James Pethokoukis

By prodding Washington to agree on a debt plan, Standard & Poor’s might achieve just the opposite. Its dour take on Treasuries could inflame the debt-ceiling debate, leaving little energy for a grand budget compromise. And the severe austerity S&P desires would have few takers anyway. Consider the following:

1)  Obviously the rating agency hopes its unnerving note will nudge lawmakers into reaching agreement on taxes and expenditures. Inaction until after the 2012 national elections risks an actual downgrade of America’s AAA bond rating.

2) But striking some mega-deal doesn’t have top priority on Capitol Hill. First up is the battle over raising the debt ceiling. Democrats want a clean vote on a bill, while Republicans are trying to tack on various debt reduction measures. The GOP quickly pointed to S&P’s statement as further justification of its bargaining position.

3) That the rating agency made no mention of the debt ceiling is irrelevant. Nor does it matter that Congress just released a report blaming S&P and its peers for triggering the financial crisis. Politicians take their friends where they can find them. And S&P’s warning is spurring Republicans to dig in. That helps ensure the negotiations will be arduous, requiring Capitol Hill’s nearly undivided attention until July and potentially pushing the country to the brink of default. There probably won’t be much chance to work on major changes to taxing and spending.

4) Such efforts didn’t have much momentum anyway. A bipartisan “Gang of Six” in the Senate is working on a proposal that draws on recommendations from the president’s debt panel. And it was gaining support among Republicans until House Budget Chairman Paul Ryan released his plan.

5) Even if Congress moves toward compromise, making S&P happy won’t be easy. A key metric for the firm is the ratio of net interest payments to government revenue. Goldman Sachs found that all the major reform plans would still allow that ratio to increase to levels that rating agencies would probably consider worrisome.  Avoiding that would require defense cuts, immediate cuts to senior benefits and/or tax increases. Good luck with that.

Given the acrimony, if S&P really wants Washington to act, it may find it actually takes more than a warning.

“To attract any Republican votes to a debt ceiling increase, you’re going to have to come up with some serious spending reductions and some budget process reforms. There is going to have to be a significant incentive.”

That is from my chat yesterday with Senator John Thune.  Now I think it is even more evident that getting a 2011 budget will be easier than increasing the debt ceiling to pay for it. I will add, however, that I think it is smart to try and use whatever leverage is out there to gain more spending cuts and budgetary reforms.

1. But right now the two issues are on separate tracks — and it looks likely that it will stay that way. The GOP-controlled House, with its complement of small-government Tea Party members, has already passed a bill that would cut domestic spending by $61 billion this year. Such a reduction would slash discretionary programs — everything other than defense and mandatory social spending — by an average of 25 percent. The Senate, run by Democrats, prefers to keep such spending flat.

2. Democrats may have the president in their camp, but more of them face re-election campaigns in 2012 than their Republican opposite numbers. Although another short-term fix is possible, after the give-and-take of a final deal to fund the government could include cuts of around $30 billion.

3. But Republican sources say there’s a long way to go before finding common ground, even within their party, on raising the debt ceiling. Adding to the uncertainty are new polls showing the American public unwilling to accept significant cuts in Social Security and the like. Another variable is a bipartisan group currently conducting closed-door talks to fashion a 10-year “grand compromise” on the budget. Their plan could emerge smack in the middle of the debt ceiling debate.

Bottom line: The path to avoid a debt default remains murky, though both sides know it would be a disaster.

Republicans aren’t scared to toy with the U.S. debt limit. Both parties now seem to agree that failing to raise the country’s borrowing cap would be a disaster. But brinkmanship looks likely as Republicans hold out for cuts far deeper than Democrats will easily accept. Pushed far enough, the tactic could still rattle Treasury markets.

Leaders inside the GOP certainly know their recent political history. And they have no intention of allowing their party to suffer a repeat of what happened in 1995. When Republicans took control of Congress that year, they squandered public confidence by being seen as responsible for shutting down the government in a budget dispute with President Bill Clinton.

The political damage would be far worse today if Republicans took the fall for making Uncle Sam look as though he might default on his obligations. But the GOP also must contend with its new Tea Party colleagues. The newcomers say they want to radically shrink the federal government in exchange for acceding to raising the debt ceiling. At $14.3 trillion currently, the limit could be reached in two months. One faction says it wants to cut non-security spending by 50 percent — also excluding Social Security and Medicare — by $2.5 trillion over 10 years. Sen. Rand Paul of Kentucky is prepared to go even further.

By contrast, President Barack Obama is looking to trim just $40 billion a year by freezing current spending at current levels. Reconciling what GOP spending hawks want and what Obama would conceivably accept will be difficult. Republican leaders are already planning for temporary gridlock. One option is to explicitly prioritize paying the interest on public debt. All other spending would need to be cut by $125 billion for each month the stalemate continues. Another path would be to raise the ceiling, adopt the Obama freeze but also include strict spending caps. Sen. Bob Corker of Tennessee and Sen. Claire McCaskill of Missouris have cooked up a bill that would do the following: “Put in place a 10-year glide path to cap all spending – discretionary and mandatory – to a declining percentage of the country’s gross domestic product, eventually bringing spending down from the current level, 24.7 percent of GDP, to the 40-year historical level of 20.6 percent.”

The release of Obama’s budget in two weeks will give a better sense of the gap between the two sides. Until it is closed, investors in U.S. bonds need to steel themselves for rhetoric that sounds more alarming than the consensus on the debt ceiling suggests.