Deficit hawks woke up to find another nail file for their talons today, as Standard and Poor's rating agency has revised its outlook of U.S debt from "stable" to "negative." While our credit rating remains a sterling AAA, the ratings agency places the odds of an official credit downgrade before 2013 at one-in-three.
Despite a flurry of deficit-related activity in the last few weeks, with the House approving a plan to wind down Medicare and the president releasing for the first time a proposal to cut about $4 trillion in the next decade, S&P evidently finds all this business to be much sound and fury signifying nothing.
Markets, which as a rule don't like surprises, are taking the news poorly, but not that poorly, because after all, this is a warning more than a punishment. The Dow fell 200 points within a few minutes of trading and bond yields are up slightly, which suggests higher risk associated with U.S. debt.
It's about reputation. That might sound like a high-school playground thing, but it's more. Debt is about trust. Interest rates rise and fall on a country's fiscal character, so reputation matters. If we blow past our debt ceiling (an increasingly likely scenario given the standoff between between Democrats and Republicans), it hurts our standing with international markets, and we'll pay a price. If we refuse to raise taxes or cut deeply over time into domestic spending, it hurts our reputation with international investors, and we pay a price. That "price" can manifest itself in many ways: stock shocks, higher mortgage rates, fewer loans, and worse.
The upshot is that this downgrade is insignificant as a piece of news and very significant as a piece of foreshadowing. Think of the headlines today -- falling stocks, higher yields, mild panic -- and imagine the bad news multiplied by a factor of 10. This is why deficits matter.
Update: Headline changed to reflect S&P nomenclature. I had formerly written that our fiscal picture had been "downgraded" while the rating stayed the same. Although this was an accurate description of the new report, the term "downgraded" is loaded for credit agencies, and the headline has been changed to reflect this.
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