bull tiltLast week, Congress passed the bill for an immediate $900 billion debt ceiling increase in exchange for the “hope” for “change” totaling $2.1 trillion in cuts over the next ten years, then passed the buck for the responsibility for finding the cuts to a 12-member fiscal firewall committee called the Congressional Joint Select Committee on Deficit Reduction. Before the end of the week, nearly 2/3 of the $900 billion was already committed, Fannie was holding its hand out for $300 billion more and Standard and Poor’s had thrown political caution to the wind, given the Treasury Department the finger and sunk America’s credit rating to AA+ for the first time in history.

The predictable play from the media and the Administration throughout the legislative process has been to demagogue conservative congressmen early on when those legislators insisted on the same type of spending cuts and systemic changes (i.e. a balanced budget amendment and $4 trillion dollars in cuts, the proverbial "Cut Cap Balance Act" passed out of the House and falling by six votes in the Senate) that S&P eventually implied support for in its statement released Friday. The media has changed their tone numerous times, ranging from feigned compliments designed to lure conservative “Tea Party” lawmakers to support the eventual poison pill, i.e., “this bill means the Tea Party conservatives run Washington”, to vitriolic denouncements within hours of final passage, i.e. “the Tea Party suicide bomber vote holdouts have caused a collapse in the markets.” In the wake of the S&P move, the familiar refrain is that this is the “Tea Party downgrade”.

The truth of the matter is more complicated, as is always the case in a free market economy rarely understood by Washington lawmakers and insiders bent on ever-increasing regulation in lieu of wealth creation. (Even White House Press Secretary Jay Carney admitted as much when someone slipped him the truth serum in a presser over the weekend causing him to gaffe, “the White House and Congress doesn’t create jobs, just the environment necessary for jobs to be created”). The subsequent shellacking of the DOW for nearly 700 points last week and another 634 yesterday has come in swift response to the “compromise deal”, as Wall Street investment analysts respond to the reality of more government debt in exchange for nominal cuts that fell far short of the $4 trillion dollars the Big Three credit rating agencies were calling for in advance of the deal. It’s almost as if the marketplace knows the cuts are a red herring in a town that rarely makes a true cut that is not buoyed by spending on the other end. (One only wishes the media would be honest enough to admit that the President did get his revenues, in the form of a hidden tax called inflation that hits the corporate jet owner as readily as the working stiff).

Investor risk instruments do not bow to political rhetoric. They are firmly fixed in market realities and the incentives provided by investor confidence. It takes more than the passage of a bill authorizing more debt and the release of more bonds to convince investors to purchase those bonds. At some point, the value of any product is determined by its relative availability and the existence of the product in the market does not preclude a market for the product. When this happens, de-leveraging occurs in response to the glut.

In the past, the plan for jump-starting the economy has worked thus; in order to stimulate spending in the marketplace, Treasury releases product (T-bills) and the Federal Reserve issues Federal Reserve Notes to purchase the government debt and, thereby, legitimize it and make resources available for government spending on jobs, debt service, entitlement spending, you name it. This creates an artificial market for the debt because, after all, there is a buyer, even though the buyer is, essentially (while unofficially) a central bank created in cooperation with the government back in 1913. The artificial nature of the arrangement is papered over by the old adage that Treasury bonds are protected by the “good faith and credit of the United States government”. After all, section 4 of the 14th amendment itself states that “the validity of the public debt of the United States, authorized by law...shall not be questioned.” The breakdown in the scheme happens when the power behind our government’s “good faith and credit” - the American taxpayer - is leveraged and destroyed to such a degree that they are unable to produce through GDP to a point where the world (and U.S. debt holders) takes notice. Investors go elsewhere or create a liquidity trap like the one we are seeing now where trillions of dollars sit on the sidelines to ride out the storm. It’s only a matter of time before the only buyer left is the one “in the family” - the Federal Reserve itself. The scenario becomes more or less like the entrepreneur who gets his initial seed capital from friends and family and tries to use the momentum to raise outside funding. What happens when outside funding sources balk at his idea, recognize that his only funding is coming from his own “friends and fools” network, and turn their back on him? The point of the analogy is, nepotism only gets you so far when you’re forced to go back hat in hand to the same source time and time again. Put another way, a leader with no following is just a lonely man out for a walk.

The good news is, buried in the grim reaper report of Standard and Poor’s are some roadmaps for a way out, if Washington will only give up its garbage-in- garbage-out fascination with producing mathematical illusion through the Congressional Budget Office and get down to an honest fix.

The S&P statement released Friday rationalizes its decision to downgrade U.S. debt for the first time in history on a number of factors:

. The Budget Control Act of 2011 “envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability.”

In other words, when non-discretionary spending (Medicare, Medicaid, Social Security, etc) make up well over half of the average federal budget and are hemorraging money from a non-existent trust fund, the answer is structural change of the manner in which benefits are distributed with an eye toward long-term solvency, not throwing more money down the rabbit hole.

.Regardless of the 2012 election outcome, S&P believes that “by then, the government debt burden will likely be higher, the needed medium-term fiscal adjustment potentially greater, and the inflection point on the U.S. population's demographics and other age-related spending drivers [will be] closer at hand...”

The obvious implication here is that, unless the trajectory changes, S&P has no reason to believe that there won’t be yet another need for additional debt, if for no other reason due to the aging demographics of baby boomers lining up to collect promised benefits.

The report gives an upside scenario where the net general government debt of the U.S. would rise from an estimated 74% of GDP by the end of 2011 to 79% in 2015 and 85% by 2021. The downside scenario projects the net public debt burden rising from 74% of GDP in 2011 to 90% in 2015 and to 101% by 2021. Contrary to the position the U.S. is in long-term, the report indicates that the debt burden of countries with similar difficulties like Canada, France, Germany and the U.K., will decline either before or by 2015.

Ultimately, all of this amounts to “put up or shut up” for Congress and the Administration. The S&P report represents an olive branch to the federal government alongside an unequivocal message - get your fiscal House in order while you still have the authority to do so or learn that authority is not absolute in a global marketplace that does not bend to your rhetorical whims.
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