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4 possible costs of the debt-ceiling debate

September 17, 2012

| MoneyRates.com Senior Financial Analyst, CFA

Famed Watergate reporter Bob Woodward's latest book, "The Price of Politics," deals with 2011's standoff between Democrats and Republicans about raising the debt ceiling. This week, the bond rating agency Moody's provided a reminder that the price of politics may yet get steeper.

While not yet downgrading the U.S. credit rating, Moody's warned that the prospect for a downgrade seemed likely unless the U.S. government found a constructive way to address its debt situation. While a downgrade by Moody's alone is unlikely to directly impact the interest rates the U.S. government must pay when it borrows money, the warning by the rating agency is reflective of growing concern within the financial community about the fiscal condition of the U.S. That rising level of concern could eventually affect borrowing costs.

A tough needle to thread

In its comments on the challenges facing the government, Moody's correctly put its finger on the two variables that must be managed. Moody's called for the U.S. to produce a plan that would stabilize and then reduce the ratio of debt to Gross Domestic Product (GDP). Given the slow economy, this is a tough needle to thread: Budget cutting or tax increases could reduce debt, but doing either too severely could also drag down GDP. The trick will be to come up with a credible debt reduction plan that isn't seen as too damaging to economic growth.

This would be a tough challenge under any circumstances, but it is made all the more difficult by the dysfunctional relationship between Democrats and Republicans in Congress. As Woodward's book recaps, that relationship brought the nation to the brink of a fiscal crisis last year.

Paying the price in multiple ways

If the two parties can't make the compromises and sacrifices necessary to solve the fiscal challenge, then Americans could find themselves paying the price of politics in multiple ways:

  1. Credit concerns will eventually cause the U.S. to pay higher interest rates. In this instance, U.S. could also be written as "us" -- that is, American taxpayers.
  2. Savings accounts could get the worst of both worlds. Continued economic sluggishness could mean that savings accounts continue to pay minimal interest rates -- even as the government has to pay rising interest rates.
  3. Entitlements are on track to get out of control. Without funding and benefit reform, costs will escalate sharply as the American population ages.
  4. A stock market setback could cost more than a tax increase. The investment community seems likely to embrace a plan that includes steady cost-cutting with selective revenue increases. Such a compromise could very well result in a stock rally that rewards the wealthy by far more than the cost of any tax increase. Failure to find such a solution, however, could have the opposite effect.

Unfortunately, major elections tend to polarize political parties rather than bring them together. Unless that changes soon after the election, expect the price of politics to go up in 2013.

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