Politicalmonkey2010

The Truth Shall Set You Free…It might piss you off first, but it will set you free.

Debt Ceiling and the US Debt Downgrade – Self Inflicted Wound

Posted by politicalmonkey2010 on August 6, 2011

(Originally published on Aug. 6, 2011, updated Aug. 8, 2011)

What is the issue?

US Debt Downgrade:  History, Cause and Effect

The United States has lost its top AAA credit rating for the first time, in a move that could severely undermine the recovery of the world’s largest economy and prompt further calamitous falls on world stock markets next week.

History of the US Debt

The full faith and credit of the U.S. was established by Alexander Hamilton’s 1790 push to have the fledgling federal government assume and pay back debts that states incurred during the Revolutionary War. It has gone largely unquestioned since, with just the occasional hiccup, including a 1979 debt-ceiling argument that delayed a few payments.

Recent demographic and economic changes, in particular the aging population and ballooning health-care costs, have made the long-term U.S. picture an ugly one, a problem exacerbated by a deep recession, which cut tax receipts and prompted a flood of fresh debt-financed spending.

What is the debt ceiling exactly? It’s a cap set by Congress on the amount of debt the federal government can legally borrow. The cap applies to debt owed to the public (i.e., anyone who buys U.S. bonds) plus debt owed to federal government trust funds such as those for Social Security and Medicare.

The first limit was set in 1917 and set at $11.5 billion, according to the Center for a Responsible Federal Budget. Previously, Congress had to sign off every time the federal government issued debt.

How is the ceiling determined? They don’t admit it, but lawmakers tacitly agree to raise the debt ceiling every time they vote for a spending hike or tax cut.

“Congress has already passed and the president has already signed legislation that increases spending or decreases revenues. Those decisions have already been made,” said Susan Irving, director for federal budget issues at the Government Accountability Office.

So in reality arguing over the debt ceiling is essentially arguing over whether to pay the bills the country has already incurred.

How many times has the ceiling been raised? Since March 1962, the debt ceiling has been raised 74 times, according to the Congressional Research Service. Ten of those times have occurred since 2001.

Graphic Presentation of Debt and Deficit

What is the difference between Debt and Deficit?

The deficit is the difference between the money Government takes in, called receipts, and what the Government spends, called outlays, each year.  Receipts include the money the Government takes in from income, excise and social insurance taxes as well as fees and other income. Outlays include all Federal spending including social security and Medicare benefits along with all other spending ranging from medical research to interest payments on the debt. When there is a deficit, Treasury must borrow the money needed for the government to pay its bills. We borrow the money by selling Treasury securities like T-bills, notes, Treasury Inflation-Protected securities and savings bonds to the public. Additionally, the Government Trust Funds are required by law to invest accumulated surpluses in Treasury securities. The Treasury securities issued to the public and to the Government Trust Funds (intragovernmental holdings) then become part of the total debt.  The debt can be viewed is as accumulated deficits.

30 year snap shot from Ronald Reagan to present…

Spending under Reagan averaged 22.4% of GDP, well above the 1971–2009 average of 20.6%. Yes, much of this was for defense, but almost everything went up during his Administration. Farm subsidies, for example, rose 140%. If you lower taxes and don’t trim expenses, there is only one way to make up the difference: by borrowing. The national debt tripled, from $712 billion in 1980 to $2 trillion in 1988.

Tax hikes and spending restraint under George H.W. Bush and even more so under Bill Clinton brought the problem under control and in the late Clinton years even produced a budget surplus. Then came the George W. Bush tax cuts, expanded health care benefits and two wars—all unpaid for—without any tax increases. The result: the surplus disappeared, and by 2008, the debt had ballooned to $10 billion. The final blow was the financial crisis and recession, which meant that federal tax revenues collapsed, followed by more tax cuts and stimulus spending. The debt rose to its current $14.3 trillion.

With federal taxes at 15% of GDP, a historic low, and spending at 24% of GDP, there is really no conceivable way to close the gap without increasing taxes—either raising rates or eliminating deductions and loopholes

Cause of the Downgrade

Intro:

This Congress,  has proved to be purely motivated by fear of losing Tea Party and Conservative America’s vote has at every opportunity been an obstructionist force.  As Sen. Minority leader Mitch McConnell said the GOP’s goal is to make Obama a one term President, and to achieve that goal they are more than willing to sacrifice the American economy.

Coming three days after the conclusion of the exhausting showdown over the debt ceiling increase, the S&P announcement was a thumbs-down on Washington from a major Wall Street voice.

“The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed,” the S&P wrote. “The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge.”

