08/01/2011 05:21 pm ET Updated Oct 01, 2011

Deficit-Reduction Plan Would Threaten Economic Recovery, Not Remove Downgrade Threat

NEW YORK -- The deficit-reduction deal that emerged late Sunday runs the risk of exacerbating two opposite problems at the same time: It cuts enough government spending to imperil a weak economy, yet not enough to spare the United States from the prospect that its credit rating will be downgraded.

The plan would cut $2.4 trillion in federal government spending over the next decade, an initiative that economists say could harm the economic recovery as growth remains painfully slow. With home prices falling, the unemployment rate rising and gross domestic product expanding at a rate that's worryingly close to zero, federal spending cuts or tax increases could hinder what little progress is being made, experts say.

But seen another way, the deficit-reduction plan might not be big enough: It falls short of the criteria that the credit rating agency Standard & Poor's alluded to last week. Fears that the U.S. government's debt might be downgraded have not been allayed, with some experts saying a downgrade could come this week.

The proposed deal pleased few and left many with a sense of unease. Stimulus programs the federal government still has in place -- unemployment benefits and the payroll tax cut -- are set to expire at the end of the year. Under the plan, cuts that start relatively small next year would increase over the course of the decade.

"If anything, the budget agreement in the short run is going to make things worse," said Gary Burtless, a former Labor Department economist and a current fellow at the Brookings Institution, in Washington. "By reducing spending even by very modest amounts in the short run, we're probably doing the exact opposite of what we ought to be doing if we want to lift the ranks of the employed."

The current conversation in the nation's halls of power, he said, is "a little like a debate over how much we should trim the government back in 1932."

The economy isn't officially in a recession, but it feels that way to many Americans. After it seemed the economic recovery was gathering momentum late last year, a variety of indicators showed progress slowing this spring. The unemployment rate rose back above 9 percent in April, and has continued rising in the ensuing months.

On Friday, the government announced the nation's gross domestic product grew at an annual rate of 1.3 percent in the second quarter, far below what economists had expected. First-quarter growth was revised down to 0.4 percent, close to recession territory.

The stream of gloomy data continued. On Monday, the Institute for Supply Management announced that activity in the manufacturing sector barely increased at all in July. The ISM's closely watched index, in which a value below 50 percent indicates contraction, logged just 50.9 percent, falling short both of expectations and of the previous month's measure.

New orders in manufacturing shrank for the first time since June 2009, the ISM said.

"The economy is incredibly fragile right now," said Nariman Behravesh, chief economist at IHS Global Insight. "Clearly it's not the time to be cutting spending or raising staxes."

But the deal economists say could threaten the economic recovery might also incite a downgrade, if spending cuts are deemed not deep enough.

Standard & Poor's has threatened to dock the sterling AAA credit rating of the U.S. government if the legislation to raise the debt ceiling doesn't come with a "realistic and credible" plan to reduce the long-term deficit. Even if the debt ceiling is raised before the Aug. 2 deadline set by the Treasury and the government avoids defaulting on its loans, S&P might still issue a downgrade.

The credit rating agency said late last week that a $4 trillion reduction in the deficit would be a "good down payment." The plan reached on Sunday, though, calls for cuts that don't come near that figure. The non-partisan Congressional Budget Office estimated Monday that the plan would reduce the deficit by at least $2.1 trillion between 2012 and 2021.

A spokesman for S&P declined to comment on whether a downgrade is in the cards, explaining that the company's analysts must first finish reviewing the details of the proposed deal.

But independent economists see a downgrade looming.

"This likely does not take the downgrade threat off the table," said Royal Bank of Scotland economists in a strategy note released Monday.

"We would not be at all surprised to see a rating downgrade come as soon as this week," the macroeconomic research firm Capital Economics said in a release Monday.

A downgrade could increase the U.S. Treasury's cost of borrowing, as its debt would be perceived as riskier. That in turn might increase interest rates throughout the economy that are tied to the Treasury rate, pushing up the price of getting a student loan, a car loan or a mortgage.

A reduction in the Treasury's rating, which it has held for nearly a century, could increase the government's cost of borrowing by $100 billion a year, said Terry Belton, global head of fixed income strategy at JPMorgan Chase, during a conference call last week.

Some economists said a downgrade to AA would cause only short-term disruption, which would later smooth out. Economists say there's no substitute for safe-haven Treasury debt in financial markets, even if it doesn't have a perfect credit rating.

"There might be an initial wobble in the markets, where maybe U.S. Treasury yields or borrowing costs might rise a little bit. The dollar might be hit, equities might fall back. But I think all of those moves will be fairly muted and short-lived," said Paul Dales, senior U.S. economist at Capital Economics, the firm that said a downgrade could happen this week.

A weak economy tends to push Treasury yields down, as investor demand for that debt increases. Persistently weak economic growth, Dales said, would ultimately counteract any effect of a downgrade.

"Markets will quickly turn their attention back to the economic fundamentals, which is a weak growth outlook and fading inflation fears," he said.

Other economists, though, maintain that a downgrade could significantly threaten the economy, hindering the meager progress being made.

"A reduction of the AAA rating would ultimately mean the economy has to deal with the burden of higher interest rates," said Bernard Baumohl, chief global economist of the Economic Outlook Group.

"Given that the economy right now is already very fragile," he said, "a rise in interest rates that would result from a downgrade would jeopardize this recovery."