U.S. Debt Downgrade: When $1 Trillion Isn?t Nearly Enough

Standard and Poor’s, one of the Big Three ratings agencies, just downgraded the U.S. sovereign debt from a sterling AAA to a less trustworthy AA+.

By doing so, it has shattered a 70-year trend. For the first time in that long, the U.S. no longer enjoys the highest ratings and has arguably lost its "risk-free" status.

This, despite the U.S. economic, military, and technological lead in the world and despite the $1 trillion in spending cuts over the next 10 years.

The $1 trillion debt ceiling deal, however, is clearly not enough and represents yet another example of Washington’s habit of kicking the can down the road.

So what would have been enough?

The U.S. debt is over $14 trillion and reached 100 percent of GDP. An often-cited study by Ken Rogoff and Carmen Reinhart states that a healthy economy can handle no higher than a 90 percent debt-to-GDP ratio.

As for a dollar figure for deficit cuts, it would have to be at least $4 trillion over the next decade or so.

The $4 trillion figure initially came from the Bowles-Simpson fiscal commission. Since then, it has served as a useful reference.

Here is what S&P sovereign-rating chief John Chambers had to say about it on a conference call (via Fox News):

“The $4 trillion, depending on whether it is front-loaded or back-loaded, is not going to do the trick in terms of stabilizing U.S. government debt-to GDP ratios. But it takes you pretty far along. And I think a grand bargain of that nature would signal, you know, the seriousness of policy makers to address the fiscal issues of the United States, to actually stabilize the debt-to-GDP.”

The debt ceiling plan does provide for a bi-partisan commission to recommend $1.5 trillion in further deficit reductions. However, that’s still only $2.5 trillion in total, which is well short of what the U.S. needs to cut.

It’s ridiculous that President Obama and Congress cannot even stomach $2.5 trillion in deficit reductions in one sitting. What’s more troubling, however, is each side’s refusal to touch their "untouchables."

The Republicans refuse to touch tax hikes. The Democrats refuse to touch Medicare and Social Security. However, big changes need to be made to all three in order to meaningfully reduce the budget deficit.

Unfortunately, a looming default was not enough of a crisis to spur Washington to tackle these issues. The fear now is that only the bond market can scare U.S. politicians into real reform.

The bond market made Europe embrace austerity. It may be needed again to force reform upon the U.S.