America continues to be rapt — and perhaps alarmed — by the ongoing debt ceiling negotiations. Yet even as the negotiations proceed, a daunting reality has been largely obscured. Other than preventing a default on August 2nd, these negotiations, including any of the current permutations referred to as “grand bargains,” could end up producing nothing more than getting us back to where we are right now. Why? Because a deal that only avoids a credit “default” and not a “downgrade” may be equally devastating. In short, if the credit rating of the country is lowered, the ensuing rise in interest rates would virtually cancel out all the long-term savings proposed by either side.
A credit rating reflects an extensive analysis of how well a particular entity — in this case the federal government of the United States — can service its underlying loans. The current credit rating of the United States is AAA, which is the safest credit rating there is. America has had an AAA rating since 1917, when Moody’s first began such assignments.
Back in April, long before the debt ceiling debate reached the fevered pitch it has currently assumed, one of those ratings agencies, Standard & Poor’s, lowered the nation’s outlook regarding its long-term credit rating from “stable” to “negative.” That change was essentially a warning that if America did not get its debt under control, there was a one-in-three chance that S&P would lower the AAA rating over the next two years.
A scant three months later, S&P had upped the ante to a fifty-fifty chance over the ensuing three months, and possibly as early as August. The principal impetus for such a downgrade would be a deal whereby the U.S. raises the debt ceiling, but does nothing to address ongoing deficits. ”Under this scenario, we expect that interest rates could rise–say, 50 bps on short-term rates and double that on the long end–though this may depend on whether Treasuries would lose their status as the safe haven that investors have historically perceived them to be, or whether physical assets such as gold would benefit from such a flight to quality,” S&P said. In other words, interest rates could go even higher if the world no longer views America as the ultimate port in any financial storm.
Historically speaking, interest rates are near all-time lows, meaning the U.S. can borrow money at incredibly cheap rates. Despite that reality, interest payments on the debt were over $413 billion in 2010, and more than $385 billion in the first nine months of FY2011. $413 billion of interest on $14 trillion of debt comes to about 3 percent. Roughly speaking, a one percent rise in interest rates would add another $140 billion of interest payments to the existing debt. More debt? More interest. Higher interest payments? Greater and greater amounts of debt.
Former Federal Reserve governor Lawrence B. Lindsay explains the implications. “At present, the average cost of Treasury borrowing is 2.5%,” he writes. “The average over the last two decades was 5.7%. Should we ramp up to the higher number, annual interest expenses would be roughly $420 billion higher in 2014 and $700 billion higher in 2020.” Multiply the low number by the same ten years, and the most ambitious “grand bargain” of $4 trillion of “savings” currently proposed yields no savings whatsoever.
Mr. Lindsay then cuts to the heart of the class-warfare rhetoric promoted by Democrats. “There is no way to raise taxes enough to cover these problems. The tax-the-rich proposals of the Obama administration raise about $700 billion, less than a fifth of the budgetary consequences of the excess economic growth projected in their forecast.” The excess growth Mr. Lindsay refers to is the administration’s rosy scenario of 4, 4.5 and 4.2 percent in 2012, 2013 and 2014, respectively. The Federal Reserve has already punched a hole in the 2012 number, projecting a top rate of 3.7 percent for next year. Bottom line? “Only serious long-term spending reduction in the entitlement area can begin to address the nation’s deficit and debt problems,” Mr. Lindsay warns.
So who’s offering what? On the Republican side, House Speaker John Boehner is proceeding with a plan that offers approximately $3 trillion in spending cuts over ten years, but requires a two-step process to raise the debt ceiling. The first step is a hike of $900 billion with slightly more in the way of cuts, followed by the formation of a 12-member committee tasked with finding an additional $1.8 trillion in savings. Senate Leader Harry Reid declared that plan “dead on arrival” in the Senate, and the Obama administration issued a formal veto threat. Furthermore, in a late-breaking development, the Washington Post is reporting that some house Republicans won’t support the plan without assurances that a Balanced Budget Amendment, both voted on in Congress and sent to the states for ratification, is part of the deal.
On the Democrat side, Mr. Reid is reportedly keeping his latest plan under wraps as a ”fallback when Boehner’s [bill] fails,” according to an unnamed Democratic official. What’s currently available contains $2.7 trillion in spending cuts, no tax hikes, and a rise in the debt ceiling “until 2013,” because Democrats and the president do not want to re-visit this “problem” (read: possible tax hikes) until after the 2012 election. In this plan, $1 trillion in savings is based on “winding down” the wars in Iraq and Afghanistan. This seems to contradict the president’s assertion that whatever occurs with regard to those wars would be decided by “events on the ground.” House Republican Leader Eric Cantor characterizes the plan as a “blank check.”
In addition, lawmakers are still holding bipartisan talks aimed at reconciling their differences.
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