The U.S. Debt Ceiling Argument Is Heading Down to the Wire

What options remain? A "big" deficit-reduction package of around $4 trillion (involving both spending cuts and tax increases) has foundered on Republican opposition to the tax increases involved, and it now seems that the available options now involve spending cuts alone. The stumbling blocks now are the Republicans' demand that every dollar of debt-ceiling increase be matched by a dollar of spending cuts (that means that a package of cuts of more than $2 trillion would be needed to raise the debt ceiling enough to take us to the end of 2012), and the president's demand that any agreement raises the debt ceiling sufficiently to go beyond the 2012 elections.

House Speaker Boehner is proposing a deal with about $1.2 trillion in spending cuts with a short-term increase in the debt ceiling for the rest of the year, followed by a bigger package of spending cuts of up to $1.8 trillion to be prepared by a bipartisan panel of lawmakers. This second package would be accompanied by a debt ceiling increase to go beyond the 2012 elections. But the president says that he wants a debt-ceiling increase that goes beyond the election agreed now, and that he will veto a short-term deal. But if that is his only option—and the alternative is, for example, not sending out social security payments—he will be under extreme pressure to change his mind.

Senate Majority Leader Reid is working on a much bigger package of spending cuts that would supposedly reach the $2.7 trillion mark, which would be sufficient to get Republican agreement on a debt-ceiling hike that goes to the end of 2012. The question here is just where these cuts would come from, and whether Democrats would sign on to cuts this large with no revenue component.

The most likely outcome is that some combination of the Boehner and Reid proposals is worked out that can command enough support to get the debt ceiling raised.

What will ratings agencies do? Raising the debt ceiling will not be sufficient to avoid a U.S. ratings downgrade. S&P has made very clear that it needs to see a "credible solution to the rising U.S. government debt burden," or it will lower the U.S. credit rating below AAA. A credible $4 trillion "big package" would have sufficed, but a $1–2 trillion package would probably be insufficient to avoid a downgrade, unless accompanied by a credible agreement on further action.

What happens if the United States gets downgraded? A downgrade in the U.S. debt rating by one or more ratings agency would add an extra risk premium to U.S. interest rates, although just how much is very hard to say, since we would be moving into unknown territory, a world where the benchmark asset no longer carries a AAA rating. There are—as yet—no obviously attractive alternatives to the U.S. dollar as the world's primary reserve currency and to U.S. Treasury securities as the benchmark "riskless" asset. So Treasuries are likely to retain their benchmark status, even if tainted after a downgrade, but with an extra risk premium built in.

Markets are not yet in panic. There has been no panic in the financial markets on Monday after the collapse of the "big" package late Friday and the absence of any agreement over the weekend. Equities were down slightly, and bond yields up very slightly. Markets seem more concerned over the risk of a debt downgrade, rather than of hitting the debt ceiling, still assuming that there will be some sort of agreement that will raise the ceiling by August 2. If we get to the end of this week with no agreement in place, we can safely assume that they will be far less sanguine.