Washington, DC, August 9, 2011 --  

America's public finances have been in sad shape for long before the S&P downgrade. Americans, like the rest of the rich world, must stop living beyond their means.

When government officials and pundits reacted with shock and horror to the downgrade of the U.S. credit rating by Standard and Poor's, it was as if they were living in another universe.

Treasury officials furiously engaged in a last minute exchange with S&P auditors before the downgrade, desperately hoping that its pleas and disputes over technical details could avert what the agency plainly had said would happen if politicians could not agree on a major deficit reduction.¹ Treasury Secretary Tim Geithner said "S&P has shown really terrible judgment"² and left-wing Senator Bernie Sanders asked, "Where were they four years ago when they and other credit-rating agencies helped cause this horrendous recession by providing AAA ratings to worthless subprime mortgage securities?"³

Indeed. Yet the proper criticism of S&P is not that it has been too hard on the United States, but as in the case of the subprime securities, why it has been so soft. In both the cases of judging mortgage debt and U.S. Treasuries, government and Wall Street insiders have long been out of touch with reality, succumbing to an internal groupthink despite ample evidence to the contrary.

U.S. officials and Wall Street insiders have long repeated the mantra that U.S. Treasury bonds are very safe because they are "backed by the full faith and credit of the U.S. Government." Yet when Geithner recited this to a group of Chinese economic students two years ago, they laughed in his face.⁴ Given today's conditions is it likely that the U.S. government will not pay back its debts? No. But it also is not inconceivable. By downgrading America's credit rating from AAA to AA+, S&P is simply acknowledging what many outside observers, such as the Chinese students and this web column, have known for years. Welcome to reality.

The simple truth is that the United States has so far failed to address its long-term debt problem. Despite several months of political infighting and a threat of a government shutdown over the budget this spring, and several more months of wrangling and the threat of a temporary default over raising the debt limit this summer, America has not made sufficient changes its unsustainable borrowing binge.

The debt ceiling agreement reached last week is widely reported to include 2.1 trillion in deficit reduction over the next ten years. Yet these same numbers reported by the Congressional Budget Office shown that much of this savings is put off many years into the future. For 2012, savings amounts to a measly $21 billion, of dedicated cuts, plus an average of $120 billion per year over ten years that haven't been decided yet⁵, won't be decided until a Thanksgiving deadline, and may end up in much smaller cuts in 2012 if a different agreement is reached. Even assuming that next year's deficit cuts come to the full $141 billion, this is only about half the size of the cuts the British government made, relative to GDP, over a year ago.⁶

The automatic cuts in the debt deal are evenly divided between defense and other discretionary spending. Already, patrons of these big government programs are girding for battle to protect their places at the trough. Defense Secretary Leon Panetta, for example, denounced the automatic trigger as a "doomsday mechanism" that "would do real damage to our security, our troops and their families, and our military's ability to protect the nation."⁷ He argues that there should be no further cuts to the enormous Pentagon's budget under his control. Big surprise.

This goes to show that while people have been finally forced to look reality in the face, that doesn't mean they are going to go along quietly and accept it. Steep declines in international stock markets this week and last (despite strong earnings suggesting stocks are the best value in a generation), combined with a mind-boggling rise in demand for the downgraded U.S. treasury bills show that people are not behaving rationally given this new reality.

Acceptance will take time. When it comes, the public, the markets and even politicians will be forced to realize that the world will not end because the United States has an AA+ rating. The government will simply have to begin living within its means, and start to pay down its debts.

While this means Americans will have less free cash to spend on junk they don't need from consumer-oriented businesses, there will be plenty of opportunity for corporations to make money, and plenty of jobs for people with skills in demand by sustainable businesses.

The sooner people accept this reality, the sooner the world economy will be able to return to healthy growth. In the meantime, watch out for politicians and central bankers offering escapist theories and easy fixes. The rich world's debt problems are straightforward and very solvable, provided it is willing to endure the pain needed to right its course.

Related Web Columns:

Time For What Doesn't Feel Good, July 12, 2011

None Too Impressive, April 15, 2011

Living Like There's No Tomorrow, November 9, 2010

A Grek Canary in an American Mine, December 15, 2009

From America to Zimbabwe, March 24, 2009

Yawning Toward Disaster, September 2, 2008

1. Washington Post, Treasury, S&P Wrangle Minutes Before a Historic Downgrade, August 7, 2011

2. Marketwatch, Geithner Keeps Heat on S&P, August 7, 2011

3. Los Angeles Times, U.S. Credit Downgrade Unlikely to Fix Logjam in Congress, August 7, 2011

4. Telegraph, Geithner Insists Chinese Dollar Assets Are Safe, June 1, 2009

5. Congressional Budget Office, Letter to the Speaker of the House and the Senate Majority Leader, August 1, 2011

6. Economist, Ouch! June 22, 2010

7. Washington Post, Panetta Warns Against 'Doomsday' Cuts of $600 Billion in Defense Spending, August 4, 2011