Right on cue Sen. Jim DeMint (R-S.C.), who opposed the deal to raise the debt ceiling, used the downgraded credit rating to call for the ouster of Treasury Secretary Timothy Geithner. “The President should demand that Secretary Geithner resign and immediately replace him with someone who will help Washington focus on balancing our budget and allowing the private sector to create jobs,” DeMint said in a statement.

S&P took no stand on revenue increases or spending cuts. They took no stand on defense cuts versus entitlements cuts. They only say that we must get our house in order.

· The downgrade reflects our opinion that the fiscal consolidation plan
that Congress and the Administration recently agreed to falls short of
what, in our view, would be necessary to stabilize the government’s
medium-term debt dynamics.
· More broadly, the downgrade reflects our view that the effectiveness,
stability, and predictability of American policymaking and political
institutions have weakened at a time of ongoing fiscal and economic
challenges to a degree more than we envisioned when we assigned a
negative outlook to the rating on April 18, 2011.
· Since then, we have changed our view of the difficulties in bridging the
gulf between the political parties over fiscal policy, which makes us
pessimistic about the capacity of Congress and the Administration to be
able to leverage their agreement this week into a broader fiscal
consolidation plan that stabilizes the government’s debt dynamics any
time soon.

In an unusual Saturday conference call with reporters, senior S.& P. officials insisted the ratings firm hadn’t overstepped its bounds by focusing on the political paralysis in Washington as much as fiscal policy in determining the new rating. “The debacle over the debt ceiling continued until almost the midnight hour,” said John B. Chambers, chairman of S.& P.’s sovereign ratings committee.  Another S.& P. official, David Beers, added that “fiscal policy, like other government policy, is fundamentally a political process.”   Once again, emphasizing that it is not the finances as much as the politics, the obstructionism that plagues this country.

China, the world’s largest holder of US debt, condemned the “short-sighted” political wrangling in the US and said the world needed a new and stable global reserve currency.  In a comment article the official Xinhua news agency said China had “every right now to demand the United States address its structural debt problems and ensure the safety of China’s dollar assets. International supervision over the issue of US dollars should be introduced and a new, stable and secured global reserve currency may also be an option to avert a catastrophe caused by any single country.”

Interesting note,  China’s leading credit rating agency Wednesday (2 days prior to  S& P) downgraded U.S. sovereign debt after putting it on negative watch last month. The Dagong Global Credit Rating Company, which lowered the United States to A+ last November after the U.S. Federal Reserve decided to continue loosening its monetary policy, announced a further downgrade to A, indicating heightened doubts over Washington’s long-term ability to repay its debts.

“The squabbling between the two political parties on raising the U.S. debt ceiling reflected an irreversible trend on the United States’ declining ability to repay its debts,” Dagong Chairman Guan Jianzhong told CNN.

“The two parties acted in a very irresponsible way and their actions greatly exposed the negative impact of the U.S. political system on its economic fundamentals,” he said.

The filibuster, historically employed about once a decade, is now a routine procedure that allows the minority to thwart the will of the majority. In 2009, Senate Republicans filibustered a stunning 80% of major legislation.

The downgrade from S&P has been brewing for months. S&P’s sovereign debt team, led by company veteran David T. Beers, had grown increasingly skeptical that Washington policy makers would make significant progress in reducing the deficit, given the tortured talks over raising the debt ceiling. In recent warnings, the company said Washington should strive to reduce the deficit by $4 trillion over 10 years, suggesting anything less would be insufficient. Remember Pres. Obama originally offered $4 trillion and that was rejected by the GOP.

Effect

US treasuries, once seen as the safest investment in the world, are now rated lower than bonds issued by countries such as the UK, Germany or France. The move is likely to raise borrowing costs for the US government, companies and consumers.  If, as a result of these congressional antics, interest rates on America’s debt rise by 1% —in other words, if the world asks for just a little bit more interest to lend us money—the budget deficit will rise by $1.3 trillion over 10 years. That would more than wipe out the entire 10 years of cuts proposed in the debt deal.

The downgrade will force traders and investors to reconsider what has been an elemental assumption of modern finance.

For an American economic recovery that can’t find much traction, and could do more damage to investors’ increasing lack of faith in a political system that is struggling to reach consensus even on everyday policy matters. It could lead to the prompt debt downgrades of numerous companies and states, driving up their costs of borrowing. Policy makers are also anxious about any hidden icebergs the move could suddenly reveal.

A key concern will be whether the appetite for U.S. debt might change among foreign investors, in particular China, the world’s largest foreign holder of U.S. Treasurys. In 1945, foreigners owned just 1% of U.S. Treasurys; today they own a record high 46%, according to research done by Bank of America Merrill Lynch.

The U.S. debt downgrade could pose another hurdle for battered state and local governments.

