of the United States’ sovereign credit rating seems inevitable.

Variable #2 – inflation: A high rate of inflation points to structural problems in the government’s finances. When a government appears unable or unwilling to pay for current budgetary expenses through taxes or debt issuance, it must resort to inflationary money finance. Public dissatisfaction with inflation may in turn lead to political instability.

Analysis: Alan Greenspan is pulling a mass-psychological con job. He continues to state that inflation is "quiescent" – although he has been a bit more hawkish of late. Apparently, the maestro doesn’t go grocery shopping or to the gas station or house hunting. Americans are living in a state of cognitive dissonance. We know that prices are rising, but so many believe that Mr. Greenspan has everything under control. Not surprisingly, Doug Noland, of The Prudent Bear, does not share the maestro’s view of quiescent inflation. Here is what he wrote in his December 31, 2004 Credit Bubble Bulletin:

The U.S. economy is in the midst of a distorted boom, with an increasingly ingrained inflationary bias. Asset bubbles are heavily influencing spending and investing patterns, hence the underlying structure of the economy. The nature of the U.S. bubble economy – where gross financial excess is required to fuel minimally acceptable employment gains – will be an issue for 2005. Current market rates and liquidity conditions appear poised to initially foster stronger-than-expected demand domestically and globally, although the unstable and unbalanced nature of the current global expansion will continue to provide fodder for those arguing for an imminent slowdown. I expect the Chinese and Asian inflationary booms to become increasingly problematic. Energy and commodities will remain in tight supply, with prices extraordinarily volatile but with a continued upward bias. The current minority Fed view that inflation and marketplace speculation pose increasing risks has potential to become consensus. And I can certainly envisage a scenario of increasingly anxious central bankers eyeing inflationary pressures and unstable markets across the globe.

Let’s not lose sight of the fact that inflation itself is an assault against private property (i.e. money) and should be viewed accordingly by the bond market and credit rating agencies.

Variable #3 – GDP growth: A relatively high rate of economic growth suggests that a country’s existing debt burden will become easier to service over time.

Analysis: As alluded to above, the U.S. government is lying about rising prices. This also serves to distort the United States’ gross domestic product (GDP) growth figures. Bill Gross, the highly respected bond fund manager at PIMCO, penned the following in the October 2004 issue of Investment Outlook titled "Haute Con Job:"

No I cannot sit quietly on this one, nor as I’ve mentioned, have other notables in the past few years. The CPI as calculated may not be a conspiracy but it’s definitely a con job foisted on an unwitting public by government officials who choose to look the other way or who convince themselves that they are fostering some logical adjustment in a New Age Economy dependent on the markets and not the marketplace for its survival. If the CPI is so low and therefore real wages in the black, tell me why U.S. consumers are resorting to hundreds of billions in home equity takeouts to keep consumption above the line. If real GDP growth is so high, tell me why this economy hasn’t created any jobs over the past four years. High productivity? Nonsense, in part – statistical, hedonically created nonsense. My sense is that the CPI is really 1% higher than official figures and that real GDP is 1% less. You are witnessing a "haute con job" and one day those gorgeous statistics just like those gorgeous models, will lose their makeup, add a few pounds and wind up resembling a middle-aged Mom in a cotton skirt with better things to do than to chase the latest fad or ephemeral fashion. (emphasis added)

Here, we have spectacular evidence of moral hazard. The very entity that owns the printing press is "measuring" the depreciation of its monetary unit while also measuring economic growth. The rating agencies must come to understand that the federal government is putting out works of fiction with respect to the CPI and to GDP growth.

Variable #4 – fiscal balance: A large federal deficit absorbs private domestic savings and suggests that a government lacks the ability or will to tax its citizenry to cover current expenses or to service its debt.

Analysis: The U.S. government’s debt increased by $595.8 billion during its fiscal-year 2004. Consequently, at fiscal year-end 9/30/04, the national debt stood at $7,379,052,696,330. As of January 20, 2005, the national debt totaled to $7,613,215,612,328.

If the sheer magnitude of America’s national debt doesn’t cause alarm, then reading over the U.S. government’s September 30, 2004 financial report should evoke terror. Please note the federal government does not report its financial condition according to generally accepted accounting principles (GAAP) – which serves to understate the magnitude of its liabilities. Here is Uncle Sam’s balance sheet as presented in the September 30, 2004 financial report:

The preceding September 30, 2004 balance sheet illustrates that the U.S. government has a negative net worth of over $7.7 trillion. Keep in mind this balance sheet does not reflect intragovernmental debt holdings (such as those held by the Social Security "trust" fund) nor does this balance sheet include accrued liabilities such as the net present value of pension, Social Security, and other obligations. Hence, this balance sheet grossly understates the enormity of the U.S. government’s deficit net worth position.

