What Will Cause the Next U.S. Credit Downgrade

The U.S. rating could sink again if Congress doesn't cut spending soon.

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In July of 2011, Standard & Poor's announced that it would cut the U.S. credit rating from its vaunted AAA status within three months "if we conclude that Congress and the Administration have not achieved a credible solution to the rising U.S. government debt burden."

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Members of Congress apparently didn't notice (or care). They dickered over raising the U.S. borrowing limit until the last second, and delayed meaningful action on cutting spending. So as promised, on August 5, 2011, S&P cut the U.S. credit rating by one notch for the first time ever. The stock market fell by nearly 7 percent.

The agencies that rate sovereign debt are once again spelling out what will lead to another U.S. downgrade, and Congress seems not to be listening this time, either. Moody's and Fitch still give America's debt their top rating, but like S&P, they've put the United States on a negative outlook, which means a downgrade could be coming.

The recent deal to avert the fiscal cliff helped a little by preventing widespread tax hikes that probably would have caused a recession and made the national debt even worse. That deal also resolved some long standing questions by locking in tax rates permanently instead of leaving them subject to further political action, which reduces uncertainty.

But the deal did virtually nothing to cut spending or improve the nation's shaky finances, which is why further downgrades seem likely. Here's what could trigger them:

Another standoff over the debt ceiling. The nation's borrowing limit will need to be raised again around late February, and another political cage match that threatens a default on U.S. debt will cut confidence in America's governing machinery even more. "Failure to reach agreement on raising the debt ceiling in a timely manner—weeks in advance rather than just a single day before the funding capacity of the federal government is exhausted, as happened in August 2011—would raise questions about US governance on fiscal matters," Fitch said in a December report. Such a standoff will "prompt a formal review of the U.S. rating."

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A failure to cut spending in 2013. Just about everybody agrees that Washington still has to axe hundreds of billions in annual spending to stabilize its finances. Some hope it will happen as part of a deal to extend the debt ceiling. The problem is that most government spending actually benefits somebody—seniors, home buyers, the poor, defense contractors—and Congress has proven itself particularly reluctant to reduce anybody's benefits.

Moody's wants to see spending cuts, and perhaps even more tax hikes, as part of a big budget deal in the first few months of 2013 that would convincingly improve the government's long-termfinances. "The debt trajectory resulting from this process is likely to determine whether the Aaa rating is returned to a stable outlook or downgraded," Moody's said in a statement following the January 1 fiscal-cliff deal. If Congress continually delays spending cuts—the habit in recent years—a downgrade could come by summer.

A rise in interest rates. Historically low interest rates are a huge break for taxpayers, because they help keep the interest payments on $16 trillion worth of national debt lower than they'd otherwise be. If interest rates were to rise, the Treasury would have to fork over more money to borrow, which would have to come from money spent elsewhere, higher taxes, or even more borrowing. Standard & Poor's says that higher interest rates are one scenario that could it to downgrade U.S. debt a second time.

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The Federal Reserve has considerable power to keep interest rates low, but it can't necessarily overcome market forces if there's strong upward pressure on rates. That's not a problem now, but it could be in the future, especially if inflation picks up, as some economists expect.

A recession. Another economic downturn would put more people out of work, lower government revenue from income taxes, and possibly require more federal stimulus spending. Any of those things would make the U.S. debt burden more intractable, leading to another downgrade.

That's why policymakers are in such a tricky spot now. They must simultaneously raise taxes and cut spending, but not so abruptly that it torpedoes the economy. The best plan would be one that phases in adequate austerity measures over time, so everybody knows what's coming, with minimal disruption today. But that sort of deftness may be beyond the capabilities of a bare-knuckle Congress.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback to Success. Follow him on Twitter: @rickjnewman.