NEW DOWNGRADE THREAT

Supercommittee failure could trigger US credit downgrade, economists warn

Economists predict dire consequences if committee fails to reach agreement on how to reduce America's massive debt

Dominic Rushe in New York
guardian.co.uk, Friday 18 November 2011 12.45 EST


Economists are warning of dire consequences if US politicians fail to make progress this weekend in tense talks aimed at reducing America's massive deficit ahead of a Wednesday deadline.

The bi-partisan congressional super-committee is charged with drawing up plans for a $1.2tn reduction in the nation's deficit by the middle of next week. Failure to do so will trigger an automatic "sequester" that will make cuts of that size to defence and social welfare programmes starting in 2013. But the two sides seem far from finding a solution after clashing over tax revenues.

While Wednesday is the official deadline for the supercommittee to report back, it has until Monday to tell the Congressional Budget Office about the impact any plan they send to Congress will have on the budget.

"Time is running out. What I can say is we are leaving no stone unturned, negotiations continue and we are looking to find a way. We recognise what's at stake and we're hoping to reach an agreement," Democrat committee member Chris Van Hollen told CNN Friday.

Failure to reach an agreement on what is essentially a small reduction on the deficit – just 0.7% of gross domestic product in 2013 – could trigger another rating's agency downgrade, warned economists including Paul Ashworth, chief North American economist at Capital Economics.

"With all this pressure to reach an agreement, it really doesn't look good if they can't find a solution," said Ashworth.

He said that the US had much more serious problems that would need tackling first.

"The US is already spending 7% of GDP on Medicare and Medicaid [the government-run health schemes] and that will be up to 10-11% in the next two decades. Debt is on an unsustainable path, and if they can't reach an agreement on this, it doesn't look good for the future."

Ratings agency Standard & Poor's cited the "extremely difficult" political conditions in Washington when it made the controversial decision to downgrade its rating on US debt in August. The firm also put the US "on watch' implying further cuts could come.

Morgan Stanley analyst Christine Tan predicted earlier this month that there was now a one-in-three possibility of another downgrade.

"If the supercommittee fails to reach a $1.2tn deficit reduction deal, if such a deal relies more upon accounting changes than real deficit reduction, or if congressional action lessens the impact of the $1.2tn automatic trigger, we believe this could potentially provide S&P with a pretext to downgrade the US further from AA+ to AA," wrote Tan in a note to investors.

HSBC's chief economist, Kevin Logan, said a "procrastination" solution was now the most likely outcome, with an agreement that specifies targets for spending cuts and revenue increases but leaves the details to congressional committees.

Passing the the hard choices back to congressional committees would lead to "lengthy and heated battles over the US deficit throughout 2012, we believe. The rating agencies might be tolerant of this for a while, but failure to make clear progress could lead to downgrades of the US sovereign credit rating at some point next year," Logan said.

David Semmens, US economist at Standard Chartered, said: "I think they will be forced into action. If not the consequences will be long-lasting. Failure will further highlight the political deadlock in Washington. It's very important the the supercommittee sends a strong message to the markets that the US is getting its house in order."

Stock markets are already under pressure form the credit crisis now sweeping Europe and further signals of a lack of leadership in the US could have negative consequences for the markets, said Semmens.

One of the major sticking points facing the supercommittee is what to do with Bush-era tax cuts that are set to expire at the end of 2012. Republicans are against any agreement that does not extend current income-tax rates.

Democrats want them extended only for lower- and middle-income Americans. Extending all the Bush tax cuts would add about $3.7tn to the deficit over the next decade.

Like the automatic deficit cuts, the Bush-era tax cuts too will automatically expire unless an agreement is reached. Gus Faucher, director of macroeconomics at Moody's Analytics, said: "We will see deficit reductions whether the super committee makes an agreement or not."

He said the "level of enmity" between Republicans and Democrats did raise concern, but he expects that some agreement will be reached.