Page 4 of the U.S. government’s 9/30/04 financial report contains a section titled Liabilities and Additional Responsibilities. This is where the staggering scope of Uncle Sam’s liabilities is brought to light. Here is an excerpt:

The 2004 balance sheet shows assets of $1,397 billion and liabilities of $9,107 billion, for a negative net position of $7,710 billion. In addition, the Government’s responsibilities to make future payments for social insurance and certain other programs are not shown as liabilities according to Federal accounting standards; however, they are measured in other contexts. These programmatic commitments remain Federal responsibilities and as currently structured will have a significant claim on budgetary resources in the future.

…the net present value for all of the responsibilities (for current participants over a 75-year period) is $45,892 billion, including Medicare and Social Security payments, pensions and benefits for Federal employees and veterans, and other financial responsibilities. The reader needs to understand these responsibilities to get a more complete understanding of the Government’s finances.

Yes, you read that correctly. The net present value of the federal government’s "welfare" obligations is nearly $46 trillion. Add in the liabilities shown on the balance sheet above, and Uncle Sam’s liabilities exceed $50 trillion. With a government that took in a little over $1.9 trillion in revenues in 2004 and has seen its national debt increase every year since 1957, there is absolutely no way the federal government can continue to service its debt and fund its welfare obligations – short of resorting to inflating away these liabilities. Other options include outright repudiation of the national debt (i.e. a default) and canceling all welfare programs. How a country, with this horrible of a financial condition, merits a AAA sovereign credit rating is beyond me.

Variable #5 – external balance. A large current account deficit indicates that the public and private sectors together rely heavily on funds from abroad. Current account deficits that persist result in growth in foreign indebtedness, which may become unsustainable over time.

Analysis: Regarding the United States’ current account deficit, it is rapidly approaching the point of unsustainability. Tony Allison drives the point home as follows:

Perhaps the most daunting debt of all is that owed to foreign sources, our current account deficit. This is the evil twin to our lack of domestic saving. We must borrow savings from the rest of the world to sustain our economy. It is estimated that the U.S. is currently sucking in 80% of the world’s savings. Approximately 50% of Treasury debt is now in foreign hands. The current account deficit is projected to exceed $600 billion for 2004 and continue to increase in future years. At 6% of GNP, the U.S. current account deficit has reached a level that has precipitated currency crises in numerous developing countries.

Is it any wonder that the U.S. dollar has become such a weak kitten in the currency market? The day will come when we can no longer count on the kindness of strangers. Are rating agencies taking note of this?

Variable #6 – external debt. A higher debt burden should correspond to a higher risk of default. The weight of the burden increases as a country’s foreign currency debt rises relative to its foreign currency earnings (exports).

Analysis: Speaking of depending upon the kindness of strangers, Uncle Sam’s overall debt to foreigners (i.e. governments, etc.) has grown to distressing proportions. As Doug Noland conveyed in his December 31, 2004 Credit Bubble Bulletin: "Fed Foreign ‘Custody’ Holdings of Treasury, Agency debt gained $5.7 billion to $1.336 trillion for the week ended December 29. Year-to-date, Custody Holdings are up $269.0 billion, or 25.2% annualized." (emphasis in original)

In the context of a gold standard, James Grant made the following observation, about external debt, in a recent Forbes article:

The hallmark of the classical gold standard was the prompt adjustment of international payments imbalances. The hallmark of the pure paper standard is the indefinite postponement of international payments imbalances. Under the gold standard, a deficit country, if it persisted in its deficit, would eventually run out of gold. Under the pure paper standard, a deficit country, if it's the U.S., can keep right on printing money.

That is, it can keep on printing until its creditors cry: "Uncle!" The New York Fed estimates that, at year-end 2003, foreign central banks held $2.1 trillion in dollar-denominated securities, "equivalent to more than half of marketable Treasury debt outstanding."

Is this massive external-debt burden high enough to warrant the interest of rating agencies? If not, then perhaps they should read a topical Forbes article titled A Word from a Dollar Bear: Warren Buffett’s vote of no confidence in U.S. fiscal policies is up to $20 billion. When Warren Buffett speaks, perhaps the rating agencies should listen.

Variable #7 – economic development. Although level of development is already measured by our per capita income variable, the rating agencies appear to factor a threshold effect into the relationship between economic development and risk. That is, once countries reach a certain income or level of development, they may be less likely to default. We proxy for this minimum income or development level with a simple indicator variable noting whether or not a country is classified as industrialized by the International Monetary Fund.

