US Economy Special Analysis: America's Credit Rating is Downgraded --- And It May Happen Again

Standard and Poor's announcement on Friday that they have downgraded America's long-term credit rating from AAA to AA+ is sure to excite much comment over the next few days. For now, however, the point is that no-one is quite sure of the effects might be. Because this is the first downgrade in American history, there is no precedent to consider.

Already the media are offering differing outlooks, ranging from the outright gloomy to the more optimistic projection that the downgrade will be nothing more than a psychological blow to America's prestige. This early evaluation by Ezra Klein in The Washington Post is as clear an appraisal as any before the Asian markets actually tip off what the downgrade means when they open Sunday night.

More interesting, in terms of US politics, is that S&P have made it clear in their press release that this downgrade could be just the first step, with a further reduction to AA if certain policy changes are not made in Washington. Thisis no surprise: S&P had warned since April that if no long-term plan to halt America's soaring debt was put in place, then a downgrade would be the response. Politicians in Washington ignored that caution, and it will be interesting to see how those same politicians will react to the conditions S&P are setting out to avoid a further downgrade:

Our revised upside scenario --- which, other things being equal, we view as consistent with the outlook on the "AA+" long-term rating being revised to stable --- retains these same macroeconomic assumptions. In addition, it incorporates $950 billion of new revenues on the assumption that the 2001 and 2003 tax cuts for high earners lapse from 2013 onwards, as the Administration is advocating.

Note that this is the scenario whereby S&P would keep the US at a AA+ rating --- there is none set out for the US to get its AAA rating back. And the "macroeconomic assumptions" are favourable GDP growth rates (3%), and a manageable inflation rate (2%).  S&P notes that recent figures from the Bureau of Economic Analysis show that 3% GDP growth may be too optimistic, and cautions that GDP growth of only 2.5% is enough for the US to fall under their “less-favourable” rating.

The press release concludes with this assessment of what Washington must do to avoid a further downgrade:

The outlook on the long-term rating is negative. As our downside alternate fiscal scenario illustrates, a higher public debt trajectory than we currently assume could lead us to lower the long-term rating again. On the other hand, as our upside scenario highlights, if the recommendations of the Congressional Joint Select Committee on Deficit Reduction–independently or coupled with other initiatives, such as the lapsing of the 2001 and 2003 tax cuts for high earners–lead to fiscal consolidation measures beyond the minimum mandated, and we believe they are likely to slow the deterioration of the government’s debt dynamics, the long-term rating could stabilize at "AA+".

After the initial hyperbole about the downgrade has died down, it is this warning that will emerge as the crucial development. The good news is that it gives moderate Republicans an escape clause to join Democrats and adopt a balanced approach to solving the debt problem. And if that the S&P's assessment seems overtly partisan in its call for revenues to be increased as Democrats have demanded, the agency also makes insists on reform of entitlement spending, which they note “the containment of which we and most other independent observers regard as key to long-term fiscal sustainability".

These comments introduce a new dynamic to debt reduction talks. S&P is not rating America's ability to pay its bills, but its political ability to stop the United States' slide into further indebtedness. The agency notes that the US has been downgraded while nations who hold a greater debt to GDP ratio remain at AAA becaus those nations have put plans into place to begin reducing their debt by 2015. Under no foreseeable scenario does S&P foresee a decrease in --- or even a levelling of --- the American debt to GDP ratio.

Who's to blame? The politicians:

The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently.

S&P will come under some staggering criticism for this move, especially after they ( and the other credit rating agencies) were given a large part of the blame for the 2007-8 financial crisis in the official report on that event. There is no doubt, however, that its downgrade has brought new urgency for politicians to agree upon “the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently”.

That is what S&P wants, and perhaps this step --- if the economy does not completely implode as a result --- might prove a significant turning point for the US to get past political brinkmanship and and facethe tough decisions required to come up with a long-term solution to the debt problem.