The Super Committee’s failure to come up with $1.2 trillion in budget savings over the next ten years should not affect the U.S. credit rating—or immediately affect the interest rates paid on Treasuries or their value. However, investors still need to be cautious about loading up on those securities—the longer term outlook is not so good.
Although the Super Committee did not agree to a combination of $1.2 trillion in spending cuts and tax hikes, the automatic trigger in the Budget Control Act will impose cuts of $1.2 trillion on defense, non-entitlement domestic spending and some payments to hospitals and health care providers.
Savings from winding down the wars in Afghanistan and Iraq were already scored into budget projections; hence, additional defense cuts will be from the “base” military budget—expenditures that maintain readiness and defend U.S. security interests around the globe.
The Budget Control Act, passed in August, already cut defense spending by $450 billion over ten years, and another $500 billion is simply unacceptable. U.S. hardware is aging—pilots are flying the same fighters as did their fathers; cyber-warfare requires new capabilities, in addition to traditional land, air and sea forces; and China is building a Navy and will be spending on defense 60 percent as much as the United States within a decade—with lower personnel costs and without America’s global responsibilities. More, not fewer, naval resources will be needed to counter that challenge in the Pacific—on his recent trip to the region, President Obama committed to a beefed up U.S. presence there.
Republicans in Congress will propose repealing the $500 billion cut—or something close to it—but liberal Democrats will demand that be paid for with cuts in other places or more likely, revenue enhancers—aka tax increases. Anti-tax advocates like Grover Norquist won’t be able to stop such a deal—hard realities, especially national security concerns, have a way of these denting the clout of mono-line political activists.
A deal on defense spending, pending or consummated, will legitimize similar tradeoffs to reduce other cuts mandated by the Budget Act, and make some tax increases acceptable, even among many conservative Republicans in Congress.
The bottom line is the impact on the deficit of the Super Committee failure will be marginal.
The budget dance that follows should not provide a premise for S&P to lower its AA+ bond rating on U.S. government debt, or for Moody and Fitch to lower their AAA rating.
Longer term, the cuts required in the Budget Act won’t be enough. The United States will continue to borrow too much and grow too slowly until more important structural issues are addressed. Within a few years, or sooner, U.S. borrowing costs will be much higher than today.
Currently, Washington enjoys low borrowing costs, because foreign central banks, private institutions and ordinary investors are all fleeing European debt.
Similarly, questions about China’s banks and dodgy accounting standards, along with Beijing’s exhortations that yuan appreciation has run to course, are causing money from the Middle Kingdom to flee to America. That money is dumping into Treasuries, solid corporate and state debt, and even junk bonds, which are currently overpriced.
Within a few years, that money will leave, after Europe has its ultimate financial crisis and then recovers. and investors realize that China’s sovereign debt is no more risky than U.S. paper. Rates on Treasuries will rise, as investors become much more nervous that either Washington won’t be able to continue floating $1 trillion a year in new debt or the Fed will simply roll the printing presses to buy what Treasuries investors won’t take.
Long bond rates will rise, and Treasuries bought today will lose value. Simply put, in 2014, why would someone pay as much for Treasuries maturing 27 years later and yielding 3 percent, when a new 30 year bond pays 5 percent. At that point investors who purchased bonds today either must wait for those to mature and endure low interest rates, or take a haircut if they sell.
The message to the ordinary investor is simple, Treasuries are safe up to a point—the U.S. government can always print money if necessary to honor its debt—but those investors should only buy bonds with maturities no longer than their circumstances permit them to have their money tied up. Treasuries won’t be long a liquid investment.
Peter Morici is a professor at the Smith School of Business at the University of Maryland and former chief economist at the U.S. International Trade Commission. Follow him on Twitter@pmorici1.
Peter Morici served as Chief Economist at the U.S. International Trade Commission from 1993 to 1995. He is an economist and professor at the Smith School of Business, University of Maryland, and a widely published columnist. He is the five time winner of the MarketWatch best forecaster award. Follow him on Twitter @PMorici1.