The danger is from the spending cuts, not the potential downgrade

The headlines are all about the risks of default or a too small deficit reduction package causing a downgrade of US debt.

And while markets react to those issues, they all miss the point.

The consequences of a downgrade to US govt debt are minor at best.
Note that when Japan was downgraded below Botswana,
with a debt/GDP ratio nearly triple that of the US,
interest rates remained the lowest in the world

The real risk comes from the spending cuts.

No debt ceiling extension is the worst case-
Government spending falls by some $150 billion/month as expenses can’t exceed revenues
Fed Chairman Bernanke mentioned that might reduce GDP by a full 6%
And that’s just the first order effect, as a falling economy means falling tax revenues,
Which means further reductions in Treasury spending in a pro cyclical nightmare.

And if they do extend the debt ceiling it will be with prescribed spending cuts.
This too adds drag to the economy.
The more the cuts are meaningful and immediate, the more the drag on the economy increases.

Because the markets don’t yet understand this,
the feedback they are giving is misleading policy makers,
and encouraging them to make deeper, more meaningful cuts.

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