S&P Debt Warning Timed to Prod Reform: Analysts

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Stock market investors may not like it but stripping the U.S. of its long-term AAA credit rating may be the only way to force real fiscal reform in this country.

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As the Dow Jones Industrial Average fell 140 points Monday on an announcement from Standard & Poor’s that the influential rating agency had lowered its outlook for U.S. debt to “negative” from “stable,” some analysts welcomed the warning.

“It’s good that S&P is bringing this into focus. The public at large still isn’t aware of how large the coming fiscal train wreck is,” said Axel Merk, author of "Sustainable Wealth"and president of Merk Funds.

S&P said in a report that it could take away the U.S.’s coveted AAA rating by 2013 if politicians fail to address the nation’s troubles with bloated budgets and sharply rising deficits.

Indeed, S&P said its skeptical Congress will get the job done.

“We believe there is a material risk that U.S. policy makers might not reach an agreement on how to address medium and long-term budgetary challenges by 2013,” the report states.

If nothing is done by then the U.S. would find itself in a “meaningfully weaker” fiscal position than other countries whose debt is rated AAA by S&P, and the rating agency would be forced to lower its U.S. rating.

Merk said it’s not an idle threat.

“Unfortunately, it’s dead serious,” he said. “It will happen if we don’t get entitlement reform that is serious and earnest.”

And, if that happens, the security long considered to be the safest of all safe havens – U.S. Treasury bills – will lose much of their luster in the eyes of investors. That would make it more difficult for the U.S. to issue debt, a situation that has its advantages and disadvantages.

Much like the current argument related to raising the debt ceiling, the debate can be circular. If the U.S. can’t issue bonds as freely as it has in the past, it would likely lead to an economic slowdown as it would be more difficult to fund all manner of government projects funded by debt.

Fiscal hawks might view that as a positive, however, arguing that if there is no money to fund it it shouldn’t be funded.

In the same fashion, those same fiscal hawks have argued against raising the current debt limit from its current level of $14.3 trillion, notwithstanding concerns that a default by the U.S. on its massive debt load could have a traumatic ripple effect on the global economy. Raising the debt limit, they argue, simply allows the government to spend money it doesn’t have.

No one believes the U.S. losing its AAA debt rating would have nearly the impact of the U.S. defaulting on its debt.

Dan Greenhaus of Miller Tabak observed in a note to his clients that other countries have survived the ratings cut: “The experience of Canada and Japan show that the loss of a AAA rating is not a death blow. If governmental finances can be adjusted (in the case of Canada) or domestic participants continue to find the debt attractive (in the case of Japan), higher yields on a sustained basis are not assured.”

In any event, S&P’s report seemed timed to prod politicians in Washington, D.C., toward some form of long-term deficit reduction plan at a time when the debate over government spending and borrowing is squarely in the public eye.

In addition to the debt ceiling, Congress recently wrangled over a budget for fiscal year 2011, a battle that threatened to shut down the government. President Obama, apparently seeking to regain control of the debate, last week proposed a plan to cut $4 trillion from the deficit over the next 12 years by cutting defense spending and making changes that make Medicare and Medicaid more cost efficient.

Merk said current entitlement spending is leading the U.S. down an “unsustainable” path.

“The math doesn’t work down the road,” he said.

Should a cut to the U.S. debt rating have a negative impact on global bond markets, as Merk predicts, he believes it could serve as the catalyst for genuine reform.

“The only language politicians understand is the language of the bond market,” he said. “We’ve seen it in Europe -- when bond markets move, suddenly all sorts of reform is possible.”

Reform must entail sacrifices by the American people, starting with raising the retirement age for Social Security benefits. Raising taxes on the rich won’t solve America’s fiscal woes, according to Merk.

Merk said S&P’s two year deadline seemed about appropriate because the U.S. isn’t going to fall off an economic cliff tomorrow. But there are risks to putting off a solution.

As more funds are required to pay down the larger and larger debt, it offers politicians less flexibility in terms of where they can cut in order to reduce spending across all government services.

“We can wait a year or two but every year that we wait the options become more difficult,” Merk explained.