What the S&P U.S. Credit Rating Downgrade Means

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Ignore all the grumbling you will hear in the next few days about Standard & Poor’s. Yes, the ratings agency miscalled tens of billions of dollars of mortgage bonds leading up to the financial crisis. Yes, it’s an organization fraught with conflicts of interest, where debt issuers game the system to get the highest ratings. And yes, even in coming to its conclusion about the U.S. credit worthiness it appears S&P’s team of crack analysts made a minor $2 trillion error in calculating how much debt the U.S. would accumulate in the next 10 years (they said $22 trillion, but best guesses are $20 trillion). Know this: The ratings agency’s decision on Friday to downgrade the credit rating of the U.S. government to AA+ from AAA – stripping the U.S. of the highest rating for the first time in 70 years – was 100% correct.

There are a lot of reasons the U.S. no longer deserves the S&P’s highest credit rating. Not all are political. U.S. growth is slowing. The current recovery has dragged on at an anemic pace for more than two years, and it’s not clear when that will end. Economists had been looking for the U.S. GDP to grow 3% this year. It will be more like 2%.

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But the slower growth trend is likely to extend past the current recovery, no matter when we pull out of it.┬áThe recoveries from the past two recessions have been among the slowest on record, and suggests the underlying strength of the U.S. economy is weakening. But that’s just the beginning of why the downgrade makes sense.

There’s more: The aging of the U.S. population is likely to significantly boost healthcare costs and increase inflation. And a multi-decade long increase in the wealth gap in the U.S. has led to a vast increase in the amount of debt most Americas have. It has lowered the standard of our healthcare and education systems, and also made the U.S. more vulnerable to future financial crisis.

But, to be sure, a large part of the current downgrade is political. And those aren’t going away anytime soon either. The fracturing of our political system has led to the rise of political parties that are unwilling to compromise on our biggest challenges. It is clear that the rise of the Tea Party and the pledge of Republicans in general to never raise taxes, along with the Democrats unwillingness to cut Social Security, produced the downgrade. In its decision to downgrade the U.S. debt, the S&P specifically cited the lack of tax increases and cuts to entitlement programs in the debt ceiling deal as the reason they were lowering the U.S.’s rating. Worse, S&P said the U.S. is likely to face a further ratings downgrade if the government continues to extend the Bush tax cuts for the wealthiest Americas.

So what does the downgrade mean? Despite the mistakes S&P has made in the recent past, it’s ratings still matter. As I pointed out earlier this week, on average countries with lower ratings have higher interest rates. So borrowing costs of not only the U.S. government but also American consumers is likely to go up, even if not significantly at first. What’s more, Treasury bonds, long one of the most stable securities in the market, are likely to get more volatile.

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That being said, one should not view the current downgrade of the U.S. debt as a new economic event. It is the latest blow that the U.S. economy has taken from the huge ramp up in housing and other debt that lead to the financial crisis. Economists have long predicted that the credit crisis would cause the U.S. economy to grow at a slower pace for years to come. How exactly that slower growth would play out was not clear. Now we have one more piece of the puzzle – relatively higher interest rates that will make it harder for the government, Americans and corporations to borrow money and expand. And after all the borrowing we have done in the past few decades, it’s an outcome we deserve.