07/21/2011 12:34 pm ET | Updated Sep 20, 2011

Debt Ceiling Misconception and Deception

The debt ceiling debate that has dominated the headlines over the past month has been thoroughly infused with a string of unfortunate misconceptions and a number of blatant deceptions. As a result, the entire process has been mostly hot air. While a recitation of all the errors would be better attempted by a novelist rather than a weekly columnist, I'll offer my short list.

After having failed utterly to warn investors of the dangers associated with the toxic debt of entities like Enron, Fannie Mae, Freddie Mac and AIG, as well as the perils of investing in mortgage-backed securities and sovereign debt of various bankrupt countries, the credit ratings agencies (CRAs) have now apparently decided to be more vigilant. A key feature of this repentance may have been its conspicuous warnings that the U.S. could have its debt rating lowered if Washington failed to make progress on its fiscal imbalances. But then, just in case anyone was getting the impression that these rating agencies actually cared about fiscal prudence, Moody's suggested this week that its concerns would be lessened if Washington were to make a deal on the debt ceiling or if it would simply eliminate its self-imposed statutory debt limit altogether. In other words, Moody's believes that our nation's problems are more a function of squabbling politicians rather than a chronic, unresolved problem of borrowing more than we can ever hope to repay.

With or without a deal, the CRAs should have already lowered their debt ratings on the $14.3 trillion in U.S. debt. In fact the rating should be lowered again if the debt ceiling is raised. And it should be lowered still further if we eliminated the debt ceiling altogether. To lower the rating because the limit is not raised is like cutting the FICO score of a homeless person because he is denied a home equity loan.

Republicans are making another misconception about the debt ceiling debate if they believe they can dramatically cut government spending without hurting the economy in the short term. A recent poll from Pew Research Center for the People and the Press showed that 53 percent of GOP and 65 percent of Tea Party members said there would be no economic crisis resulting from not raising the debt ceiling.

They argue that leaving money in the private sector is better for an economy than sending the money to Washington to be spent by government. That much is true. But a very large portion of current government spending does not come from taxing or borrowing, but from printed money courtesy of the Fed. If the Fed stops printing, inflation and consumption are sure to fall. While this is certainly necessary in the long run, it will be nevertheless devastating in the near term.

Over the last decade and a half our economy has floated up on a succession of asset bubbles, all made possible by the Fed. Our central bank lowers borrowing costs far below market levels. Commercial banks then expand the money supply by making goofy loans to the government or to the private sector, mostly to inflate asset prices. As a consequence, debt levels and asset values soar. Without fail, asset prices and debt levels soon become intractable, and the Fed and commercial banks are forced to cut off the monetary spigot, either on their own volition or because the demand for money plummets. The economy is forced to deleverage and consumers are forced to sell assets and pay down debt. Recession ensues. That's exactly what would happen once $1.5 trillion worth of austerity suddenly crashes into the economy come Aug. 2. Republicans would not survive the political fallout.

And then there is the deception that comes courtesy of the Democrats, who believe we need to raise taxes in order to balance our budget. The American economy produces $15 trillion in GDP per annum but has $115 trillion in unfunded liabilities. With a hole like that, no amount of taxes could balance the budget. Raising revenue from the 14 percent of GDP, as it is today, to the 20 percent it was in 2000 would barely make a dent toward funding our Social Security and Medicare liabilities. Therefore, we need to cut entitlement spending dramatically. But the Democrats refuse to face the obvious facts.

With the Tea Party gaining traction in Congress and causing nightmares for incumbents, Republicans have little incentive to raise the debt ceiling (although they raised it seven times under George W. Bush). Democrats aren't going to reduce entitlements without raising taxes on "the rich," and Republicans aren't going to raise taxes when the unemployment rate is 9.2 percent. There's your stalemate, and anyone expecting a significant deal to cut more than $4 trillion in spending by the Aug. 2 deadline will be severely disappointed. Although there has been some movement by the so-called "Gang of Six," a group of centrist senators, in recent days, a real deal may be more unlikely than most people think. And even if a much smaller deal of appeasement can be reached in time, the credit rating agencies may follow through on their promise to downgrade our sovereign debt. The fallout from such a downgrade of U.S. debt will prove quite damaging to Treasury prices. But an even worse outcome will occur if we continue to raise the debt ceiling without significant spending cuts, and then receive the real debt downgrade from our foreign creditors.

In my opinion, the best news for the long-term future of this nation is the Republican "cut, cap and balance" plan that just passed the House, which should also include a limit on government spending as a percentage of the economy. It now heads to a much harder hurdle in the Democrat-controlled Senate, and then if it passes that, to a certain veto from President Obama. At least something so promising got to the table at all. However, I think the country needs some more tastes of brutal reality before such bitter medicine has a chance of going down.

Michael Pento is the Senior Economist for Euro Pacific Capital.