Monday's surprise announcement that the outlook for U.S. debt has been downgraded reverberated around the world. Global markets shuddered. Investors rubbed their eyes as they re-read the announcement and then hit the "sell" button. Markets declined by 1 to 2 percent. Yet, by the end of the week, stocks and bonds recovered. Was this some kind of false alarm?

First the facts: the Standard & Poor's Rating Services Inc.(S&P) has reduced the outlook for U.S. debt from "stable" to "negative." It did not change its AAA rating for U.S. federal debt nor does it plan to do so anytime in the near future. But it is potentially the first step in an actual ratings downgrade. The White House had been given advance warning last Friday. Officials tried to forestall the credit agency's actions but S&P is convinced that our high debt and deficit levels are raising the possibility that the U.S. fiscal situation could become "meaningfully weaker" if the government fails to improve the country's financial health.

A barrage of spin doctors, led by Treasury Secretary Timothy Geithner, was launched on the nation's airwaves this week in an effort to assure one and all that there is no cause for alarm. It reminded me of that scene in "The Wizard of Oz" in which Toto pulls the curtain away from the Wizard revealing his fire- breathing, smoke-making, image projection machine.

"Pay no attention to that man behind the curtain," the Wizard bellows through his loud speaker system. But like Dorothy, we Americans should ignore the Wizards advice whether in Oz, or in this case, Washington.

The change in the ratings outlook, like a warning shot across the nation's bow, says to me that unless we get our house in order, and do so quickly, there will be hell to pay.

S&P recognizes that all the grand standing going on right now between the political parties is just that. They have no intention of do anything about the deficit until after the next election. Both sides are simply jockeying for position. They are using the deficit to put their presidential candidate and party in the best position to capture the election which is still two years away.

S&P's base case assumes $4 trillion to $5 trillion in deficit reduction would need to occur over the next 10 to 12 years, but it also insists that there needs to be a concrete plan in places for deficit cutting that is actually implemented by 2013. That implies a spending decline of at least 20% of U.S. GDP and an agreement prior to the next presidential elections.

What's at stake here is another Black Swan event, in my opinion. If the politicians flub this one, and our credit rating is cut, I suspect the greenback will be worth about half of its value today. Interest rates across the board in the United States will skyrocket. That will pretty much gut any hopes of a continued economic recovery and the unemployment rate, well, you get the picture.

You might wonder, therefore, why the politicians are stalling since they know the consequences as well as you and me. Taxes, a cut in spending, this year's budget, the debt ceiling – everything appears to be a political football. Politicians blithely fiddle while Rome burns because they all know the truth behind the nation's books.

Historically, politicians and their parties have very little to do with balancing the nation's budget. The most important single variable, when it comes to reducing the deficit, balancing the budget, or actually enjoying a surplus is economic growth. The stronger and longer the period of economic growth, the faster the deficit is reduced. The problem in this recovery is that due to its nature, the U.S. recovery has been anemic and therefore revenues (taxes) aren't coming in fast enough to reduce the deficit as it has in prior economic cycles.

This time around, a combination of growth and spending cuts are called for but politicians on both sides of the aisle are notorious for kicking that particular can down the corridor. The S&P is warning them that the "the can stops here."

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.

The best rallies are those that move up, take a breather and then move up again. That way markets do not get extended, the gains are fairly predictable, as are the pullbacks. It appears that is the kind of market we are in at present.

The S&P 500 Index reached a low of 1,249 exactly one month ago. It then soared 7.2 percent to 1,339 in the next 23 days. We began this pullback a week ago and so far have given back less than 2 percent of those gains. I would expect a bit more time and possibly downside before resuming our march toward 1,400 on the S&P.

If you are looking for excuses (as so many of us do) to explain the short-term gyrations in the market there are plenty of culprits. If you are a Republican, it's all about the runaway deficit and the opposition's unwillingness/inability to tackle spending and raise taxes. Democrats will argue it's the fault of the GOP and the tea party that narrowly missed shutting down the government by tacking on superfluous riders to the deal. I expect increased rhetoric and market volatility as the debate on the debt ceiling intensifies, so be prepared.

But all of that is simply headline news. The real questions that are making the rounds of trading floors and hedge fund offices are these: At what point does "non-core" inflation, (energy and food, for example) start to impact corporate profits? Are we already seeing some of that risk this quarter as companies voice their concerns about profit margins in the future?

When will the widening gap between America's haves and have-nots reach a boiling point? Over 70 percent of the population is caught in a terrible climate of stagflation while the top 30 percent get richer and richer. Higher commodity prices will eventually force producers to pass on price increases to consumers. Will these consumers demand higher wages in order to stay afloat? Will corporations respond by raising worker's income or will they hold the line? If they hold the line, will that mean consumer spending retreats and the economy slows? Either way, corporate profits will suffer.

Overseas, Spain's real estate losses are massive and at some point will come to the forefront. How will Europe and the world meet that challenge? Spain, unlike Greece, Portugal and Ireland, is a big economy and problems there would have a severe impact on other economies.

Will China be able to continue its role as the world's economic locomotive? The government is struggling to engineer a "soft landing" as it attempts to control/reduce inflation while maintaining a high growth rate. At best, this is a difficult task and if they over tighten, causing their economy to falter, what will that do to global economic growth?

At the center of this debate is QE 2. There is an extremely high correlation between the rise in commodity prices, the stock market and the Federal Reserve's open market purchases of securities. The ripple effect of QE 2 has spread all over the world and the above questions center on what happens with the end of QE2 in June.

The Fed is flooding the economy with money and that money is sitting in bank vaults and on corporate balance sheets. So there is plenty of money to hire workers and raise wages to pay for those higher prices brought on by sky-rocketing commodity prices. Of course, what I am describing is the beginning of an inflationary cycle that, if left unchecked, could lead to hyper-inflation.

Given that no one knows how this story will turn out, one can forgive the two steps forward, one step back volatility in the markets. Gold and silver continue to rocket higher since all we can be sure of right now is that the Fed will continue to pump money into the economy until June. It is also why I believe the stock market, regardless of these short-term pullbacks, is heading higher for now.

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.