Drawing a AAA-Road Map for Post-Downgrade America

The country's most critical structural problem isn't employment or entitlements. It's Washington. And its window to govern by leadership rather than crisis is getting narrower every day. 615 usa pray stock reuters.jpgREUTERS

The S&P downgrade late Friday afternoon in Washington kicked off the most anxious and frenetic week in world markets since the Great Recession ended. The rating agency's observation that U.S. politics was broken might have seemed like old news to voters, but to outsiders it was a stunning confirmation that the recovery is all but over and Washington has no clue how to get it back on track. But the panic over the downgrade and subsequent sell-off has glossed over what exactly our AA+ means for the economy, our prospects, and the road back to a sterling rating. With a little help from a report published yesterday by the Committee for a Responsible Federal Budget, here is your guide to the downgrade.

Don't Panic ...

The first thing to understand about this downgrade is that it is not, in itself, a reason to panic. U.S. long-term Treasury bonds have been downgraded from AAA to AA+, which according to S&P means that instead of an "extremely strong capacity to meet" our financial commitments, we now have a "very strong capacity" to do so - not much of a difference.

In addition, at least for now, the other two major rating agencies - as well two of the other three minor certified agencies that rate US debt - still rate U.S. Treasuries as AAA, also denoted "Aaa."

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Those concerned that everyone will start dumping our debt en masse as a result of this downgrade shouldn't be. In the case of domestic money market funds, recent regulations basically deem U.S. Treasuries as safe assets no matter what happens to them; and frankly there aren't many other assets to flock to right now. As former CBO Director Rudy Penner would say, "we're still the finest looking horse in the glue factory." This second point also rings true with respect to our international investors. We are the world's reserve currency and have more bonds in the global market than all AAA-rated countries combined.

Rather than going up, interest rates have actually fallen a bit since the rating downgrade. This is not inconsistent with what has happened to other AAA-downgraded countries, where interest rate effects have generally been quite small.

... Okay, Panic a Little

If rating downgrades don't augur immediate crises, they tend to indicate trouble on the horizon. Of the 10 other countries that have been downgraded from AAA, eight experienced further downgrades and five have still never recovered their AAA rating. Deeper downgrades have been associated with interest rate spikes, and the fact that both S&P and Moody's have us on a negative outlook suggests that more downgrades could be in our future.

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What are the consequences of further downgrades? The most direct one could be higher interest rates, as investors insist on a risk premium. Even a 0.1 percent increase in interest rates would mean an additional $130 billion in government spending on interest over the next 10 years that we would have to offset in hiring taxes or fewer investments to meet the same debt goal. A 0.7% increase in interest rates would be enough to erase all of the gains from the recent debt deal.

Presented by

Marc Goldwein is the senior policy director of the Committee for a Responsible Federal Budget.

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