UI professor: US must confront debt before investors lose faith

The bill raising the debt ceiling was signed into law Tuesday by President Obama.

George Pennacchi, University finance professor, spoke with The Daily Illini about the impact this deal will have on the nation’s finances.

*The Daily Illini: Does this deal address the underlying problems that got us into this situation? Is it a stopgap or something better?*

*George Pennacchi:* It addresses the underlying problems, but only partly; it’s not going to be the final solution to our difficulties with such a high level of federal government debt. It addresses the short term problem of the debt ceiling requiring being raised. The IMF predicts that by this year the ratio of the federal government debt to GDP will be over 100 percent, so we’re going to have more debt than say, one year of total income. This two-and-a-half trillion dollar cut is not going to be a sizable effect. Currently the federal government is borrowing about 43 cents for every dollar it spends and of course as the government keeps borrowing its debt total keeps rising.

*DI:* The current step of the new bill has no new tax revenue, and the Bush tax cuts will be around until 2013. Does the lack of any new revenue undermine this bill? Can we lower the national deficit without increasing revenue?

*Pennacchi:* Well it is possible to solve the deficit problem just by spending cuts, but of course they would have to be larger than they would be without also some higher tax revenue. The possibility where both parties could come to an agreement would be if marginal tax rates were lowered but many tax deductions were eliminated. I think that’s where there’s a possibility (for compromise). Many economists would probably embrace that type of structure because it would simplify the tax system and actually make it more efficient.

*DI:* Can we reduce the deficit in the long term without reform to entitlements like Medicare?

*Pennacchi:* Only with significant increases in taxes.

Again, there’s many dimensions where possibly both parties could come to an agreement between Social Security and Medicare, and — at least for Social Security — having a different inflation adjustment than the one we currently use would allow benefits to increase, but not as rapidly as they have in the past. Increasing the age for qualifying for these programs would also help, and potentially there would be an agreement among parties for those types of reforms. And possibly increasing the income level where Social Security payroll taxes are effective. Those are areas where we could see some compromise, and it could help put those two, big expensive entitlement programs on a more viable long run status.

*DI:* What will the effects be if the U.S.’s credit rating is downgraded?

*Pennacchi:* Regarding the U.S. credit rating, I think many people exaggerate the effect that a downgrade by Standard & Poor’s from AAA to AA would have. Standard & Poor’s is so far the only major credit rating agency that has said that they have a high probability of downgrading the U.S. It’s happened before that other countries have been downgraded from AAA: Japan, Canada, Australia, have been downgraded, and in most cases it hasn’t really had much of any effect on stock prices or even treasury yields. Why? Because when you come down to it, these credit agencies are just groups of individuals expressing their opinion, but their opinions don’t necessarily matter that much relative to what investors are willing to pay for treasury securities. As long as countries such as China and Japan continue to want to hold U.S. Treasury securities, we probably will not going to see a big impact from one the credit agencies downgraded U.S. debt. That said, if the U.S. doesn’t do any more than this current deal, then it is very likely that investors, as well as credit rating agencies, will lose faith in the U.S. Treasury if our debt to GDP ratio keeps going up.