US debt downgrade may now be inevitable

(July 20, 2011 - by John W. Schoen, Senior producer, msnbc.com)

As the stalemate over debt talks dragged on Wednesday, Congress and the White House may have passed the point of no return in avoiding a U.S. government debt downgrade.

If Uncle Sam loses his coveted AAA rating, the cost of borrowing goes up, the economy slows further and jobs get even tougher to find.

With hopes fading for a broad deficit-cutting package of spending cuts and tax increases, the White House Wednesday signaled that President Barack Obama could support a short-term extension of the U.S. borrowing limit as long as it was part of a broader long-term deficit reduction deal.

"We are in the 11th hour," said White House press secretary Jay Carney, repeating what Obama had said Tuesday. "We need to meet, talk, consult and narrow down in fairly short order what train we’re riding into the station."

Carney also said the president would be willing to support a short-term extension as a stop-gap measure, but not without "an agreement on a larger deal."

Though the Treasury has said it has enough cash until August 2 to keep paying the government’s bills, including interest payments on $14 trillion in debt, time is rapidly running out for a comprehensive deal. The most promising to date, proposed by the so-called "Gang of Six" senators, would involve painful cuts and controversial tax increases.

Even if a broad agreement could be reached this week, both sides would have to hammer out specific line items and then return to their respective caucuses to sell the deal.

The alternative is a deal that raises the debt limit temporarily to allow the Treasury to pay its bills. But bond rating agencies Standard and Poor’s and Moody’s have said such stopgap moves would jeopardize the government’s top-notch AAA credit rating.

"With the clock ticking, we doubt there is time to reach agreement on a comprehensive plan," said Paul Ashworth, chief U.S. economist at Capital Economics. "Instead, we expect a smaller scale plan to be passed that cuts $1.5 trillion from discretionary spending over the next decade. ... But it may not be enough to satisfy the rating agencies. The federal government is therefore still likely to lose its AAA rating within the next three months."

The immediate impact of such a downgrade would be a jump in interest rates. Just as a consumer with a lower credit score has to pay higher interest rates on their credit card, a downgrade of the Treasury’s debt rating would raise the cost of borrowing. That would increase the nation’s interest payments on fresh debt, driving the government even deeper into deficit.

The prospect of higher interest rates isn’t just speculation. After Congress delayed raising the debt limit in 1979 and the Treasury then had technical problems, the U.S. missed interest payments on about $120 million of debt. Though the glitch caused only a brief delay, that technical default raised interest rates by more than half a percentage point.

A half point rise in interest rates may not sound like a lot. But in April, economists at JPMorgan estimated that would be enough to knock a full percentage point off gross domestic product, which has already slowed to a growth rate of less than 2 percent. With job growth already below the pace needed to create work for new entrants to the labor force, unemployment would begin rising again.

The loss of Uncle Sam’s AAA rating would hurt more than just the Treasury. Some state and local governments, already enduring their own painful budget cuts, would see borrowing costs rise. All three ratings agencies have warned that top ratings on billions of dollars of municipal debt secured by U.S. Treasuries could fall if the federal rating is cut. More than $130 billion in municipal debt is at risk of downgrade from AAA, Moody’s said last week.

The cost of mortgages would also rise as ratings are cut on bonds guaranteed by mortgage financing agencies Fannie Mae and Freddie Mac. Moody’s also put hundreds of AAA-rated bonds issued by 15 states on review, including Maryland and Virginia, whose economies rely heavily on the federal government.

Central bankers bracing for default

The U.S. Federal Reserve is also actively preparing for the possibility that the United States could default if there’s not an agreement to lift the debt ceiling, a top Fed policymaker told Reuters Wednesday.

Philadelphia Federal Reserve Bank President Charles Plosser said the Fed has been working closely with the Treasury for the past few months, ironing out what to do if the world’s biggest economy runs out of cash on Aug. 2.

"We are in contingency planning mode," Plosser told Reuters in an interview at the regional central bank’s headquarters in Philadelphia. "We are all engaged ... It’s a very active process."

Because the Fed effectively acts as the Treasury’s bank - clearing government checks to everyone from social security recipients to government workers - Plosser said the Fed is trying to work out which checks would be good and which ones wouldn’t. Central bankers are also trying to sort through the thorny question of how to deal with the Treasury securities that banks put up as collateral when they borrow from the Fed.

"It could be very bad," said Plosser. "At some level we don’t really know what the consequences could be. It could be very serious. It could be less serious. Do we really want to run that experiment?"