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A Downgrade Is Serious Business

A Commentary by Lawrence Kudlow

Thursday, July 28, 2011

Standard & Poor's government-credit-ratings guru David Beers played his cards close to the vest on the topic of a U.S. downgrade in our CNBC interview this week. However, this head of S&P's global sovereign-ratings business -- with a staff of 80 covering 126 countries -- issued three strong warnings to the debt-ceiling negotiators in Washington.

Beers avoided direct comments on any of the key debt-limit plans. But when I asked him about joint congressional committees that would report back with additional budget savings at the end of the year, he said, "Well, naturally, it's going to raise questions ... we would have to look at the balance of incentives and disincentives that might increase or decrease the probability of that type of approach being effective."

In other words, both the Harry Reid plan and the John Boehner plan could contribute to a downgrade this summer since it's uncertain whether joint committees will get the necessary votes for large-scale budget cuts and deficit reduction by year-end. There are no guarantees.

I then asked Beers about a two-step debt increase. This is part of Speaker Boehner's plan -- a roughly $1 trillion debt-ceiling hike now and a roughly $1.8 trillion increase next year. Beers has a problem with that.

"Well, we'll look at it," he said. "But we've also said on the 14th of July that we would be concerned if we thought that the debt-ceiling debate would come back and be open, and we'd have to go through all this again and again and again."

I asked, "And that would be a negative in your view?"

He responded, "That would be a negative in our view."

We then talked about prioritizing debt payments, where the government would parcel out incoming revenues in August in order to cover federal obligations, including interest on Treasury securities.

From the Jay Powell analysis (bipartisanpolicy.org), Uncle Sam could pay off interest on the debt, benefits for Social Security, Medicare and Medicaid, defense payments, and unemployment benefits with incoming cash, but would still be $134 billion -- or 44 percent -- short of budget-obligation requirements.

Beers said that would not constitute a formal default. But he added: "It would mean a very sudden fiscal shock. ... You'd essentially be running a cash surplus to pay off the debt as it matures. So potentially that would be deeply disruptive to the economy. ... We would suspect that that's not a tenable situation for very long."

On July 21, S&P issued a warning that there's a 50 percent chance of a U.S. downgrade. A week earlier, S&P placed the U.S. on "credit-watch negative" based on the rising risk of a policy stalemate. Of course, that clock continues to tick.

Beers is looking carefully at all the debt plans on the table, and he wants to know three things: Are they actionable? Can they be implemented? And are they credible?

In particular, he's looking for "some buy-in across the political divide, across both parties, because politics can and will change. ... And if there's ownership by both sides of the program, then that would give us more confidence." In other words, bipartisanship compromise.

More generally, Beers wants to see the U.S. federal-debt-to-GDP ratio move on a downward trend. Unlike other AAA countries -- such as Britain, France or Canada -- the U.S. has not yet undertaken large-scale policy changes that would reverse its rising trajectory of government debt. That trajectory must fall over the medium-to-longer term. And that has Beers worried.

And like a lot of analysts, he's concerned that a U.S. debt downgrade could raise Treasury rates by 25 to 50 basis points if the rating drops from AAA to AA. "That, of course, would filter through to other interest-rate-sensitive kinds of debt," said Beers, like mortgages, Fannie and Freddie, insurance companies, overnight bank lending, and on and on.

Stock prices already seem to be falling around 100 points a day on investor fears of the negative economic consequences of a U.S. debt downgrade. People may be moving out of stocks and bonds into cash and government-guaranteed savings accounts to protect themselves in the event of a worst-case scenario.

CEOs are hoarding cash for their companies. The economy is barely growing. And folks are leaving the dollar for gold and foreign currencies.

And with less than a week until the Aug. 2 debt-limit deadline, Congress still dithers.

A debt downgrade is very serious business. Does Washington get that? S&P's David Beers most certainly does.

Larry Kudlow, National Review Online's Economics Editor, is host of CNBC's "The Kudlow Report" and author of the daily web blog Kudlow's Money Politic$.

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