How a Debt Downgrade Would Harm America

Uncle Sam may soon see its credit rating cut from AAA—even if there is a debt deal.

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For the last few years, a cut in the credit rating of the mighty United States has seemed like a distant possibility that we didn't need to worry about just yet. Well, the distant future is about to arrive.

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Rating agency Standard & Poor's now says there's a 50-50 chance it will cut America's credit rating by one notch, from the top level, AAA, to the next level, AA+, or perhaps even lower. That would be the first cut to America's credit rating since 1941, when S&P began tracking it. One trigger could be the failure of politicians in Washington to reach an agreement on raising the federal government's borrowing limit, which would force deep cuts in spending by early August. The other big rating agencies, Moody's and Fitch, have expressed similar concern about the debt standoff in Washington.

But America's credit rating could fall even if there is a last-minute deal to extend the borrowing limit. That's because the nation's mushrooming debt load—which has hit about $14 trillion and seems certain to keep growing—has become an intractable problem that's likely to produce adverse consequences no matter what happens. And the longer politicians in Washington dither, the worse the problem becomes. S&P says that if there's no credible plan to start reducing the size of America's debt soon, it may downgrade the nation's credit rating even if the borrowing limit is raised. Since Republicans and Democrats remain deeply divided over the mix of spending cuts and tax increases needed to fix the problem, a downgrade looks distinctly possible. S&P says it could happen as early as August.

A downgrade in the sovereign credit rating of the United States wouldn't necessarily be a disaster. Of 127 countries rated by S&P, only 18 have the top AAA rating, including Canada, the United Kingdom, France, Germany, Switzerland, most Scandinavian countries, Hong Kong, Singapore, and Australia. A one-notch drop would still leave the United States a step or two above countries such as Belgium, Spain, Japan, Kuwait, New Zealand, and our emerging rival, China. But a credit-rating cut would still be an undeniable blow to American prestige. And there would probably be a negative reaction in global financial markets, which could damage the already weak U.S. economy. Here are some of the likely consequences if America's credit is downgraded:

Rising interest rates. A downgrade would mean that treasury securities, long considered one of the world's safest investments, would be deemed riskier. That could have a widespread impact on financial markets. Investment funds such as pensions and money-market funds that are required to hold a certain amount of top-rated debt might be forced to sell some treasury securities, and they wouldn't be able to hold as much in the future. So that could depress demand for treasuries, which means the U.S. government would have to pay higher interest rates to entice lenders. Since many types of loans are tied to treasury rates, it would probably get more expensive for home buyers to take out a mortgage, companies to borrow, and most other borrowers to get a loan.

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That doesn't mean interest rates would soar. For one thing, the Federal Reserve might react to a downgrade with more quantitative easing meant to put downward pressure on rates. There could also be a further slowing of the global economy, which would stunt demand for credit, keeping rates lower than they'd otherwise be. Investment bank UBS estimates that rates would rise by only about one quarter of a percentage point. Others think rates could go up by half a point or more. That assumes the United States doesn't default on the $14 trillion worth of debt it already owes. If Washington did default, the consequences would be far worse.

A possible recession. The daisy chain of events following a downgrade might be enough to stall the sputtering economic recovery and force another downturn. Rising interest rates alone would be like a new tax, forcing anybody taking out a loan to pay more. A cut in the nation's credit rating could also lead to cuts in the ratings for big U.S. companies, since corporate entities are rarely rated higher than the countries in which they conduct much of their business. That would raise companies' borrowing costs and give them one more reason not to hire. If Washington suddenly felt pressure to pass sharp and immediate cuts in government spending, to boost the nation's rating back to AAA, that would take money out of the economy and reduce GDP growth. One of the most unpredictable factors would be how a downgrade affects consumer and business confidence, not just in the United States but in the economies of key trading partners as well. It's clear that confidence would decline. But forecasters are mostly guessing when they try to estimate whether the drop would be bad enough to trigger another recession.

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There could be a couple of upsides to this development, such as a reduced risk of runaway inflation and falling oil and gas prices. The Fed's recent actions have pumped money into the economy, which is why some investors worry about inflation. But it also takes rising wages to force prices up—and as many Americans know, a weak job market is already holding wages down. Another recession would make hiring weaker still. Oil and gas prices usually fall during a recession as well, since demand drops off. A new recession could even bring a renewed risk of deflation, which some economists think is scarier than inflation.

America's debt problem would get even worse. If interest rates rose, the United States would have to pay more to borrow, which would leave less money for other things and require even more borrowing if other spending remained stable. If a recession resulted from a downgrade, that would lead to more layoffs, lower tax revenues, and bigger deficits than the White House now forecasts. It would also raise pressure on Washington to enact more stimulus spending—which would have to come from borrowed money that would raise the debt even more. If the debt grew by more than expected, that could lead to further downgrades in the U.S. credit rating, which would make the whole problem that much worse.

The dollar could begin to lose its coveted "reserve" status. There are already signs that big purchasers of U.S. government debt, such as China and other global investors, are growing leery of Washington's dysfunctional infighting and looking for other ways to invest large holdings of cash. They're not likely to flee U.S. treasuries en masse, but they could begin to diversify away from dollar-denominated assets. At the moment there are no strong alternatives, which is one reason Washington has gotten away with debt shenanigans as long as it has. But bonds from Germany or other more stable countries could start to look more attractive than treasuries.

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If demand for treasuries were to fall significantly, Washington would simply not be able to afford the same level of domestic spending or overseas influence it has become accustomed to. "If the United States were to lose the privilege of being the world's reserve currency, it would transform American power," says Sebastian Mallaby of the Council on Foreign Relations. A shortage of funds, he says, would sharply constrain the nation's ability to project power abroad. He doesn't think that will happen immediately, but it could develop in incremental and irreversible steps—even if there is a reasonable deal on the debt ceiling. "The basic logic is pretty depressing," Mallaby says. "Any happiness around a [debt] deal in Washington may be rather short-lived."

Despite the high-stakes brinksmanship in Washington, most analysts still believe that Republicans and Democrats will eke out an agreement that avoids the worst-case scenario: a halt to Washington's borrowing, a sudden and sharp cut in spending, and possible default on America's debt. That's such a doomsday development that there'd be an uproar if it happened. But the usual Washington response to the debt problem—talk tough about it, then delay any major action—is no longer viable either. If the United States is still the world's financial leader, it's time to start acting that way.

Twitter: @rickjnewman

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