Has America suddenly become a bad financial risk even though it avoided a default on its debt? In the future will the U.S. government pay its bills on time, and in full? These were the questions posed nationally and globally the moment after Standard & Poor's, a leading ratings firm which evaluates the creditworthiness of debt, both corporate and governmental, pegged the U.S. as only a AA+ risk, a downgrade from the previous AAA rating, the top gold standard rating for no-risk lending. Never before has the U.S. lost its triple-A rating. (For more on what the downgrade means, check out The S&P Downgrade: What Does It Mean?) Higher interest rates are also a disincentive to invest in a down-trending stock market. Investors will ask, "Why risk a see-saw ride on a volatile, but essentially bear market when a stable rate of return, even though relatively low, is guaranteed?"
TUTORIAL: Economics Basics
Why the demotion for the U.S.?
Standard and Poor's said the recent agreement between Congress and the Obama administration "falls short" of what is "necessary to stabilize the government's medium term debt dynamics" and also criticized U.S. policy making and political institutions. In the immediate wake of the downgrade, equities and financial markets the world over reacted with sharp declines. In the U.S. alone, billions of dollars in stock market value was wiped out as jittery investors liquidated their holdings while Dow Jones Industrial Average prices fell steadily almost 700 points throughout the initial selling frenzy.
As stock prices fell, the price of gold soared to above $1,700 an ounce in response to the downgrade. Gold is a traditional safe haven and inflation hedge in troubled financial times.
With a lower credit rating, the U.S. government will have to pay more interest on its debt to attract lenders. Increased costs to service national debt - the interest paid on what is owed - will ripple through the entire economy. Credit card purchases, mortgage rates, commercial and consumer loans will require increased interest, with perhaps an increase in fees. Some experts have predicted an initial increase of from 50 to 75 basis points to a full one percent rise in rates. But interest rates could continue to increase as the crisis worsens.
As the cost of doing business increases with the higher costs of borrowing to finance expansion, research and development, and hiring, the economic recovery will be short-stopped and desperately needed jobs will not materialize. Businesses with huge cash holdings in banks will be even less motivated to invest their cash in risky new ventures and instead, just let their money languish while earning more in guaranteed interest. (For more, read Stashing Your Cash: Mattress Or Market?)
Although an AA+ credit rating is still just one step away from the top, the perception globally is that the U.S. is now in financial trouble. Financial projections indicate that the U.S. national debt will increase through the coming years and partisan political squabbling is predicted to continue without a resolution to the problems.
At issue on the political front are the means by which government revenues are increased to reduce the debt. Should taxes be raised and tax loopholes plugged? Should entitlement programs such as Social Security and Medicare and Medicaid be amended so that less money is paid out, fewer people covered, and means testing applied to determine who gets benefits and how much?
Most urgently, what should the Congress do about the national debt ceiling - how much can the U.S. be allowed to borrow - and is a balanced budget amendment to the U.S. Constitution financially practical, and can it be passed?
Yet financial experts and economists disagree on the significance of the downgrade. Some say that ultimately there will be little impact on the economy and that markets will stabilize and interest rates will remain fairly steady. The U.S. is still an economic powerhouse despite its current problems, says this faction of authorities, and a U.S. default on debt will never happen.
A more skeptical and cautious group of experts and Wall Street investors as well, are uncertain about the short term and long term effects of the downgrade. They predict sluggish growth and the potential for further economic problems if there's a sudden spike in oil prices or if the European debt crisis worsens.
If U.S. debt is now seen as a slightly shakier bet, where in the world is money safe these days? Countries with triple A ratings include Australia, Canada, Hong Kong and the Isle of Man.
Despite the Standard & Poor's downgrade of U.S. debt, two other major ratings services, Moody's Investors Service and Fitch Ratings, have kept their evaluation of U.S. creditworthiness at the top. As the first week after the downgrade began, investors reportedly were still buying U.S. Treasuries and rates had yet to climb.
Higher interest rates are also a disincentive to invest in a down-trending stock market. Investors will ask, "Why risk a see-saw ride on a volatile, but essentially bear market when a stable rate of return, even though relatively low, is guaranteed?"