S&P;’s warning to Uncle Sam

Credit rating agency Standard & Poor’s sounded the alarm Monday about persistent federal deficits, saying there was a 1-in-3 chance that it would downgrade U.S. Treasury bonds by 2013 from their current AAA level. Unless President Obama and Congress agree quickly on a meaningful plan to reduce the federal red ink, the agency said, the government could find itself too deep in debt within two years to justify its current, impeccable credit rating.

Such a move would force the federal government to pay higher interest rates on the money it borrows, adding billions of dollars to the deficit. It also would drive up costs for the many other debtors and those seeking new loans.

Evidently S&P wasn’t impressed by the recent activity in Washington, including the deal to trim the government’s spending authority this year by nearly $40 billion and the House-passed budget resolution that would cut projected spending over the next decade by almost $6 trillion. Nor should it be. The right response to the country’s fiscal problems is an enforceable, long-term plan to eliminate the deficit and start paying down debt, and Washington has yet to adopt one. But there are more hopeful signs on that front than S&P’s warning would suggest.

Financial markets don’t care about the magnitude of a country’s borrowing; they care about how large that amount is compared with its economy, as measured by its gross domestic product. When the publicly held debt reaches 80% of a country’s GDP, credit agencies start worrying about the country’s ability to manage its finances and stop its debt from growing. Debt levels well above a country’s GDP may leave the government unable to cover its interest payments even if it slashes services and raises taxes, at which point it will have no choice but to seek a bailout or default.

The total debt the United States currently owes to the public, which excludes $4.6 trillion owed to the Social Security Trust Fund and other governmental entities, is $9.7 trillion, or about 64% of GDP. S&P projects that the debt will rise to 84% of GDP in 2013, assuming solid but unspectacular economic growth and only a gradual decrease in the deficit. The agency noted that Obama and congressional leaders have laid out significant deficit-cutting goals. But in giving the country’s long-term outlook a negative grade — the first time the agency has ever done so — it said there was “significant risk” that there will be no agreement on how to reach those goals until after the 2012 elections.

That’s a reasonable assumption, considering how long Republicans and Democrats in Congress spent fighting over the comparatively measly cuts in funding for the rest of fiscal 2011. The agency’s skepticism resonated with U.S. investors, who drove stock prices down sharply Monday.

Congress and the White House can’t afford to ignore this warning shot. The credit markets gave Washington a pass as it ran up large deficits after 2001 to finance tax cuts and two foreign wars, and again when tax revenues collapsed and spending mushroomed in the wake of the 2008 recession. But the markets’ patience is limited, and they’re paying much closer attention than before to Washington’s balance sheet. If confidence in the government’s ability to repay its debts slips, the result will be far worse than a one-day drop in the Dow.

Yet there are hopeful signs in Washington too. House Republicans and the White House have both unveiled plans to slow the growth of entitlements, defense spending and other federal programs by trillions of dollars over the next decade. Both plans also call for an overhaul of the tax code that attacks the proliferation of costly loopholes, exemptions and deductions. Meanwhile, a bipartisan group of senators continues to close in on its own plan to stop the debt from growing faster than the economy. That plan is expected to include enforcement mechanisms that would cut spending and increase revenue automatically if Congress didn’t take the steps needed to hit its annual targets. Obama included a similar failsafe in the plan he released last week.

There are wide gaps between the plans, reflecting sharp differences over such things as the amount of tax revenue the federal government should be collecting and the right way to preserve healthcare for the poor and the elderly. But Washington’s current leadership has also shown that it is able and willing to bridge the ideological gulf between the parties, albeit with a lot of posturing along the way. The S&P report shows that the deals thus far haven’t impressed the credit markets. When it comes to putting the country’s fiscal house back in order, the real work has yet to be done.