The Silver Lining in the U.S. Debt Downgrade

Credit.com's Adam Levin on the silver lining in the downgrade.

Aug. 12, 2011— -- No matter which side of the political fence or economic Continental Divide you sit on, few can deny that this was the week that was. It began with the controversial debt-ceiling deal about which I wrote in my last column. Shortly after the President signed off and the legislation became law—a remarkably silly law, even in the context of a country with so many silly laws—Moody's issued a statement that it would not change the AAA rating given to US government debt, although the company's "outlook" was announced as negative. This signaled to the cognoscenti that there was about a one-in-four chance that the rating would be lowered in the short term. Moody's is one of the big three rating agencies that rate debt issued by corporations, governments, and investment banking products such as the now famous (or infamous) mortgage-backed securities which damn near destroyed the world economic order.

If the U.S. Credit Rating Goes Down, Your Credit Card's Interest Rate Goes Up

But then last Friday evening, Standard & Poor's, arguably the best-known and most important of the rating agencies, lowered its rating on U.S. debt from AAA to AA-plus. This was the first time in history that the U.S. debt rating fell below AAA. It came as a surprise to many—despite the endless discussion of the possibility of a ratings cut throughout the world media over the months-long course of the debt ceiling tragicomedy. Part of the surprise was the timing of the announcement, made after U.S. markets were closed for the weekend, though historically many businesses announce bad news on Friday evenings in the hope that panics can be averted if people have a few days to digest and reflect upon it. The first market reaction came when Asia opened on Sunday night, and then when Europe opened a few hours later but still several hours before trading began in New York.

Over the weekend, experts around the world explained why the actual lowering of the rating wasn't important, that it was already baked into the market's pricing of equities, and that it wouldn't have the effect of raising interest rates paid by the Treasury, or paid by us to our mortgagor or credit card company. Lots of reasons were given as to why the action by S&P was really a nonevent: after all, Japan's debt had been downgraded some years ago with no discernible effect on their interest rates or their economy as a whole. Everyone knew that the debt ceiling would be lifted anyway, and everyone knows that it always will be; and, of course, countries like France, whose debt-to-GDP ratio is much worse than America's, still have an AAA rating so any downgrading of U.S. paper was merely a blip.

By now, literally everyone in the world with access to a newspaper, television, radio, or computer knows what has happened since then. The Dow took a 640-point nosedive, along with every major stock market around the world. There was what is known on Wall Street as "flight to quality." Gold went over $1750 per ounce, the Swiss franc—always dull but very stable—went through the roof against every other major currency in the world—and guess what? Yields on treasury bills dropped, as a massive number of those flights to quality circled around but landed on the roof of the Fed. I could write endlessly about what happened, why it happened, and what it means politically, economically and globally–but I'm sure you've already read way too much from way too many people on those subjects without getting any real understanding of the facts or issues.

What's Really Going On

So let me take you through a very simple analysis, followed by a very simple analogy. Here's how I see it, and how I believe history will see it, stripped of all artifice and needless complication. When S&P lowered the rating on U.S. debt, it was the final nail in the coffin of denial about what's really going on in the United States economy and in the world. In explaining why the cut was made, S&P pointed out, however vaguely or discreetly, that political gridlock in the United States was a factor. It reiterated something it had alluded to in earlier releases, which was that the cuts agreed to in the debt compromise were not sufficient to solve the long-term problem—a problem that cannot be solved except by severe budget cuts and, dare I say it, significant revenue increases principally in the form of tax rate hikes for the rich, or the elimination of the now infamous Bush tax cuts, which were set to expire by their own terms at the end of last year but were extended to the end of 2012. Thus what S&P really said, much more loudly, persuasively and officially than it had ever been said before was—ENOUGH ALREADY!