Fifteen states could lose their triple-A rating, including Maryland, New Mexico, South Carolina, Tennessee and Virginia, increasing borrowing costs at a time of fiscal strain for municipal governments, analysts say.

Analysts consider these states vulnerable to a downgrade because many of them rely heavily on federal spending on programs such as Medicaid or are home to thousands of federal employees. If Washington reacts to the downgrade with big cuts in spending, including layoffs of federal workers, than these states could face acute fiscal strains that warrant a downgrade.

“The downgrade of U.S. federal debt could result in de facto credit downgrades of some state-level…debt, which has been priced and rated as if the federal government were the backer of last resort,” Jason Schenker, president of Prestige Economics LLC, wrote in a note to clients Saturday.

Mr. Schenker said the cost of refinancing debt is likely to become more expensive, which “could result in a further bleeding of state and local government jobs.”

The only sure municipal candidates for a downgrade, according to S&P, are public-housing agencies that provide low-income housing and “generally move in lockstep with the sovereign rating and would be downgraded appropriately.”

U.S. Federal Reserve Chairman Ben Bernanke described very well, in Congressional testimony last month, the role U.S. Government debt plays in the interest rate charged for other loans/debt.

Bernanke said U.S. Government bonds are considered the lowest-risk bond investment class in the world, and serve as a benchmark for interest rates for other, more-risky bond and asset classes. If investors can’t count on the safety of U.S. debt, they would ask for higher interest on that asset class, pushing up the interest rates on other assets, among other ripple effects, he said.

In layman’s terms, many lenders will say, “Hey, if a U.S. Government bond is now a riskier investment, the money we lend you for your 30-year home mortgage is now a riskier investment, so I have to charge you a higher rate of interest. Sorry, but those are the market conditions today.”

As of Friday, the average interest rate for a 30-year, fixed-rate mortgage was 4.31 percent; for a 15-year mortgage, it was 3.48 percent, as tabulated by bankrate.com. For a 48-month new car loan, it was 4.85 percent; for a 48-month used car loan, it was 4.37 percent. For credit cards, for borrowers with outstanding credit, it was 10.83 percent.

In short, S&P’s downgrade may very well increase the borrowing costs for governments, businesses, home buyers, and consumers — something that would further slow the barely-growing U.S. economy, complicating policy makers’ efforts to increase job growth and address the nation’s biggest problem — its high 9.1 percent unemployment rate.

It’s possible the blow in the short run might be more psychological than practical. Rival ratings firms Moody’s Investors Service and Fitch Ratings have maintained their top-notch ratings for U.S. debt in recent days.

***UPDATE*****

Monday, Aug. 8, 2011

Even with a weekend for people to digest the information, the results on the first trading day was catastrophic, no doubt the European crisis was a factor.

Moody’s  Investors Service weighed in and explained Monday why it was sticking with its triple-A bond rating and negative outlook for the United States— setting itself apart from Standard & Poor’s.  Its negative outlook, which it also assigned on Aug. 2, was due to political squabbling in Washington — the biggest potential threat to the bond rating.

“We expect the economic recovery will continue and additional budget deficit reduction initiatives will be put in place by 2013,” said Moody’s, in its report on Monday. “The political parties now appear to share similar deficit reduction objectives.”

But Moody’s also said, “However, the disagreement between the two parties over the means by which to achieve deficit reduction and the difficulties experienced in reaching a compromise on raising the debt ceiling highlight the risks of political polarization. This uncertainty is among the drivers of our negative outlook.”

All three major U.S. stock indexes sank between 5% and 7%, pushing the Dow below 11,000 for the first time since last November.

U.S. stocks have fallen 15% during the past two weeks.

Though observers said S&P’s downgrade shouldn’t matter all that much, the market wasn’t buying it.

The Dow Jones industrial average (INDU) sank 635 points, or 5.6%, to 10,810.

The S&P 500 (SPX) lost 80 points, or 6.7%, to 1,120.

And the Nasdaq Composite (COMP) dropped 175 points, or 6.9%, to 2,358.

The sell-off was worse than the 512-point drop stocks experienced only three trading sessions ago.

Few companies were spared. All members of the Dow 30 and all members of the S&P 500 traded lower.

Financial stocks were among the hardest hit, with Bank of America (BAC, Fortune 500) plunging 20%, and Citigroup (C, Fortune 500) and Morgan Stanley (MS, Fortune 500) dropped roughly 15%.

The VIX (VIX) — Wall Street’s so-called “fear’ index — jumped 44% to 45.98, the highest level since early 2009.

“Investors are having one reaction to the downgrade: sell first and ask questions later,” said Paul Zemsky, head of asset allocation with ING Investment Management.

Gold futures for December delivery surged $61.40, or 3.7%, to top $1,713.20 an ounce as investors sought additional safe havens.

