Monday, July 25, 2011

The Failure of Both Parties to Avert a U.S. Debt Downgrade and What Happens After

Disclaimer: I am not a financial expert, not by any means, on any day, in any reality. Which makes it, from my point of view, all the more amazing that as I watched this last weekend the political back-and-forth on the "debt ceiling/potential default/possible sovereign debt downgrade/risk of a run on the markets" became increasingly apparent that I don't seem to know, for all intents and purposes, much less than Speaker Boehner and Majority leaders Reid and Cantor. And that, in and of itself, is very scary.

Here's what we do know about the debt ceiling crisis so far.

1. The ratings services (S&P, Moody's, Fitch) have clearly indicated that there is a strong likelihood of a downgrade of U.S. debt issuances, i.e. treasuries, if the U.S. government does not manage to come up with a fiscal plan that signals to investors (markets, world governments) that: A) those treasuries will always be good and B) those treasuries will always be good. Translation: no default and no massive cranking up of the federal printing presses to redeem those bonds in highly deflated dollars were a 14th amendment option to be exercised by the POTUS.

2. The two parties cannot seem to come up with an agreement that satisfies deficit reduction (we're not even talking about debt reduction but the projected growth of the debt that occurs through deficit spending) from the standpoint of the ratings agencies. That seems to about a 4 trillion dollar plan. Such a plan is not achievable without real cuts in spending and revenue growth, i.e. added taxes. And that, by all appearances, will simply not happen, even if a smaller deficit reduction plan is tied to a debt ceiling increase. Will Congress allow a default? The prevailing wisdom has always indicated that that is an "impossibility".

However, that wisdom seems less solid and secure day by day. If a default is averted, however, it is almost certain that whatever plan is agreed upon by both houses and signed by the President will fail to satisfy the ratings agencies. Downgrade, then, would seem inevitable and nearly unavoidable.

What are the consequences of a downgrade of U.S. treasuries? It will become more expensive to sell them, meaning that the yield will have to increase in order to lure bond buyers who are now less certain about the solidity of those debt issuances. That increase in payable interest on treasuries will reverberate throughout the economy and will translate into higher costs for nearly everything. It will certainly make it more difficult for A) individuals to purchase homes and B) builders to obtain needed credit which will savage both ends of the real estate market (sales prices and new construction) and inevitably translate into lower retail sales for building supplies and higher unemployment.

This is precisely why asian markets are more concerned at the moment with the risk of downgrade than the risk of default. Default will likely not occur. But a downgrade is made more likely by the length of time it takes both parties to hammer out an agreement and by the quality of the agreement itself, i.e. does the agreement result in meaningful deficit reduction and not just smoke and mirrors. A downgrade will throw heaping buckets of confusion and uncertainty into every corner of the world, but, particularly, in wealthy and rising nation-states that park their monetary reserves into U.S. treasuries, a parking spot that has traditionally been viewed as sacrosanct and unassailable.

Without that level of certainty, foreign and domestic investors will have to reconsider where to invest. This could mean, on the more optimistic side, lower levels of investment in U.S. debt which brings increases borrowing costs and translates into inflation, unemployment, and a further flattening of the retail real estate market and housing starts, a key economic driver. On the more pessimistic side, it could mean government shortfalls and market imposed spending cuts, i.e. not enough money to pay the bills (social security, medicare, Department of Defense, etc). Monetary shortfalls, of course, would further erode confidence in the ability of the U.S. to make good on its promise to redeem its bonds without running the presses, which could get the point. It becomes cyclical.

How will things really shake out? No one really knows. However, the possibilities and probabilities should terrify anyone who has the ability to read and extrapolate (draw a conclusion from a series of known facts). And that seems to exclude most members of the Tea Party and many Democrats, particularly the ultra-liberal orthodoxy.

All of this could have been avoided one week ago, of course. It also could have been avoided if the public school system had done a better job of educating the general public so that better choices could be made with regard to who we vote into office.

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