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Debt-Ceiling Debate: Beware of a Ratings Downgrade

Yesterday, Fitch Ratings downgraded Minnesota from AAA to AA-plus. Minnesota is locked in a budget battle and was required to balance its budget by midnight on June 30 or face a shutdown of its government. Minnesota missed the deadline and the government is now shut down.

Notably, Minnesota has already begun slashing its public spending, including furloughing 20,000 of its 36,000 employees and shutting the doors to its state parks. Minnesota is losing revenue, the shutdown is taking $23 million of spending power out of the state's economy each week, and Minnesota may delay a $700 million payment to its public schools.

This delay highlights one of the tragedies of the budget deficits, which is that the first casualty always seems to be the future quality of our children’s education system.

Furthermore, the downgrade impacts Minnesota's $5.7 billion of general obligation bonds and will inevitably lead to higher borrowing rates for the state in the future, exacerbating Minnesota's fiscal problems.

Why should the administration and Congress care about Minnesota?

Uncle Sam taking money out of your wallet
iStockphoto
Uncle Sam taking money out of your wallet

The U.S. may be Minnesota on August 2. If the debt ceiling is not raised, the United States will officially be insolvent. In plain terms, the U.S. would be unable to pay its debts as they become due.

The administration would find itself in the precarious position of having to decide which obligations to meet and which obligations to stretch out. And as payments are not made, the rating agencies may downgrade the United States. This possibility bears repeating. The United States could be downgraded!

Is this such a big deal?

Perhaps the failure to raise the debt ceiling and a short-term technical default on public bonds or the inability to pay certain debts will not harm the U.S. But do our political leaders want to take that chance? Let's play what-if.

What if critical federal services are suspended? What if seniors who rely on their social security checks each month to live are not paid? What if federal courts close their doors? What if the United States is downgraded?

What if, in the face of higher perceived risk, China and Russia decide they will only lend money to the U.S. at higher interest rates? What if we witness mass protests or worse? What if our sputtering economy dives back into a recession?

But don't we have to reduce our debt?

Yes. I have been writing about the need to reduce our nation's debtfor more than two years. And yesterday (Thursday), a McClatchy-Marist poll demonstrated that 59 percent of Americans want the federal government to focus on solving the country's debt problems before focusing on the economic recovery.

The American public realizes that we need to lower the public debt to sustainable levels for our nation to be strong over the long term, and they are willing to feel some continued pain over the short-term to achieve this.

We have consistently seen the power of debt reduction in the corporate context. An over-levered corporation's growth opportunity is constrained. Once a restructuring is achieved and the debt is reduced to reasonable levels, corporate growth is unleashed, allowing companies to expand and compete. The public gets this and wants to apply these principles to our national economy.

Isn't that what the administration and Congress are trying to do?

Yes. The administration and Congress are in the process of negotiating spending cuts that aspire to cut our deficit and reduce our long-term debt, including our unfunded obligations to Social Security and Medicare.

These are complex issues that require a careful process and serious, multi-faceted solutions, which take time to properly develop. In light of this, it may not be appropriate to use the debt ceiling to force a solution.

Yet in some ways it seems logical. As raising the debt ceiling increases our debt, it does not seem unreasonable to negotiate now to assure that we cut spending in an amount equal to the amount we raise the debt ceiling.

However, the risks of failing to raise the debt ceiling could be too great. We are witnessing the administration and Congress simultaneously pointing guns at each other and themselves, daring the other to pull the trigger. Will the trigger get pulled? That's the $14.3 trillion question.

So, what needs to be done?

The administration and Congress need to lead, not play politics. They must sit down and prepare a long-term debt reduction restructuring plan, which will put the U.S. back on track to grow.

This will take time. This will take political will and courage. This will not be for the faint of heart. This will require compromising for the greater good. This will take negotiations and a workable solution to cut our public debt and reform our unfunded entitlement programs so we can grow over the long term.

And we need to raise the debt ceiling. We don't want the U.S. to mirror Minnesota. Beware of the downgrade and all the implications it would bring.

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Jon Henes is a partner in the restructuring group at Kirkland & Ellis LLP where he has led some of the most complex restructurings in the United States and abroad across a variety of industries, including media, chemicals, energy, manufacturing, real estate, retail and telecommunications. Jon has also frequently appeared on CNBC's "Worldwide Exchange" as a guest expert on various financial and economic topics, federal, state and local fiscal issues.