“The downgrade just put investors on an already-heightened state of alert,” said Rob Lutts, chief investment officer of Cabot Money Management. “People are exiting any equities they have, and selling off any assets that have any risk exposure.”

European stocks ended the session sharply lower. Britain’s FTSE 100 (FTSE) dropped 2.7%, the DAX (DAX) in Germany sank 4.7% and France’s CAC 40 (CAC) dropped 4.2%.

Meanwhile, Asian markets ended deep in the red. The Shanghai Composite retreated 3.8%, the Hang Seng in Hong Kong and Japan’s Nikkei each fell 2.2%.

Bonds: Currencies and commodities: The yen and the Swiss franc — perceived to be two of the world’s safest currencies — rose against the dollar.

Standard & Poor’s Ratings Services on Monday downgraded the credit ratings of Fannie Mae and Freddie Mac and other entities linked to long-term U.S. debt.

S&P also lowered the ratings for: farm lenders; long-term U.S. government-backed debt issued by 32 banks and credit unions; and three major clearinghouses, which are used to execute trades of stocks, bonds and options.

All the downgrades were from AAA to AA+, reflecting the same downgrade S&P made of long-term U.S. government debt on Friday.

The downgrade of the mortgage giants Fannie and Freddie reflected their “direct reliance” on the U.S. government, S&P said.

The U.S. government rescued the two mortgage giants in September 2008 and has funded them since the financial crisis. Fannie and Freddie own or guarantee about half of all U.S. mortgages and nearly all new mortgages. So if the U.S. government can’t pay its bills, neither can Fannie and Freddie.

It’s unclear how the lower credit rating would affect consumers. The downgrade applied only to corporate bonds, not the mortgage-backed securities that Fannie and Freddie issue.

Sources:

http://money.cnn.com/2011/01/03/news/economy/debt_ceiling_faqs/index.htm

http://www.rollcall.com/news/Standard-Poor-debt-ceiling-credit-rating-downgrade-208046-1.html

http://www.guardian.co.uk/business/2011/aug/06/us-credit-rating-downgrade-china

http://www.whitehouse.gov/the-press-office/2011/04/13/fact-sheet-presidents-framework-shared-prosperity-and-shared-fiscal-resp

http://online.wsj.com/article/SB10001424053111903366504576490841235575386.html

http://online.wsj.com/article/SB10001424053111903366504576492032031492642.html

S & P Report:  http://www.standardandpoors.com/servlet/BlobServer?blobheadername3=MDT-Type&blobcol=urldata&blobtable=MungoBlobs&blobheadervalue2=inline%3B+filename%3DUS_Downgraded_AA%2B.pdf&blobheadername2=Content-Disposition&blobheadervalue1=application%2Fpdf&blobkey=id&blobheadername1=content-type&blobwhere=1243942957443&blobheadervalue3=UTF-8

http://edition.cnn.com/2011/BUSINESS/08/02/china.us.rating/index.html

http://www.ibtimes.com/articles/193579/20110806/downgrade-standard-mortgage-rates-car-loans-auto-loans-and-poor-s-debt-aaa-aaa-s-p-interest-ownage.htm

http://www.nytimes.com/2011/08/07/business/a-rush-to-assess-standard-and-poors-downgrade-of-united-states-credit-rating.html

http://www.fareedzakaria.com/home/Articles/Entries/2011/8/4_The_Debt_Deals_Failure.html

http://money.cnn.com/2011/08/08/markets/markets_newyork/?hpt=hp_p1&iref=NS1

http://money.cnn.com/2011/08/08/news/economy/moodys_rating_downgrade/index.htm?iid=Popular

http://www.usgovernmentspending.com/federal_budget

http://www.usgovernmentspending.com/budget_battle.php?year=2011_2016&disp=12&units=b&fy=fy12

http://www.treasurydirect.gov/news/pressroom/pressroom_bpd08052004.htm

http://www.forbes.com/feeds/ap/2011/08/08/real_estate-financials-us-debt-rating-s-amp-p_8608744.html

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One Response to “Debt Ceiling and the US Debt Downgrade – Self Inflicted Wound”

  1. gesvol said

    I am not sure even without the downgrade if Congress is willing and able to actually pass anything that will promote job growth. And without that, Obama’s options are pretty limited.

    One (of the many things) frustrating thing about this whole debacle is that Republicans refuse to raise a single penny of tax revenue even off the richest of individuals and the biggest of corporations. Yet, through their actions, they seem more than willing to let interest rates go up, which impacts everyone. So it’s ok for everyone to have to pay more, just so long as none of it goes to the government?

    I fear another recession is coming. I think one party welcomes that because they think it will help them in 2012. The other party either doesn’t have the political will or ability (or both) to stop it.

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