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Spending cuts may salvage U.S. credit rating

A U.S. flag flies at the Capitol July 30, 2011 on Capitol Hill in Washington, DC. Members of the Congress continued to debate on the debt ceiling plan.

Alex Wong/Getty Images

American politicians appear to have avoided a self-imposed debt default, and likely have done enough to forestall an embarrassing ejection from the ranks of the world's most trustworthy borrowers.

But the longer-term damage done by the brinksmanship in Washington will only become clear once the current political turmoil eases and global investors readjust their compasses.

The compromise that took root on Sunday would slash spending to reduce the U.S. deficit by almost $3-trillion over the next decade, while restoring the government's borrowing authority before the Treasury Department starts to run short of cash this week. The size of the cuts may be enough to head off what last week seemed almost inevitable - a historic downgrade of the U.S. government's triple-A credit rating. A downgrade has the potential to cause upheaval in the world's financial markets.

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"It would be overoptimistic to say this is a big step forward, but it is a big enough initial step to satisfy the credit rating agencies," said Phillip Swagel, an economics professor at the University of Maryland who was chief economist at the Treasury Department during the financial crisis. "This is a down payment on future reform."

Though the agreement was being finalized Sunday evening, Prof. Swagel said he was confident the consensus would hold. The proposal had the backing of the leaders of both parties in the Senate. The final hurdle will be a House of Representatives vote.

The austerity measures were the key demand of the Republican-controlled House for agreeing to support the lifting of the $14.3-trillion (U.S.) debt ceiling before a Tuesday deadline - the moment the Treasury says it will run out of accounting tricks to keep the bills paid. Failure to pay bondholders would constitute the first default in U.S. history.

pending cuts will do little concrete to help an economy that is struggling to maintain momentum two years after a recession that, according to new data, was significantly deeper than previously thought.

State and local governments, scrambling to live up to balanced-budget laws amid weaker revenue as a result of the economic downturn, have been a drag on economic growth for three consecutive quarters, and now the federal government appears set to join them. There are no measures in Washington's compromise that would jolt demand, offsetting corporate American's reluctance to spend growing profits.

However, the prospect of Washington getting a handle on a budget shortfall that is more than 9 per cent of GDP could leave some executives feeling better about the investing in the United States. That dividend, if it comes, is weeks or months away.

Also, the dollar-value attached to the agreement appears large enough to get the credit rating agencies off the U.S. government's back. Earlier this month, both Standard & Poor's and Moody's Investors Service said they were considering stripping the U.S. of its gilded standing because of doubts over politicians' willingness to address rising debt levels.

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On Friday, Moody's said in a report that the U.S. likely would maintain its triple-A credit rating, despite what analyst Stephen Hess characterized as the "limited magnitude" of competing Democratic and Republican deficit-reduction proposals. However, Moody's concluded that the Treasury would ensure that bondholders are paid no matter what happens on Capitol Hill, and that faster economic growth next year will lessen the strain that the debt burden currently is exerting on the economy.

Also last week, Standard & Poor's president Devan Sharma told a House committee that his agency's report on the U.S. was being "misquoted," dismissing the widely-held notion that S&P would issue a downgrade if politicians failed to shrink the budget shortfall by anything less than $4-trillion. S&P believes a $4-trillion program would stabilize the growth of the U.S.'s debt-to-GDP ratio, but that doesn't mean that is what is required to maintain a triple-A rating, Mr. Sharma said.

The prospect of an end to the months-long dispute could ease the minds of investors, at least over the short term. Stocks in the U.S. tumbled last week even though many of the country's biggest publicly traded companies have reported strong earnings over the past couple of weeks. The U.S. dollar was weaker against its peers.

But there is disquiet in financial markets that Washington's protracted squabble over a legislative measure that was once dealt with as a matter of routine has done significant damage to the country's reputation as the world's leading economy.

"The compromise is not enough to offset the considerable economic damage already inflicted by the debt debacle, let alone restore confidence that the political system is able to respond to the serious structural challenges undermining growth and jobs," Mohamed El-Erian, chief executive officer of Pacific Management Investment Co., said in a commentary Sunday.

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About the Author
Senior fellow at the Centre for International Governance Innovation

Kevin Carmichael is a senior fellow at the Centre for International Governance Innovation, based in Mumbai.Previously, he was Report on Business's correspondent in Washington. He has covered finance and economics for a decade, mostly as a reporter with Bloomberg News in Ottawa and Washington. A native of New Brunswick's Upper St. More

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