Here's how it all can come apart, and why Congress - and Obama - are both on the wrong track.

Note this story from Bloomberg:

Political wrangling over a plan to reduce the deficit may cost the U.S. its AAA rating, adding $100 billion a year to government costs while dragging down economic growth, according to Wall Street bond dealers.

A U.S. credit-rating cut would likely raise the nation’s borrowing costs by increasing Treasury yields by 60 to 70 basis points over the “medium term,” JPMorgan Chase & Co.’s Terry Belton said today on a conference call hosted by the Securities Industry and Financial Markets Association.

But that's just the start, you see.

Right now rates are at historic lows.  So let's presume that the economy "improves"; if that happens then rates go up.  In fact, there was a hearing this afternoon in the House Banking Subcommittee talking about exactly that.

Here's the current Treasury MTS; it shows total interest on the public debt last year was $355 billion, and this year thus far is $386 billion.  This implies (on a grossed-up 9/12ths basis) that the blended interest rate on the debt is running about 3%.

Here's the problem, in short: Rates have nowhere to go but up.

So is 70 basis points "realistic"?  No.  If the economy improves, they'll go up double that or more just on their own on the short end.  Then you get to add this "penalty" from the downgrade.

We have the government claiming they will "cut" about $1 trillion in real spending (the rest is gimmicks - the wind-down of the wars that were going to happen anyway) over the next ten years.

But if the economy improves the increased cost of the interest on the existing debt will be double that over the same ten years, and if we get downgraded you can double that again! 

Each 100 basis points on $15 trillion in debt is $150 billion a year - every year - and the CBO says we'll have $25 trillion in debt by 2020. 

At a 4% blended interest rate this load on that $25 trillion will come to $1 trillion in interest annually - just 1 percent higher in interest than we're paying now!

We will not get to 2020 folks; this is, in fact, exactly how the death spiral happens.

Interest expense as a percentage of government, this year, if the MTS thus far is 9/12ths of the total (through June), will run $515 billion.  This out of a budget of $3.8 trillion (approximately) is ~14% of the total federal budget.  To put this in perspective this is about 50% of the total receipts under federal income tax - just to pay interest!

Now I'm probably being pessimistic, because there's a roughly $80 billion "whack" that comes from semi-annual coupon payments in the trust funds, and we've already gotten both of those.  So let's be nice and call the trust fund interest accrued already, which means we now get $249 + $199, or $448ish, which is about 12% of the budget.

And that assumes that neither interest rates go up due to an improving economy or a downgrade. 

What happens if that 3% blended rate goes up 70 basis points on a downgrade?  Oh that's easy - just multiply that number by 123% and you're close enough.  Call that $551, or ~$100 billion a year more.  Each and every year for the next ten, that's $1 trillion.

The problem is that the downgrade cannot be avoided without an actual credible $4 trillion in actual reductions in the deficit from the baseline.  This means you can't count anything that was already expected to happen like the wars being wound down.

It also means at least $400 billion in actual spending reductions for FY 2012 and then $400 billion more in each of the next three to four years!  Or we can just do it in two - $750 now and $750 in FY2013.

We might get away with either of those plans, although the impact on the economy will be very significant - the exposure of the Depression we have been in since 2008 will occur with certainty.  GDP will contract and coverage - that is, the percentage of federal income that goes to interest - will actually go up for a while rather than down!  It has to because as the economy adjusts to the lack of deficit spending GDP will contract and tax revenue will fall.

It is, in fact, precisely this inescapable mathematical reality that means that we must deal with this now rather than attempting to kick the can and have the market make these choices for us.

The outcome of taking our medicine will be bad.  Very bad.

But if we don't do it - and do it now - it's going to be worse.

Much worse.