What A Credit Ratings Cut Could Mean For The U.S.

Jul 26, 2011

With a debt ceiling deadline approaching, party leaders spent the day counting votes.

There are two plans: One, the handiwork of House Majority Leader John Boehner (R-OH), the other from Senate Majority Leader Harry Reid (D-NV).

The problem is that it's not clear that either one can muster the votes necessary for approval.

Monday night, President Obama dramatized the threat this way:

"For the first time in history, our country's triple-A credit rating would be downgraded, leaving investors around the world to wonder whether the United States is still a good bet," he said. "Interest rates would skyrocket on credit cards, on mortgages and on car loans."

But it's not clear how big of a problem a credit downgrade would be.

There's no debate that if the U.S. defaults on its debt it will be a big deal. But whether it will be as catastrophic as the administration says depends on how markets react.

However, there's little doubt that a default would be very costly.

A Public Relations Issue

And what if it's just a downgrade? The government's borrowing costs would probably go up. But some experts say a downgrade is primarily a public relations issue.

"Not meaningless, because it's sort of a nice focus for the press, but it just isn't a big financial deal," says Joseph Gagnon, an economist at the Peterson Institute. He says what matters far more is how we arrive at that downgrade.

Let's say there's still a stalemate, and though there's no default, the government runs out of cash to pay its workers, contractors and Social Security benefits. That, Gagnon says, could trigger another recession.

But ratings agencies are also warning of a downgrade even if Congress raises the debt ceiling, if it doesn't also address long-term deficits. Gagnon says the economic impact of that kind of downgrade could easily be a non-event.

"You know, often times, the rating agencies are behind the curve, and this is the certainly the case now — where the rating agencies don't have any additional information that everyone else in the market has already," he says.

Japan's sovereign debt rating was cut in 2002, and he says there wasn't a big effect.

It turns out, this opinion is shared by Standard & Poor's itself. In a series of reports published last week, the ratings agency assessed the likely impact of a potential downgrade. It said, in short, it wouldn't have much of an impact.

In fact, some say given the financial situation in the U.S. it probably should have happened a long time ago.

"I would have downgraded them 10 years ago," says Kent Smetters, a former Treasury official and now a professor at the Wharton School.

'The Guts To Compromise'

Smetters says for many years he's believed that interest, Social Security and medical entitlement payments were going to rise unsustainably, leading us to this point. And what's really lost if U.S. credit gets downgraded, is any credibility that politicians on both sides have the guts to compromise.

"For me the downgrade reflects something bigger than that," he says. "It's a statement that basically says to the world, 'It's not even obvious that we're serious about dealing with the longer term problems.'"

But politicians like to suggest the country's credit rating has close ties to consumers' credit.

"I think that is a way of trying to get the voter base into action, but it's not going to have as dramatic of an impact on mortgages and credit card rates," Smetters says.

That's not to say a rating cut won't look bad.

"I would not be at all surprised if someone at Treasury was talking to the rating agencies and saying, 'Well what do you need? What do we need to avoid a downgrade? Minimum of what? How much deficit reduction?'" says the Peterson Institute's Gagnon. "I would be very surprised if they weren't talking to them and trying to get that."

Because if you can avoid both economic and public relations fallout, why wouldn't you?

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