Signs of impending economic collapse, or needless fear-mongering?

Headline news in most American newspapers this morning was the rating agency Standard and Poors lowering its outlook on the United States because of our growing budget deficit and national debt. Noting the political gridlock in Washington, S and P said there was a one in three chance that it could lower its long-term rating on the United States within two years.

The announcement triggered an immediate upward spike in the interest rate that the U.S. has to pay on its debt, and a drop on American stock markets. In response Treasury Secretary Timothy Geithner sought to reassure investors that Republicans and Democrats would be able to reach a deal to halt the growing deficits and debt. He strongly disagreed with the Standard & Poors assessment of the nation’s outlook.

This added to earlier signs of economic crisis including the disclosure that the world’s largest bond investor, manager of the world’s largest mutual fund, has sold off all its U.S. government-related holdings. Bill Gross, the legendary founder of PIMCO, the Pacific Life Investment Management Company, predicted a drop in the value of U.S. treasury bonds as the political gridlock continues, and said, “Investors like us, we sell now.”

Perhaps the most dramatic suggestion of impending economic Armageddon, was former chairman of the Federal Reserve Alan Greenspan’s call on Sunday for repeal of the Bush tax cuts to raise revenue to reduce the deficit and national debt. This is the same Alan Greenspan, champion of laissez-faire economics, disciple of Ayn Rand, appointed to chair the Federal Reserve by Ronald Reagan, who supported the tax cuts when advocated by President George W. Bush.

Although Republicans want to make the Bush tax cuts permanent, and President Obama wants to repeal them only for upper income taxpayers, Alan Greenspan now says, “This crisis is so imminent and so difficult that I think we have to allow the so-called Bush tax cuts all to expire.”

Should we all start hoarding food, gold, and guns? Maybe not. The flood of dramatic economic concern may actually push the political parties towards the necessary compromises to attack the deficit and debt crisis, which have to include both spending cuts and tax increases.

And even if the political gridlock continues, the Bush tax cuts expire automatically at the end of 2012, and the higher tax rates now advocated by Alan Greenspan kick in automatically in 2013 even if Congress does nothing. This is because the Republican Congresses that enacted the Bush tax cuts in 2001 and 2003 did so in response to the short-term economic crises caused by the collapse of the internet stock bubble and then the terrorist attacks of September 11, 2001.

The Republican leaders in Congress recognized back then that making the tax cuts permanent would be financially irresponsible, and specified that they would automatically expire at the end of 2010. Only the short-term compromise negotiated by President Obama and congressional Republicans last year extended the tax cuts for two more years to the end of 2012.

So all the bad news may actually be good for political compromise. And thanks to a previous generation of congressional Republican leadership, the worst-case scenario of continued political gridlock may actually contain some self-correcting mitigation.