On Monday, Standard and Poor’s pinned a “negative” rating on the United States fiscal outlook.  US stock markets reacted poorly.  The Dow fell 140 points (1.14%) and the other major indexes suffered similar declines.  The S&P report and the market’s reaction puzzled some analysts.  “The idea that the U.S. public finances are on an unsustainable trajectory is hardly new news,” said Capital Economics (as reported in New York Times).  Indeed, the fiscal situation might be a little rosier now given that both sides have started pushing plausible plans to reduce the debt.  But those plans and the rhetoric surrounding them don’t necessarily fuel optimism.  The Republican plan, put forward by House Budget Committee Chairman Paul Ryan, basically reiterates the party line that the debt is a spending problem alone and that tax increases must not be part of the solution.  The president’s plan repeats the campaign pledge to finance debt reduction with new taxes only on millionaires.  While there’s more encouraging news coming from the Senate, it’s not at all clear what will keep us from driving off the cliff. The bottom line is that the news about the S&P report scared me.  Yeah, it is probably a false alarm.  It might even serve the salutary purpose of frightening the political establishment into working together to prevent a debt crisis.  But it might also mark the point at which the bubble in the market for Treasury securities bursts. The bubble scenario is this:  US Treasuries are a safe asset only as long as investors believe they are.  As the safe asset, they command incredibly low interest rates.  The Treasury can borrow short term at an interest rate of ¼ percent.  As long as interest rates stay really low, Treasuries are completely safe.  The US can always roll over its debt as it comes due and interest payments will be manageable for a very long time. The problem arises if people start to believe that Treasuries might be risky, say because of a negative report from a ratings agency or some other kind of shock.  If the market started thinking that way, they would demand a higher interest rate, but at higher rates, our debt becomes much less manageable.  There’s also fallout for the private sector, which might be thrust back into a recession.  That would depress tax revenues and add to spending pressures, further adding to the debt.  If markets figure this additional risk into their assessment, they’d raise rates further, which would just make the problem worse.  Very quickly, the US government might not be able to borrow at any reasonable rate. At that point, we become insolvent.  If the debt crisis occurred now, we’d probably muddle through, although not without serious damage to our fragile economy.  And given that our debt, while large, could be easily managed in a less dysfunctional policy environment, I’d bet that this isn’t “the big one.” But the scary thing is that the bubble will burst eventually, when financial markets lose confidence in us.  It’s probably not now, but that means that the bubble could get much bigger before it explodes.  As the saying goes, “the bigger they are, the harder they fall.” Warranted or not, I’m hoping that the S&P report serves as a wake-up call.