The right wing is going to use this opportunity over and over to insist on cutbacks in the social safety net. Anything except raise taxes on wealthy people. I don't think it will work. There is no solution that does not include raising revenue as well as cutbacks in spending. As for those cutbacks, it is going to be up to the voters to pressure politicians to keep social support at existing levels.

I just posted something on this at The Agonist that you might find interesting:

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The S&P bond rating service put the AAA rating of the United States on warning today that the country faces a downgrade if it does not change direction in its fiscal policies. In technical terms this doesn’t mean anything immediately; S&P said the risk to the rating is a year or two away if deficit spending continues on its current trajectory. This is more like an auctioneer saying “fair warning” before letting the merchandise go for a dirt cheap price. The bond market didn’t pay too much attention to this development; people who are in the markets everyday already know that traders think it is only a matter of time before the US, UK, and other top-rated country credits lose their pristine halo for fiscal rectitude that is implied by a AAA rating.

The problem is the gulf between a AAA rating and any other rating is unbreachable. It’s almost like virginity; once you lose it you don’t get it back. This is especially so for the United States, which is the linchpin of the global financial system, and which has enjoyed nearly a century of preeminence in the markets, to the point where US Treasuries are the base (the “risk free rate”) from which all other bonds are priced. In fact, the US has long benefited from two critical attributes that are important to the management (and some might say exploitation) of global finance: the Treasury bond is the center of the international bond market from which all other bonds are referenced; and the US dollar is the reserve currency of the world. Both of these are now in danger of being lost.

Don’t think for a minute that this is a new development. It has taken decades of fiscal imprudence for the US to get to this point. Barack Obama and the US Congress will certainly take their share of the blame if the AAA rating is lost, but this ball began rolling downhill relentlessly with the George W. Bush tax cuts. His Vice President, Dick Cheney, was fond of saying that Ronald Reagan taught us that “deficits don’t matter.” Everyone who has ever worked in the bond market knows that deficits do indeed matter; they just don’t appear to on a day by day basis until some critical point is reached.

The “deficits don’t matter” philosophy does in fact go back to Ronald Reagan, and to the clowns who populated his administration (one of whom, Budget Director David Stockman, has redeemed himself by warning of the consequences of “deficits don’t matter” thinking). Arthur Laffer, the author of the Laffer Curve which argues that tax revenues can increase when tax cuts are enacted (at least up to a point), has not disavowed the damage done to fiscal policy by this nonsense. Grover Norquist is still out to “starve the beast” by making it politically dangerous for Republican politicians to raise taxes, thus creating endless deficits that supposedly will force Washington to cut back on spending. That never happened, because Washington grew to believe the US had an unlimited credit card. Consequently the beast was never starved, but instead grew ravenously year by year, until now it has begun to feed upon its host.

The S&P warning is a slap to the face of the Republican Party, which has campaigned for decades on the claim that the taxes you owe are money that is being stolen from you by a wasteful and bloated government. Over time, voters lost sight of the fact that taxes are payment for services rendered, and that politicians are elected to make the hard decisions about which services to provide and which to reject. What made it easy for Republicans to keep cutting taxes but not spending was their ability to borrow endlessly off a AAA rating. That privilege is now coming to an end.

The Democrats will have to get used to this as well. While never going as far as saying deficits don’t matter, the Democrats easily fell into the magical thinking of the Republicans. There never seemed to be any consequence to deficit spending, so why take deficits too seriously? President Obama is a perfect example of this. He has been able to afford a war in Iraq and Afghanistan, plus bailout the banks, plus expand unemployment benefits, without having to endure higher interest rates. He must have had an interesting weekend, with Tim Geithner having to explain to him the difference between a rating warning and an actual downgrade. This White House is not used to reining in spending, but it is going to have to get much more serious about it if it wants to avoid a rating downgrade by the next election. It won’t do anymore to brag about $38 billion in spending cuts while the federal government adds $50 billion to the deficit every two weeks.

The deficit spending of both the administration and Congress has been enabled in recent years by the Federal Reserve, which has monetized over $2 trillion of the federal debt. S&P said it did not take this Quantitative Easing program into account when it decided on issuing its rating warning, but it is hard not to notice that the biggest buyer of US government paper is now the US government itself. However you characterize it, you fall back on the fact that the Fed is printing money out of thin air, and using this money to buy up Treasuries on a weekly basis. The people who sell these Treasuries to the Fed – usually the big TBTF banks who are forced to buy them at the government auction – must be noticing that the dollars bill they are getting in exchange are increasingly thread worn.

Certainly the market is noticing; the price of everything tangible is going up and up because it has perceived real value, even silver and gold, which don’t pay dividends or interest. Central banks around the world have been complaining about the Fed’s reckless policies and the rampaging commodity inflation which is causing real suffering in poorer countries. The world has enough problem dealing with the inflationary pressure coming out of China; when the US adds its own inflationary splurge to the mix, the result can be catastrophic.

According to a lot of traders, S&P is three or four years too late in warning about the US deficits. It is not hard to believe, therefore, that now would have been an excellent opportunity for S&P to warn about Quantitative Easing. Instead it missed its opportunity. Perhaps, like many analysts, the S&P has trouble with answering a little thought experiment: if it is okay for the Fed to buy some of the Treasury debt, why not all of it, in perpetuity? Why should the US government go to the nuisance of selling its paper on the open market when it can sell an unlimited quantity to itself, and get real money in exchange?

The problem, as Germans with any sense of history will tell you, is that the US is creating unreal money at the Fed to obtain real money from the market, and over time the real money gets debased. Inflation sets in, and with everything in the markets, a point is reached where accelerating inflation cannot be controlled – too much thread worn paper is already in the market. This is precisely the sort of problem S&P should be warning about now, before that tipping point is reached. As it is, the ratings agencies will come to that conclusion when it is too late to avoid catastrophe.

A more recent expert on the risks of deficit spending might have some cogent advice for the US government. The Greek government is now coping with market rates on two year government paper in excess of 20%. Greek government securities are about as thread worn as any out there. The market is charging usurious rates for the Greek government just to roll over its debt – forget about adding any new borrowing. Well, that’s Greece you might say – a poor member of Europe with a struggling manufacturing base and overly generous pensions for its workers. Its outstanding debt in the market is equal to 100% of its annual GDP.

What many people don’t realize is that the US debt, now in excess of $14 trillion, is also at a level equal to 100% of its GDP. It can’t happen here, you still say – this is the United States, after all. Yes it can, and yes it will. This is the inexorable consequence of compounding mathematics on debt levels that only increase and never shrink. The tipping point is reached and the market demands much higher interest rates for government paper. That’s when American politicians will get very serious about reducing the deficit. The smoke and mirrors solutions being offered will be a thing of the past. The phony argument that the solution is to be found only in budget cuts will be seen as ludicrous. The government will be desperate for revenue too, and for that it will turn to the two sources left that have any money: the wealthy, and corporations.

The Republicans will be forced to jettison their sacred belief that growth and prosperity can come from cutting taxes and borrowing excessively to prop up consumption. The parasites which have thrived off such a policy – the financial industry – will have to shrink back to a far less important segment of society. The Democratic and Republican parties, if either of them survive the coming debacle, will have to return to their assigned responsibilities of deciding which of society’s priorities will get funded. And that AAA rating will be a thing of memory, perhaps never to return, just as the American position as reserve currency provider and centerpiece of the global bond market will have been squandered irretrievably.