A long-term deficit reduction compromise is needed to satisfy the market's concerns

Time is running out for Washington to get its act together on the debt ceiling. On Wednesday, credit rating agency Moody's put the U.S. debt rating on review for possible downgrade. It had warned that a formal review announcement would come if the debt ceiling dispute wasn't resolved by July. The firm says that it will downgrade the U.S. in August if the government misses a debt payment. But the rating agency also clearly states that raising the debt ceiling alone won't give it any confidence in the U.S.'s ability to tackle its broader deficit problem.

Here's the key section from Moody's statement:

If the debt limit is raised again and a default avoided, the Aaa rating would likely be confirmed. However, the outlook assigned at that time to the government bond rating would very likely be changed to negative at the conclusion of the review unless substantial and credible agreement is achieved on a budget that includes long-term deficit reduction. To retain a stable outlook, such an agreement should include a deficit trajectory that leads to stabilization and then decline in the ratios of federal government debt to GDP and debt to revenue beginning within the next few years.

Raising the debt ceiling isn't enough. Even though Republicans turned the debt ceiling debate into a broader discussion about the U.S.'s debt trajectory, the market appears to have embraced their approach. This means that there's no quick fix here: a substantial long-term deficit plan must be agreed upon by the two parties.

If such a plan doesn't arise out of the debt ceiling debate, then we almost certainly won't see one until 2013 at the soonest. Washington will have serious budget-talk fatigue after the current debate ends. Politicians also won't want to take any important, controversial votes as the big 2012 election season swings into gear this fall. The market does not want to wait that long for reassurance that the U.S. government intends to fix its deficit problem.

This has important implications for the current proposals out there. Slick political maneuvering to raise the debt ceiling might be popular in Washington, but Wall Street isn't likely to embrace any proposal that passes the buck on deficit reduction.

The idea proposed by Senate Minority Leader Mitch McConnell (R-KY) earlier this week serves as a shining example of what wouldn't pacify Moody's. He has suggested that Congress allow the President a sort of backdoor to avoid default. It would essentially give the President the power to unilaterally raise the debt ceiling unless two-thirds of Congress objects, but it would also allow Congress the ability to formally denounce the President's move (fuller explanation here).

Democrats love this idea, because it provides them the ability to raise the debt ceiling without having to endure the deep spending cuts that Republicans are demanding. Some Republicans like the idea, because it allows them an on-the-record vote against raising the debt ceiling, but still allows Democrats to raise it and avoid U.S. default.

But the market won't like the proposal for precisely the same reason that anyone living outside the Beltway probably finds it disgraceful: it fails to solve any real problem. The debt ceiling is a mere technicality. The actual problem is that U.S. borrowing is on an unsustainable path. If you look at the sovereign debt downgrades that have occurred elsewhere, you can see that U.S. debt is on a dangerous path.

If Washington fails to fix the problem now, then when will it? This is the precise question that worries Moody's, but is the rest of the market really as concerned? If a debt ceiling hike occurs without a deficit reduction plan, then we'll know pretty quickly. Rising Treasury yields will signal that Washington has failed to satisfy the market.

Image Credit: REUTERS/Larry Downing