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Let's go one more step. What precipitated this crisis—if there is one—was the adamant position of conservative Republicans that they wouldn't agree to any increase in the debt ceiling unless budget cuts were substantial and tax increases were off the table. Taking seriously the proposition that the debt ceiling might not be increased, President Obama acquiesced (either in frustration or with a greater purpose in mind) and gave them what they wanted. As Speaker John Boehner put it, "I got 98% of what I wanted." Indeed the President, in my view an intelligent, well-meaning and good man, never looked more hapless than he did in a television speech that he made during the trading day on Monday. He blamed the Republicans and tried to reassure America that we are in better shape than S&P would have us believe. The platitudes didn't work but the disruptive nature of the blame game, international frustration and fear escalated, and the market went straight down during Obama's speech, then to the bottom shortly thereafter. Meanwhile, as the Obama Administration was working feverishly to raise our collective spirit, Republican presidential hopefuls were whirling around the political bonfire screaming that we were being cluelessly led to financial slaughter by the first American leader to preside over an AA-plus nation. It didn't work for them, either.

As the week progressed, the market reacted in a classic see-saw of volatility that shaved trillions of dollars of equity value from its April high. Many pundits have opined that these wild trading gyrations and the rush into Treasuries and gold had more to do with fear and uncertainty over bank stability in Europe than the show put on in Washington and S&P's reaction to it. I concur. That said, I believe that bad theater and mordant politics mightily contributes to a loss of confidence in government and I agree with John F. Kennedy's assessment that the appearance of reality is oftentimes more important than reality. As much as I agree with so many of the things that have been said about these goings-on, and the terrible costs of the past ten days, I do believe that most people are missing the silver lining, and the true meaning of all this.

The Silver Lining

America, before FDR and the Great Depression, was a relatively conservative place, at least fiscally. As a response to the economic disaster he faced, President Roosevelt correctly started building government and building government programs, and the federal budget soared. To condense decades of history into a few sentences, what followed was World War II, which begat huge expenditures, the Marshall plan, the Cold War, the nuclear arms race, the huge demand for very expensive oil from the Middle East and the rest of the second half of the 20th century. And with only minor exceptions, after the New Deal, the federal government grew geometrically, and the federal budget increased proportionately.

There will be one lasting effect, and only one, of what happened in the last few days. Whatever else the conservative Republicans accomplished, however costly those accomplishments may be economically as well as politically, and however much their timing and tactics should be decried, something very important actually happened. The cycle of spending madness in Washington may well have been finally, and forever I think, broken. It is now PC to take the position that spending in Washington must be drastically curtailed, whether or not one believes that taxes should be increased. If you've ever had a bad fever that broke suddenly, you can understand this: the chills and ague always give way to a sweat, uncomfortable in itself but always, at least in retrospect, better than the illness that caused it.

I believe that Washington will never be the same after this week, and it will be different in a way that after some period of time—perhaps a very painful period of time—will be better for America and the rest of the world.

The simple analogy is really quite simple—after the Depression, America became a very rich and powerful country, and developed some very bad habits in the process. Just like a family: if it spends above its income when its income is strong, it becomes very hard to spend less when its prospects decline. We know intuitively what happens when we overspend, and the same thing happens to a country when it overspends. America's days of salad in the 1920s turned to steak in the '50s and caviar after that. We're hardly poor; we're still the richest country on earth—but we just can't sustain the growth rate that we would need to afford the spending we do. We have to learn to live within our means.

Like you, I believe that the events of the last few weeks were outrageous and that both parties embarrassed themselves and the nation. We must stop screaming at each other and have an adult conversation which leads to a reasonable, balanced solution that includes both permanent spending cuts and fair and appropriate revenue increases.

Like you, I am uncertain as to where we go from here as a country and as an economy. It's a very uncomfortable feeling. But sooner or later, I will be sleeping better at night, as should you, because whatever the costs of going cold turkey have been or will be, at least our children might finally be born addiction-free.

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Adam Levin is Chairman and cofounder of Credit.com and Identity Theft 911. His experience as former director of the New Jersey Division of Consumer Affairs gives him unique insight into consumer privacy, legislation and financial advocacy. He is a nationally recognized expert on identity theft and credit.