America: Downgraded & Degraded

Red China gives the US advice on the need to re-establish "common sense."

Friday night, after another wild day on Wall Street, the Standard & Poor (S&P) ratings agency made good on its three-month-old warning and downgraded the credit rating of the United States for the first time since it was granted in 1917. The move from AAA to AA+ reflected the ratings agency's contention that "difficulties in bridging the gulf between political parties," which resulted in a compromise to reduce the nation's debt by $2 trillion, didn't go far enough. "Political brinksmanship" made the ability of the U.S. to confront its growing debt problem “less stable, less effective and less predictable,” the agency contended.

The move capped a contentious debate between the ratings agency and government officials at the Treasury Department, who claimed S&P's analysis was "fundamentally flawed," according to administration sources who remained anonymous because they were unauthorized to speak about the issue publicly. Officially, the Treasury issued a statement claiming that "a judgment flawed by a $2 trillion error speaks for itself." S&P conceded the mistake, but John Chambers, head of sovereign ratings at the agency, claimed the error "doesn't change the fact that [America's] debt-to-GDP ratio, under most plausible assumptions, will continue to rise over the next decade."

And despite the Obama administration's anger, the agency itself remained unruffled. Noting that the debt deal didn't go far enough to "stabilize the government's medium-term debt dynamics," S&P also announced it was issuing a "negative outlook," raising the possibility of additional downgrades in the next two years. S&P was looking for $4 trillion in cuts. As noted above, the current debt ceiling deal calls for half that amount -- and only after additional negotiations by a 12-member committee, which aren't due to be submitted until Thanksgiving.

S&P contended some of its assumptions were based on the idea that the committee itself could remain dysfunctional, meaning it wouldn't come to an agreement on the additional cuts, and that the Bush-era tax cuts would remain in place past the end of 2012. These assumptions are somewhat dubious. With respect to additional cuts, there is a trigger mechanism in place should the committee fail to reach a consensus. With respect to taxes, it remains unclear as to whether those tax cuts will expire completely, remain intact, or be retained for the middle class and eliminated for higher earners.

Unsurprisingly, the reaction to the downgrade was both swift and predictable, with Democrats and Republicans reiterating their conflicting worldviews. "The action by S&P reaffirms the need for a balanced approach to deficit reduction that combines spending cuts with revenue-raising measures like closing taxpayer-funded giveaways to billionaires, oil companies and corporate jet owners," said Senate Majority Leader Harry Reid (D-NV). "It is my hope this wake-up call will convince Washington Democrats that they can no longer afford to tinker around the edges of our long-term debt problem," said House Speaker John Boehner (R-OH). "As S&P noted, reforming and preserving our entitlement programs is the 'key to long-term fiscal sustainability,'" he added.

Other Republicans also weighed in, with presidential candidate Michele Bachmann (R-MN) calling on the president to fire Treasury Secretary Timothy Geithner, and to submit a plan to "balance the budget, not just reduce deficits." The fire-Geithner sentiment was echoed by Sen. Jim DeMint (R-SC). "For months [Geithner] opposed all efforts to reduce the debt in return for a debt ceiling increase. His opposition to serious spending and debt reforms has been reckless and now the American people will pay the price," he said. Both criticisms were likely engendered by the fact that Geithner had said in April there was "no risk" the U.S. would lose its AAA rating.

Current Republican presidential front-runner Mitt Romney also weighed in. He characterized the downgrade as "a deeply troubling indicator of our country's decline under president Obama."

How troubling remains to be seen. If interest rates rise as a result, borrowing costs would be driven up for everything from governments at every level to rates on mortgages, credit cards and business loans. The announcement was made after the stock market closed for the weekend following a five-day span in which investors trimmed 699 points off the Dow Jones Average. That was the DJA's worst weekly showing since October 2008.

Opinions were mixed on where we're headed. "I think we will have a knee-jerk reaction on Monday," said Jack Ablin, chief investment officer at Harris Private Bank. Harvey Neiman, portfolio manager of the Neiman Large Cap Value Fund, disagreed. "The market's already been shaken out," he said. "It knew it was coming."

