S&P’s downgrade of U.S. credit rating in a nutshell

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Standard & Poors (S&P), one of three agencies that rate the credit of national governments, downgraded the credit rating of the United States from the highest rating, AAA, to AA+ with a negative outlook. This is the first time in history that this has happened. The U.S. Treasury, upon examining S&P’s analysis that prompted the downgrade, claims that it has found a math error that indicates that the downgrade should not have occurred. S&P rebutted that mathematical calculations are not the only factor in the decision to downgrade.

Sovereign credit ratings, also referred to as national credit ratings and bond ratings, are an assessment of the risk of investing in a country’s economy. That risk is divided into two categories: political risk and economic risk. S&P’s downgrade of the U.S. credit rating and outlook addressed concerns regarding both of these components.

From S&P’s press release regarding the downgrade:

The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.

ore broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.

In a nutshell, S&P downgraded the United States’ credit rating because the political brinksmanship over the debt ceiling combined with what the agency judged to be inadequate measures to stabilize the weakened economy indicated that investments in the U.S. might be riskier now than in the past. S&P is careful in their press release not to make specific policy recommendations, but criticisms of  recent budget and debt legislation hint that a combination of failures to “[contain] the growth in public spending, especially on entitlements, or [reach] an agreement on raising revenues” weighed heavily on the decision to downgrade. What this specifically suggests is that any measures taken to seriously get the country’s financial situation under control must both cut spending and raise revenues.

S&P does come very close to making specific policy recommendations on these points. They adjusted their base case scenario, the model the agency uses to make economic predictions, stating that congressional Rebublicans’ past resistance toward any measure that would raise revenues can only lead them to conclude that they will not allow any portion of the Bush tax cuts to expire in 2012. The combination of the functional discounting of raising revenues with inadequate spending cuts is a repeating theme throughout S&P’s statement explaining its downgrade. They also seem to largely hang their criticism of the extent of spending cuts on the growth of entitlement spending, strongly suggesting that the United States needs to make further cuts to Medicare, especially if it fails to raise revenues.

If the first line of defense to protect the U.S. markets against this downgrade was to question S&P’s math and disparage its credibility, the next line of defense will be to criticize S&P for even suggesting how a sovereign nation should put its fiscal house in order. That criticism wouldn’t be entirely out of line, however, much of the advice that S&P provides is good and something our leaders should seriously consider.

The good news

The other two major sovereign credit rating agencies, Moody’s and Fitch, have reaffirmed their AAA rating of the United States and are not indicating that they intend to downgrade. Since only one of three agencies have downgraded the United States’ credit rating, and since S&P has taken a bit of a credibility hit among investors in recent years, the effects of this downgrade are likely to be less than if all of the agencies had downgraded or even if one of the other agencies had issued a downgrade instead.

That said, this downgrade will still likely cause an increase in borrowing costs, and U.S. financial markets will probably take another significant hit on Monday. There is, however, a possibility that since the threat of a downgrade by one or more credit agencies has been looming for several weeks, the immediate impact will be less than if the downgrade had been more unexpected.

Takeaways and analysis

• We need a balanced approach to deficit reduction. This means both raising revenues and cutting spending.
• Revenue increases do not automatically mean higher taxes for the average American. There’s a lot more money in the country’s couch cushions than just higher taxes. Nonetheless, several recent polls show that the majority of Americans favor raising taxes on individuals making more than $250,000 a year.
• This downgrade would likely have never happened if the extreme fringe of the Republican Party (otherwise known as the Tea Party) had not taken an extraordinary misunderstanding of fiscal policy and applied it to a generally routine piece of federal business, turning the vote to raise the debt ceiling into a manufactured economic crisis.
• While Obama is now the only American president to have the country’s credit rating downgraded during his term, pinning this entirely on his administration is both intellectually dishonest and flat out wrong. The only blame that should be placed on Obama for this is for making too many concessions to Republicans and effectively abandoning the possibility of raising revenues as part of deficit reduction.
• S&P’s downgrade has as much to do with our political situation as it does our financial one. While S&P states gently, “the differences between political parties have proven to be extraordinarily difficult to bridge,” it doesn’t take an advanced degree to recognize that the vast majority of political obstructionism that has occurred of late has been at the behest of congressional Republicans, especially the Tea Party.