Why Downgrade of U.S. Credit Could Mean This Game is Over

And somewhere men are laughing, and little children shout; But there is no joy in Mudville – mighty Casey has struck out.
– “Casey at the Bat,”

by Ernest L. Thayer

Washington, like Mudville, is losing the game in the bottom of the ninth.

On Tuesday, Federal Reserve Chairman Ben Bernanke warned that the administration and Congress must avoid brinksmanship in talks to reduce the deficit and raise the debt ceiling. He is worried that a downgrade of U.S. government debt could send the globe spiraling back into a financial crisis.

The rating agencies had expressed their concerns earlier, saying they probably will downgrade the United States’ AAA credit rating.

On April 18, Standard & Poor’s changed its credit score for the U.S. from “stable” to “negative.” S&P warned of at least a one-third possibility that it would lower its long-term rating for the U.S. within two years. On June 3, Moody’s said it might put the U.S. government’s debt rating on review for a downgrade if no progress is made on raising the debt limit by mid-July. On June 9, Fitch Ratings said it will keep a watch on U.S. debt for a possible downgrade if the debt ceiling is not raised by Aug. 2.

Because the government cannot borrow more without Congressional approval, it would default on its debt obligations.

The suggestion that U.S. Treasury obligations carry a credit risk has global implications.

On April 18, Mohamed El-Erian, chief executive of the global investment management firm PIMCO, posted a blog in response to the S&P debt warning, saying, “No other country can play America’s historical role of being a reserve currency, the deepest and most liquid government market.”

A downgrade, he added, would “increase borrowing costs for all segments of U.S. society, thereby undermining investment, employment and growth. And it would curtail foreigners’ appetite to add to their already substantial holdings of U.S. assets. And it would weaken the dollar, the leading world reserve and trading currency.”

The rating agencies want the U.S. government to initiate austerity measures before the 2012 elections because America’s present fiscal path is unsustainable.

Proposed solutions

In November 2010, Simpson-Bowles and Domenici-Rivlin, two blue-chip budget-cutting panels, made proposals to get the federal debt to acceptable levels, widely considered to be 60 percent of GDP.

To cut costs, the panels recommended the government:

• Cut the number, and salaries and benefits, of federal workers.
• Reduce the costs of our health care system.
• Increase the age of Social Security eligibility.
• Decrease defense and foreign policy spending.
• Reduce entitlements, including farm subsidies, civilian and military federal pensions and student loan subsidies.

To raise revenues, the panels suggested the government:

Eliminate loopholes and tax breaks such as mortgage-interest deductions and credits for employer-provided health insurance.

Simpson-Bowles proposed raising the gasoline tax from 18.4 cents to 33.4 cents a gallon.

Domenici-Rivlin advocated a 6.5% value added tax. VAT would be applied to the estimated market value added to a product or material at each stage of its manufacture or distribution.

We need to heed the credit agencies’ warnings that they will downgrade their ratings of the country because of the impasse over the debt ceiling and our trillion-dollar deficits.

Otherwise, America within two years will incur a public debt load that exceeds 100 percent of our GNP – the tipping point for going over the cliff.

Kenneth Rogoff and Carmen Reinhart argue persuasively in their book “This Time is Different” that our debt load undermines our economy by: interest costs of our humongous debts emasculating almost every other government spending initiative and the reality that we cannot borrow trillions of dollars forever, especially from foreign lenders.

We must act. It would be no fun being a Mudville fan if Casey strikes out again.