The Federal Deficit -- Is Another Downgrade Aaa Big Deal?

A Little History on US Debt

The US government has not always run a deficit. In fact, when looking back at the US debt’s financial history, the US has really only run deficits during wartime or during financial crises-- until the 20th century. In the 20th century, the US acquired more significant deficits both in war and peace times. These occurred following WWI, the Great Depression, and WII, and in almost all years since 1960, whether we were at war or not (Chantrill).

 US Debt (% of GDP since 1792)

In the current millennium, public debt has increased by over $500 billion each year since 2003, with increases of $1 trillion in 2008, $1.9 trillion in 2009, and $1.7 trillion in 2010. As of mid December, the gross debt was over $15 trillion, $10.5 trillion held by the public and $4.65 trillion from intergovernmental holdings.

What Is A Deficit And Is It A Problem?

How is this deficit created? Simply, the federal government spends more than it takes in from its receipts (ex: taxes), so it borrows money to carry out what it promises that we will receive as benefits, including Medicare, new roads, defense, education funds, and so on. Is this really a problem?

Yes in the long-run and no in the short-run. In the long-run, if the US continues to borrow to meet its bills, there will come a point when its loans become more risky and lenders will start requiring higher interest rates. The concept is similar to when an investor requires a higher rate of return when he lends money to a company that is already in debt up to its eyeballs, and continues to acquire more debt. If the US government were a company, it would be selling junk bonds. Ironically, though, US Treasuries are currently considered among the safest assets in the world. Funny, isn't it?

In the short-run, it is not a problem and this is because, believe it or not, markets are not nervous about lending to the US. In fact, last August when S&P downgraded the US government's credit rating, its borrowing costs actually fell further. Clearly, the markets disagreed with the rating agency. But, what if another rating agency downgrades US government debt?

Another Downgrade?

Today, another rating agency, Fitch, warned the US of a credit downgrade, unless we solve our growing debt problem. Last month Fitch put the US on negative outlook, citing the failure of the special congressional committee to agree on at least $1.2 trillion in deficit reduction measures.

Fitch said in a statement, "Federal debt will rise in the absence of expenditure and tax reforms that would address the challenges of rising health and social security spending as the population ages... the high and rising federal and general government debt burden is not consistent with the U.S. retaining its 'AAA' status despite its other fundamental sovereign credit strengths" (Huffington Post).

So, what are we doing to fix this problem?

Fixing the Budget: What is the Super Committee?

We've all heard of the US budget "super committee" but what exactly is it, and what has it done to help fix the debt problem? The super committee, formally the "Congressional Joint Select Committee on Deficit Reduction," was created through the Budget Control Act of 2011 signed by President Obama and is made up equally of Republican and Democrat lawmakers to help control our federal government's budget deficit. The hope is that the committee will agree on some $1.2 trillion in budget cuts over the next 10 years. Now, however, we are just scuttling by, as last August we did not default on our debt by immediately raising the debt ceiling (a power of Congress) by $400 billion. So basically, we just borrowed more to pay off the interest payments and debts we already owe.

Last month, because of political gridlock, the super committee failed to come up with a budget plan. The Republicans did not want any tax increases and wanted to protect the tax cuts for high earners while Democrats did not want to make cuts in Social Security -- Medicare & Medicaid -- unless Republicans agreed to tax increases. Unless the committee comes up with $1.2 trillion in cuts by 2013, there will be automatic across-the-board spending cuts by our government.

Surely, controlling our spending will be one of our greatest challenges in coming years. As for now, there seems to be no real solution as Fitch continues to threaten a downgrade.

Another Downgrade May Not Be A Big Deal? What Now?

Fitch will probably cut the US's AAA rating by the end of 2013 if Congress is unable to formulate a plan to reduce the budget deficit after next year's congressional and presidential elections. For now, rating agencies will continue to warn Congress to get its act together and make cuts. Overall, like the European sovereign debt crisis, this issue is a slow moving train wreck and will continue to make headlines until fixed. 

Although a major problem in the long-run, the US government has the ability and tools to help avoid the consequences of overspending--such as higher borrowing rates-- by limiting our spending. Also, unlike individual EU nations, we are able to control our money supply more easily and if we have trouble paying our debts, the Federal Reserve can print more money to help repay them. Based on the past response of the markets to a downgrade and the faith of the markets in the US government to repay what it owes, I do not think that another downgrade by a rating agency, such as Fitch, will have a large impact on markets.