CHART OF THE DAY: Goldman Says Debt Limit ‘Plan B’ Would Be A Big Deal

Little noticed amid dire warnings from Wall Street, and increasing cacophony on Capitol Hill, the investment giant Goldman Sachs issued a report late last week concluding that even if Congress passes a relatively small budget deal when they raise the debt limit, it will still be a promising indication to investors that the U.S. fiscal trajectory will improve over the coming decade.“[T]he hypothetical $1.7trn agreement we sketch out would meaningfully reduce the debt-to-GDP ratio over the next ten years. The debt reduction would reduce interest expense by more than $300bn, for a total of around $2trn in deficit reduction,” reads the report passed my way by a Wall Street source.

Likewise, it would reduce the primary fiscal balance (i.e. the deficit excluding interest expense) by nearly 1.5% of GDP toward the end of the decade. The trajectory of these ratios has become more important not only for the markets but also for rating agencies. In its July 13 announcement placing the US rating on review for possible downgrade, Moody’s indicated that it could change the US outlook to negative following a debt limit increase, and that to retain a stable outlook, an agreement should produce a “deficit trajectory that leads to stabilization and then decline in the ratios of federal government to GDP and debt to revenue beginning within the next few years.”

Using our baseline projections as a starting point, the $1.7trn agreement we outline would represent substantial progress, but would probably fall short of Moody’s criteria. That said, we view any agreement that is reached this year as a first step; tax and entitlement reform efforts look likely following the election in 2013. With a cyclically-adjusted primary deficit of around 6% of GDP in 2011, additional consolidation clearly will be necessary, and thus we view this as the first round of what will ultimately need to be multiple deficit reduction measures over the next few years.

Part of the deal Senate leaders are cobbling together would create an ad hoc Congressional Committee to streamline a multi-trillion dollar deal (beyond these initial cuts) to reduce entitlement spending and raise new revenue. However President Obama and Congressional negotiators say they’d still prefer to pass a deal that reduced deficits by $4 trillion over a decade, though they remain at a fundamental impasse over Democrats’ insistence that any “grand bargain” include sources of modest new revenue.

This report flies in the face of an earlier warning from the ratings agency S&P, which warned it might downgrade the U.S.’s credit rating slightly if the debt limit doesn’t include up to $4 trillion in deficit reduction.

One thing that shouldn’t be overlooked, and illustrated in this graph: Goldman’s debt analysis assumes the Bush tax cuts for high-income earners expire at the end of 2012, that the Iraq and Afghanistan wars wind down, and that revenues rise with an improving economy. Take any one of those constants out of the equation and the deficit forecast darkens, to the tune of up to many hundreds of billions of dollars. And then bear in mind that a separate Goldman analysis, issued Friday, downgraded its economic recovery forecast for the coming fiscal quarters.

And, of course, if all the Bush tax cuts expire as scheduled at the end of 2012, the debt forecast is significantly rosier.