Default or downgrade. Those are the two options for the United States, in order of unpleasantness, if the politicians cannot come to some agreement soon on how to deal with their burgeoning debt levels.
While the chance of a default (which would lead to a downgrade anyway) is very low, there is actually a fair chance that we might see a downgrade.
A default means failing to meet the scheduled payments or other obligations on your debt, so in the case of the US Government this means being unable to follow through on the obligations for the government bonds that it has issued.
It's not uncommon for an individual to miss a hire purchase payment or a family to struggle to meet a mortgage payment, but the thought of the United States Government not being able to make one of its interest payments seems ridiculous, especially as a result of simple political dysfunction.
US government bonds have always been considered the ultimate safe-haven asset. Buying a 10-year US government bond (which is effectively lending money to the US Government) barely pays less than 3 per cent a year, a return that few New Zealand investors would be comfortable with. Part of the reason for this low yield is the anaemic outlook for the US economy and the expectation that the Fed Funds rate (the equivalent of our Official Cash Rate) will remain at its current near-zero level for some time.
But another big factor is that US Government bonds have always been seen as risk-free.
If investors began to see the US Government as a higher-risk borrower and began to demand a higher return from their bonds as a result, the effects would still be wide-ranging. It would lead to higher interest rates across the economy, which wouldn't be helpful given its already fragile state. Households in particular would suffer as mortgage rates increased, and businesses would also face higher borrowing costs. Even those with little or no debt would suffer, because they rely on consumers having money to spend.
The value of existing US government bonds would fall, as the existing bonds would have to be valued at a reduced price to compete with the higher rate that was now being demanded by investors for new bonds. This would mean that investors, banks and governments that have existing holdings of this US debt would see the value of their holdings fall. China and Japan are two of the largest holders of US debt, and we have already seen these countries move to diversify into other assets and currencies.
The reaction of financial markets is difficult to judge, but they would probably begin to price other investments as higher risk, given that the traditional starting point would now have moved. This could throw markets into turmoil, it would put banks and economies under pressure and create high levels of uncertainty among investors.
The more likely option is that there is no default, but there is still a ratings downgrade. Two of the major agencies that assign credit ratings are Standard & Poor's (S&P) and Moody's. These ratings are assigned on the basis of financial stability, risk and the ability to pay back debt.
A safer financial situation leads to a higher credit rating, which leads to lower interest rates and borrowing costs.
The US has an AAA rating with S&P, the highest available, and the equivalent with Moody's. However, S&P believes that the US is in a weak position compared with its closest AAA rated peers, which are France, Germany, the UK and Canada.
It is the only AAA country without a credible debt reduction plan, and both agencies want to see US debt on a downward trajectory over the next few years.
A downgrade from these high ratings has been threatened if the fiscal problem is not dealt with in a sensible and timely way.
A downgrade from AAA to the second highest, AA+, is not ideal, but it's not the end of the world either.
It might lead to higher borrowing costs which would see a slowdown in the economy, although the impact would be nowhere near as bad as that of a default.
Japan was downgraded from AAA in 2001, and has never regained that status. Canada lost its AAA rating in 1992, although a decade of fiscal consolidation saw that crown returned in 2002. Both these examples suggest that the impact of a downgrade on an economy can actually be reasonably benign in some cases. Japan had many other problems to contend with although it also had a very strong domestic saving base that was there to provide funding. However, the foreign-dependent US does not have this so the impact could be greater.
S&P has taken the strongest approach, having warned earlier this month that if Congress fails to find a credible solution to the rising debt burden there was about a 50 per cent chance of a downgrade over the next three months.
By "credible solution", S&P means the US has to find US$4 trillion ($4.6 trillion) of savings over the next decade.
Moody's has been slightly more guarded in its wording but is clearly concerned, and has also noted that without sufficient action the US will lose the top rating that it has held since 1917.
The major stumbling block to a solution is still political dysfunction and a desire from both sides to come out looking like the winner. Negotiations fell apart over the weekend with President Obama and Republican John Boehner ending discussions tersely, unable to agree over the details of the tax increases and spending cuts required to formulate a debt reduction plan.
I had expected it to be an 11th- hour solution, although the political stubbornness given the potential outcomes is still somewhat surprising.
For the record, I don't believe we will see the US default on its debt, but I do think there is a good chance that the US will be downgraded by at least one of the rating agencies. My guess is that we will begin to see the early stages of an agreement emerge soon and that a deal might be thrashed out by the time this column goes to print.
This would allow Congress just enough time to avert a default, even if the August 2 deadline was missed by a few days.
This would be good enough to avoid the worst case scenario of a default, but may not be enough to keep the risk of a downgrade away. The size and structure of an eventual proposal will be the determining factor, and at this late stage the odds of a comprehensive, multi-year deal that finds the US$4 trillion of savings that S&P wants to see are low.
A more likely outcome is a temporary extension of the debt ceiling that buys some more time for politicians to finally put together a sensible deficit reduction plan over the coming weeks that meets the rating agencies' requirements.
Or we might see a permanent plan, but one that only goes part of the way to addressing the rating agencies' concerns.
Whichever of those scenarios occurs, the threat of a downgrade is (at best) likely to be put on hold, rather than extinguished completely. And whether a downgrade is a big deal or not, markets will remain cautious until some certainty around this issue is found, and until then, volatility will remain high.
* Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on www.craigsip.com. This column is general in nature and should not be regarded as personalised investment advice.
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