Analysis: One must not confuse a country’s past glory with its future prospects. The United States has devolved from a republic to a social democracy. I would argue that the U.S. is experiencing economic "undevelopment" directly related to the decivilization process occurring in America today. In Hans-Hermann Hoppe’s fabulous book Democracy: The God That Failed, Dr. Hoppe describes what happens to a populace living under nanny-statism. He describes how the decivilizing nature of social democracy

…has led to permanently rising taxes, debts, and public employment. It has led to the destruction of the gold standard, unparalleled paper-money inflation, and increased protectionism and migration controls. Even the most fundamental private law provisions have been perverted by an unabating flood of legislation and regulation. Simultaneously, as regards civil society, the institutions of marriage and family have been increasingly weakened, the number of children has declined, and the rates of divorce, illegitimacy, single parenthood, singledom, and abortion have increased…In comparison to the nineteenth century, the cognitive prowess of the political and intellectual elites and the quality of public education have declined. And the rates of crime, structural unemployment, welfare dependency, parasitism, negligence, recklessness, incivility, pyschopathy, and hedonism have increased.

Initially, one may think that Dr. Hoppe’s words are much too harsh. Using, as proxies, the staggering amount of debt and welfare obligations being left for future American generations to tackle (as described in the analysis of "variable #4" above), I would argue that he is right on the money. In fact, I would add that this intergenerational wealth transfer is utterly despicable and immoral. The prior generations who supported income taxation, the founding of the Federal Reserve, the New Deal, the Great Society, etc. were morally and intellectually bankrupt and bear direct responsibility for the social decay we see all around us. A country experiencing a decivilization process, like the U.S., is not one that will move forward with economic development.

Is it any wonder why American manufacturers are building factories overseas? It isn’t just a matter of seeking less expensive labor. It is a matter of seeking better educated and harder working laborers than are available in the United States. Quite frankly, America’s public schools are "cranking out" high self-esteem, low skilled graduates who expect large salaries and small workloads. Social-democratic "values" are engrained in public schools at the expense of teaching students reading, writing, math, and basic science. Accordingly, public schools are at the heart of the problem of decivilization and economic undevelopment. American manufacturers know this and are voting with their feet and their wallets.

Hans-Hermann Hoppe does not stand alone in describing the ugliness of social democracy and its inherent narcissism, recklessness, and hedonism. Dr. Hans Sennholz aptly describes the social implications of a heavily indebted social-democratic society:

Our debt generation is a sad generation misguided by false notions and doctrines, and preoccupied with its own needs and wants. When economic conditions begin to deteriorate it may grow ever more egocentric and wretched, which tends to aggravate the social tension and strife. Clinging tenaciously to its transfer claims and rights, the unhappy society thus may deteriorate into a militant assembly of diverse pressure groups feuding and fighting each other.

Perhaps Standard and Poor’s and Moody’s haven’t looked closely at the terrible destruction social democracy has wrought on American society. The U.S. is going through a decivilization process and, therefore, economic undevelopment. As mentioned above, this is a factor as to why jobs are moving overseas. This, undoubtedly, should be factored in to Uncle Sam’s sovereign credit rating.

Variable #8 – default history. Other things being equal, a country that has defaulted on debt in the recent past is widely perceived as a high credit risk. Both theoretical considerations of the role of reputation in sovereign debt…and related empirical evidence indicate that defaulting sovereigns suffer a severe decline in their standing with creditors...We factor in credit reputation by using an indicator variable that notes whether or not a country has defaulted on its international bank debt since 1970.

Analysis: Over the years a mystique has emerged, regarding Uncle Sam, in which "he" believes in the sanctity of debt repayment – which of course means that default is never an option. Economics and finance professors perpetuate this myth and ignore history. In reality, the U.S. government has committed more serious transgressions than just defaulting on international bank debt. It has committed defaults that rating agency analysts should find appalling – this entails looking past mythology and seeking the truth.

Thankfully, the courageous and brilliant economist, Murray N. Rothbard, had the intellectual fortitude to tell the truth regardless of establishment thinking and conventional wisdom. In his most excellent book Making Economic Sense, Dr. Rothbard points out something that the rating agencies mysteriously ignore. Not only has Uncle Sam defaulted on its financial obligations (after the aforementioned critical date of 1970), it defaulted on an entire monetary system – remember Bretton Woods? Here is what Murray Rothbard had to say:

For two decades, the system seemed to work well, as the U.S. issued more and more dollars, and they were then used by foreign central banks as a base for their own inflation. In short, for years the U.S. was able to "export inflation" to foreign countries without suffering the ravages itself. Eventually, however, the ever-more inflated dollar became depreciated on the gold market, and the lure of high priced gold they could obtain from the U.S. at the bargain $35 per ounce led European central banks to cash in dollars for gold. The house of cards collapsed when President Nixon, in an ignominious declaration of bankruptcy, slammed shut the gold window and went off the last remnants of the gold standard in August 1971. (emphasis added)

Indeed, Dr. Rothbard was correct that this was a national declaration of bankruptcy. However, since gold was involved, perhaps this was a forgivable event. After all, many other countries were waging a war against gold (that barbarous relic) in pursuit of establishing pure fiat currency regimes. Nevertheless, this was a most spectacular default thus destroying the conventional wisdom that the United States will always honor its obligations – debt or otherwise.