The initial indication of which sentiment is correct will be reflected in the opening of the Asian stock markets Monday (late Sunday night in the U.S.). Early reports suggest Asian investors are likely to retain their holdings in U.S. Treasuries, due in large part as a means of stemming gains in their own currencies versus the dollar. Currency gains make exports more expensive in a region which depends heavily on them to remain prosperous.

Yet once again, conflicting assessments on what may occur in the short-term were evident on that side of the world as well. “Because the U.S. market remains the most liquid and deepest and as Europe still faces uncertainty, the U.S. market is not likely going to experience a huge sell-off, even with the one-notch downgrade,” wrote Philippine central bank Governor Amando Tetangco in an emailed statement. Thomas Lam, Singapore-based chief economist at OSK-DMG, disagreed. “This is clearly a wake-up call for the U.S. and those who think a downgrade doesn't matter are in denial,” he said. “Markets will enforce their discipline if the U.S. doesn't repair its credit rating.”

David Beers, head of S&P’s government debt rating unit, reflected on that possibility. “It’s always possible the rating will come back, but we don’t think it’s coming back anytime soon,” he warned.

The move by S&P made the ratings agency itself a target for criticism as well. "I really find it quite amazing that a credit agency that could rate mortgage backed securities AAA has decided to downgrade the U.S. government," said Greg Salvaggio, senior V.P. of Tempus Consulting. "I find it to be incredibly troubling from a ratings agency with a very terrible history in the last three years of its ability to quantify risk," he added. Dean Popplewell, chief currency strategist at Oanda in Toronto, concurred. "No one expected [S&P] to do it," he said. "They made sure Monday will not be boring!"

As of now, the other two major ratings agencies, Moody's and Fitch, will maintain a AAA outlook on U.S. credit. But Moody's has also lowered its outlook on U.S. debt to "negative."

Senator Mark Kirk (R-IL) called on President Obama to cancel Congress's August recess and bring lawmakers back into session to specifically address the concerns outlined in the S&P's analysis. Yet as of early Saturday, there was no statement from the president, who met with Treasury Secretary Geithner on Friday before heading to Camp David for the weekend. Prior to the downgrade on Friday, the president spoke at Washington Navy Yard, where he announced a jobs program for veterans, aka more government spending. "We are going to get through this," he said. "Things will get better. And we're going to get there together."

Perhaps we will. But considering this president never misses an opportunity to engage in rank partisanship, and has never submitted a serious -- as in written down -- budget proposal of his own, one is left to imagine what form such togetherness might take. As for the political parties themselves, it remains to be seen which worldview will gain the upper hand. And while the devil is in the details, there is no question cuts must be made. There is also no question addition revenue streams must be found.

The best of both worlds? On the cut side, a serious re-evaluation about the size and nature of government itself. Many Americans have lost sight of the reality that government functions best from the local level outward, not the national level inward. The monumental amount of waste that occurs in a process which essentially involves the states sending money to Washington, only to have Washington send it back, can no longer be tolerated.  The monumental immorality of a country in which half its population is tethered to a government underwritten by the other half must also be addressed.

On the revenue side, fundamental tax reform, as opposed to class warfare, must be undertaken. Eliminating loopholes is a no-brainer, both economically and morally, as it will give Americans the sense that everyone is paying their "fair share."

More importantly, the pie itself must be made larger. There is no viable substitute for putting more Americans back to work. And despite what many Americans might believe, brow-beating the wealth-producers, as opposed to providing them with incentive, is a fool's errand.

Lastly, every reasonable American must recognize that the way we have conducted our affairs is no longer sustainable. This is one American who would like to live long enough to see a debate about raising the debt ceiling become a moot point, with a government spending no more than it takes in, with all increases in that spending limited to a fixed percentage of GDP. One in which any spending deviation for national emergencies would require a two-thirds vote of approval by Congress.

On Saturday, China's state-run newspaper, Xinhua News Agencyexplained exactly what our current dilemma necessitates. "To cure its addiction to debts, the United States has to re-establish the common sense principle that one should live within its means," it said.

Right now the country still has the power to re-establish common sense principles. But Americans should make no mistake: if we continue to kick the fiscal can down the road, common sense principles will be imposed on us, not by us.