Washington Moves Slowly After Debt Warning

Standard and Poor’s unexpected announcement yesterday that it had put United States sovereign debt on watch with “negative” implications shocked Washington. But while Congress may heed the warning and raise the debt limit, it’s unclear if S&P’s announcement will push both parties to a longer-term debt stabilization plan.

The White House called the S&P announcement “a political” document;  Secretary of Treasury Tim Geithner said it provided more impetus for a long term debt agreement;  and Japanese officialdom said this morning that the United States bond market was still a good place to invest under current circumstances.  More importantly, neither China nor Europe had anything to say on the S&P announcement.

As in the story, “The Dog that Didn’t Bark,” China’s silence comports with its earlier announcement this year that it was paring back on its American sovereign debt holdings.  Along with the decision by the largest bond fund in the world, PIMCO, to sell all its American debt, it’s clear market participants view the upcoming three to five years as critical to the relative security of United States issuance.

S&P has a reputation of being the most cautious of the American-based rating agencies, so its analyses draw a little more attention than other sources.  All rating agencies have suffered as the financial crisis revealed a business model that some believe called into question the validity of their ratings.  However, the rating agencies moved quickly to identify the European debt crisis and downgraded quickly the sovereign debt of several countries.  Subsequent facts have validated rating agency behavior in the case of Euroland.

What did S&P really say?  It said that it was putting American long-term debt on watch with negative possibilities.  It based that action on a judgment -- a forecast if you will -- of how budget negotiations will turn out in Washington.  Since the budget process will be inherently political, it’s fair to say that S&P was making a judgment about how political behavior in Washington will evolve.  Thus, the White House was obliged to say that it was confident in the ability of Congress and the President to reach a significant long-term debt agreement that will reduce projected indebtedness over the next 20 years.  In essence, the White House’s political forecast differs from S&Ps.

As we wrote yesterday, Members of Congress aren’t hearing too much about debt and deficits on this two-week recess.  Most talk will be about $4 a gallon gasoline, lack of jobs, flooding and tornadoes, and home foreclosures.  The President, to his credit, has begun a speaking tour in which he will use the bully pulpit to pound home the message that America must act now on a long-term debt reduction plan.  When the recess ends, we expect that the Senate’s “Gang of Six” will have completed their plan for deficit restraint.  Senate Budget Committee Chairman Kent Conrad is a serious fiscal thinker who has announced that he will not run for re-election.  He certainly wants to do all he can to leave behind a legacy of real accomplishment in budget policy.

So, all the elements for a possibly productive budget settlement seem in place.  Meetings under the aegis of Vice President Joe Biden will start the first week in May, with representatives from the House, Senate, and Administration.  Senior staff from Congress and the White House have substantial prior experience in dealing with large budget negotiations.  Deficit hawks can take some solace from these steps forward.

But (isn’t there always a “but” in Washington?)—Members of Congress will also hear during this recess period from all the groups that oppose any changes to Medicare, Medicaid, Social Security and other entitlements in the federal budget.  We can expect demonstrators, waving of placards, all the usual picture posing that such events bring.  Also there’s good reason to fear that many “middle of the road” Senators and Congressmen will be taken aback by the fury of opposition and may come back to town with less than a happy face.

Nothing can happen without the President.  How he approaches his natural political allies who oppose any change to entitlements, and who want higher taxes across the board, will be the key point in negotiations.  Will the President continue to move more to the center of the political spectrum despite liberal grumbling?  So far, he remains slightly aloof, having no detailed plan of his own to tackle entitlements, but urging others to do so.

Yes, the debt ceiling will increase by Congressional vote sometime this summer.  And, yes, the United States will pay its debts promptly and in full.  But failure by Congress and the Administration to achieve a real, verifiable debt stabilization agreement will mean that another 18 months to 2 years will pass without progress on the most critical economic dilemma facing the country.

As we have said many times before, the bond vigilantes may be snoozing right now as investors continue a flight to perceived safety of principal in difficult international times.  But, when Ben Bernanke stops being buyer of last resort for Treasuries, and Congress and the Administration dither, maybe the bond boys will awaken.

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