But what about defaulting on Treasury bonds in the 20^th century? Has this ever happened in the U.S.? As a matter of fact, it has – refer to the U.S. Supreme Court case Perry v. United States, 294 U.S. 330 (1935). Per this case, John M. Perry "purchased" a $10,000 "Fourth Liberty Loan 4¼% Gold Bond of 1933–1938." When Mr. Perry sought repayment, the federal government refused to pay the loan back, in gold coin, and forced Mr. Perry to accept $10,000 of legal tender currency instead. Briefly here are some details from the case:

Plaintiff brought suit as the owner of an obligation of the United States for $10,000, known as 'Fourth Liberty Loan 4 1/4% Gold Bond of 1933– 1938.' This bond was issued pursuant to the Act of September 24, 1917, 1 et seq. (40 Stat. 288), as amended, and Treasury Department circular No. 121 dated September 28, 1918. The bond...provided: The principal and interest hereof are payable in United States gold coin of the present standard of value.

When FDR, via his 1933 Executive Order, declared it illegal to own circulating gold coins, gold bullion, and gold certificates, the federal government forced itself into the position of defaulting on paying the abovementioned Liberty bondholders in the prescribed gold coin. Hence, subsequent to FDR’s executive order, all holders of such bonds were forced to accept legal tender currency instead of "gold coin of the present standard of value." The act of confiscating gold itself was a violation of private property rights and was illegal – regardless of what government apologists say. In turn, by not paying bondholders in gold coin, the U.S. government has technically defaulted on past Treasury bond obligations. As expected, the U.S. Supreme Court ruled against Mr. Perry and in favor of Uncle Sam. This does not change the chilling truth that, in the past, the U.S. government has exercised arbitrary power to change the rules of the bond market (i.e. the means of repayment) by trampling private property rights. A default is a default.

Having gone through all eight variables, it should be obvious that both Moody’s and Standard & Poor’s have grossly overrated America’s sovereign debt – it doesn’t merit the top grade of AAA. In variables such as default history, inflation, external balance, external debt, and economic development, the U.S. should rate significantly lower than does Japan – and should rate worse in many variables as compared to a developing country such as Botswana. Look at the table below and decide for yourself. (Source – The Japan Times: Should Japan be rated below Botswana?)

Where would you rate the United States’ sovereign debt? If you refer to the embedded table, you will see S&P’s and Moody’s various investment grades. If you believe Uncle Sam is a non-investment grade risk, then you have rated U.S. Treasury debt as "junk."

Should the major rating agencies sound the alarm with respect to the U.S. government’s precariously debt-bloated financial condition – among other problems? I certainly hope so. As Raymond W. McDaniel, president of Moody’s Investors Service, has stated: "In Moody's view, the main and proper role of credit ratings is to enhance transparency and efficiency in debt capital markets by reducing the information asymmetry between borrowers and lenders." Sophisticated bond fund managers, large insurance companies, and foreign central bankers may not need to rely on Moody’s or S&P to bring information between borrowers and lenders into symmetry. This aside, millions of Americans lend money to Uncle Sam (via purchasing bonds) and, on the whole, are economically illiterate – thanks largely to public schools. A downgrade of Uncle Sam’s credit rating would surely be a huge news story and may wake up the masses to the painful truth that their country is hurtling toward a debt-induced economic disaster (even Chris P. Dialynas, a Managing Director of PIMCO, is calling for America’s foreign creditors to forgive a portion of the U.S. Treasury debt they hold). A ratings downgrade may compel Americans to direct their savings to safer havens – thus preserving a healthier pool of savings from which America’s economy can be rebuilt. (Believe me, it will need to be rebuilt after Alan Greenspan’s/America’s debt orgy comes to an end.) It is time for the credit rating agencies to muster the courage to do the right thing and downgrade Uncle Sam. Or will we hear that all too familiar question: "How could the rating agencies have missed this one?"

January 24, 2005

Eric Englund [send him mail], who has an MBA from Boise State University, lives in the state of Oregon. He is the publisher of The Hyperinflation Survival Guide by Dr. Gerald Swanson. You are invited to visit his website.

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