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Monday, August 01, 2011

A Look at the Debt Rating and Default

Although you might not get the impression by some of the things being said in our nation's capital and by television talking heads, but Republicans in the U.S. House of Representatives have already achieved a tremendous victory in the ongoing battle over federal spending and debt levels.

What would that victory be? First, the President and congressional Democrats have, effectively, accepted that any deal to raise the debt ceiling will not involve tax increases. Of course, that does not mean that President Obama will stop pushing for tax hikes, but for now, in terms of a debt ceiling agreement, tax hikes are off the table.

Second, House Republicans have won the debate over linking an increase in the debt ceiling to some kind of spending cuts or restraint. Of course, how substantive any spending restraint might be, especially in the out years, is nothing more than guess work. Still, the link has now been established between spending and the level of debt.

These are significant achievements, given where the debt ceiling debate stood not that long ago.

Do we need more? Of course. In particular, federal spending needs to be capped as a share of GDP to make sure that spending is truly reduced. In the current fiscal year, federal outlays are expected to top 25% -- the highest level since World War II. To avoid further major increases in federal debt and large tax increases, spending needs to be capped at a much lower level. The level at the end of the Clinton years seems ideal at 18.2% of GDP.

But, alas, with the current Senate majority and White House committed to big government, that simply is not going to happen. It is a debate that will have to be taken into the 2012 elections. No tax increases, some spending restraint, and future, dubious cuts in spending will be where the current debt-ceiling negotiations wind up.

But what happens if this debate drags on, approaching the Treasury Department's declared drop-dead date of August 2, or the mid-August timeframe that many analysts now talk about?

Let's be clear: The notion that the U.S. will default on its debt obligations is not realistic. Revenues would still be coming in the door, and interest payments made. Could a partial government shutdown be needed under the worst-case scenario? Sure. But that's different from default.

Possibility of a U.S. debt rating downgrade by credit rating agencies, however, does lurk. One can debate the merit of such a downgrade, if it occurred. But what would be the effect?

One of the most dismal assessments was served up in a New York Post article that quoted various analysts pointing to increased mortgage rates, higher gas prices, and a stock market decline.

It's hard, however, to make the leap from a downgrade by rating agencies on federal debt due to continuing political disputes to the market then deciding that gas prices suddenly need to rise, and stock prices need to fall. After all, nothing substantively would have changed - even in government policies - before or after such an opinion is issued by credit agencies.

On mortgage and other interest rates rising, the conventional notion is that a credit rating downgrade will lead to higher interest rates on Treasury debt, and in turn, rates in the market tied to Treasuries would rise. But the ultimate question is: how will market participants react to a slight downgrade in U.S. credit rating? Again, since nothing will have substantively changed in terms of policy and the economy, it is doubtful that there would be any significant change in interest rates.

Meanwhile, the only way a credit downgrade could affect the price of gas is if the value of the dollar declined, thereby pushing up the price of oil. However, the value of the dollar has been falling for some time, and that is overwhelmingly tied to Federal Reserve monetary policy.

Finally, given this minimal, if any, impact that a credit downgrade would have on interest rates and the dollar, there's little reason to see any significant impact on stock prices.

In the end, the debt ceiling debate is about federal spending. To the degree that spending is reined in, then there would be a positive impact on the economy in terms of fewer resources being drained away from the private sector in the short term, via borrowing or taxes, and a reduced threat of higher taxes in the future.


Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council

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