US Credit Outlook Cut to Negative

Standard & Poor cut the outlook for US long-term debt to negative. This indicates a 1/3 chance that the US credit rating  will decrease from AAA. S&P cite Washington’s unwillingness to tackle the budget problem as the main reason for the change.

Most European countries that ran up the national debt to fund bailout programs have since enacted austerity measures to bring down deficits. The US stands alone in that Republicans and Democrats spent months bickering about peanuts without even acknowledging the bigger problem of the ballooning national debt.

Of course we now have a Democratic and a Republican plan to tame government spending. It is a step in the right direction, because it put this problem on the political agenda, but given both party’s enthusiasm for endless fighting over trivialities, it is unclear that these proposals will evolve into an actionable plan.

Domestic Debt-to-GDP Ratio

The Debt-to-GDP ratio for the US is currently around 97%. This means that the total amount of outstanding debt is about equal to the value of a year’s worth of economic activity in the US.

Some people quote a ratio of around 60%. This leaves out the government debt held by the social security trust fund. However, this number is misleading. If the money the US borrowed from the trust fund will have to be paid back, it is real debt and should be counted. If the money doesn’t have to be paid back, the social security trust fund doesn’t exist and the US has a massive unfunded liability.

Either way, the US will have to come up with the money to cover the value of the debt held by the social security trust fund, so this amount should be included in the Debt-to-GDP ratio.

Debt-to-GDP Ratio of Some of Our European Neighbors

For context, here are the Debt-to-GDP ratios and S&P rating for a few countries that have made the news recently because of their financial woes.

  • Ireland 94%/BBB+
  • Portugal  83%/BBB-
  • Greece 144%/BB-

And here a few countries with high Debt-to-GDP ratios that are not currently experiencing a debt crisis

  • France 83%/AAA
  • UK  77%/AAA
  • Italy 119%/AA-
  • Belgium 99%/AA+

Clearly there are many other factors besides the Debt-to-GDP ratio that determine the creditworthiness of of a borrower, but this comparison shows that a Debt-to-GDP ratio of around 100% makes a country vulnerable to rating downgrades (see Italy and Belgium) and sovereign debt crises (see Ireland, Portugal, and Greece).

Perhaps Washington will come up with a real plan to reduce the national debt, but the current proposals won’t do it. Both the Republican and the Democratic plan are projected the increase debt levels, albeit at a slower pace than doing nothing.

 

Posted by Martin Gremm (Pivot Point Advisors)

About the author

Marc Schindler, CFP®
Marc Schindler, CFP®

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