exorbitant pain

Overnight, the US found that its prior exploitation of the exorbitant privlidge had turned into something of a pain. S&P placed their AAA on a negative outlook, commenting that:

We believe there is a material risk that US policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation is not begun by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns.

The problem with Obama’s budget is that it didn’t do anything about the long term fiscal problems of the USA. The CBO’s projections show that the deficit never gets any better than 4% of GDP, and that as a result debt to GDP grows at a little less than 2ppts of GDP per year.

The problem is obvious – if this goes on debt to GDP goes to infinity. The specific problem is that expenses grew very strongly during the GFC, and that there is no plan to trim them back. The President’s budget makes things worse by trimming revenues.

Now, I don’t think it’ll go on.  US politicians have been here before – in 1996 – and they made ends meet. This time, however, it will probably be a little harder going – it won’t be like 1996 when an internet boom made revenues grow like topsy (you can see that revenues grew stronlgly relative to GDP in the mid to late 90s).

Why am i so confident? because the choice is no longer about how much to slow the recovery by shrinking the deficit. Either the government shrinks the deficit and therefore slows the recovery (the Fed could help a bit with more QE, or just a longer period at 0bps to 25bps), or the bond market hammers growth and the deficit widens.

The bond market can do this, as the US economy is more closely tied to the 10yr Government bond rate than any other economy — after all, this is the reason  Asian reserve manager purchases of Govt bonds were able to so twist the US economy that they sewed the seeds of this crisis…

So, the choice is to tighten fiscal polocy and slow the recocery but keep the AAA — or to loose the AAA, and have the bond market slow the recovery anyways.

I know what i’d prefer if i were running for re-election in 2012.