How the U.S. Downgrade Will Change the Global Economy

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An investor looks at an electronic board showing stock information at a brokerage house in Wuhan, China, on Aug. 8, 2011 (Photo: Reuters)

Standard & Poor’s decision to strip the U.S. of its triple-A credit rating, whether we agree with it or not, signals a turning point for the entire global economy. Because of the unique role the U.S. plays in the world economy, a downgrade of the U.S. isn’t anything like a downgrade of Greece or Spain. For the past century, and especially since the end of World War II, the modern global economy as we know it has been built on top of the U.S., relying on its economic strength as a foundation and using its currency as the primary tool of world economic discourse. In many ways, the world has benefited greatly from the U.S.-led system. The past half-century has seen unprecedented economic integration and poverty alleviation, uplifting hundreds of millions out of destitution on a scale never before witnessed in history. America, simply, has been the economic engine that has made the world go round.

Now that engine is sputtering, and the potential long-term repercussions are tremendous — for the way the world invests and trades, and for how the global financial system operates.

First of all, the U.S. downgrade will force a reassessment of the entire concept of risk in the global economy. The U.S. has been considered the world’s safest investment, the standard by which all other economies are judged. But if the U.S. isn’t as safe as it once was, a domino effect may be felt throughout the world. If the U.S. doesn’t warrant a triple-A, we have to ask: Which country does? France, for example, is rated AAA, but it has a similar level of government debt as the U.S. (each around 94% of GDP in 2010), and the economy doesn’t have any better growth prospects. So if the U.S. doesn’t deserve an AAA, does France? And if such stalwarts of the global economy are riskier than they were before, what does that mean for countries with lower ratings? Should they be downgraded further?

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In the short term, that thinking likely means greater uncertainty in global markets, especially in Europe. If the U.S. isn’t triple-A, what does that tell us about Italy and Spain? The S&P downgrade could well put even more pressure on Europe’s weak economies and on European leaders to act to stem the crisis. On Sunday, the European Central Bank made a strong statement indicating that it would step in to support Spanish and Italian bonds, which have been rapidly losing value in recent weeks, threatening to escalate the euro debt crisis to catastrophic levels.

Over time, the notion of a riskier U.S.A. will lead to a rethinking of the “safe haven.” Right now, in times of stress, investors rush into U.S. dollar assets like Treasuries. But if Treasuries become riskier, where will the money go? What we’re likely seeing is the start of the reordering of risk perception that will match the major shift in economic clout to the developing world. While ratings on the core economies of the West have been dropping, those on some high-powered emerging markets, like Indonesia, have been rising. The U.S. downgrade, in other words, is going to alter the way investors decide what is safe and what is not safe, and allocate their money accordingly.

That, however, will be a slow process. Don’t expect a mass flight from U.S. government debt because of the S&P downgrade. The fact is that, whatever the financial situation of the U.S. and the paralyzed state of decisionmaking in Washington, the world is stuck with America and American assets for now. Just about every institution in the world holds Treasuries as a core part of their assets, from the Chinese central bank to European pension funds. There is simply no other country that can provide the depth of capital markets that the U.S. offers the world. If people started selling Treasuries, what would they buy? Euro-zone bonds? I think not. Emerging-market assets? There simply are not enough of them out there to buy. And some of the world’s top developing nations (like China) control capital flows and currency trading, limiting access to the assets that exist. The situation is no different with the U.S. dollar in general. With so much of the world’s business conducted in dollars, there is no other currency that can take its place, however America’s financial standing might be changing. Much of the world is in a dollar trap from which it cannot so easily escape.

The S&P downgrade will likely speed along efforts to replace the U.S. dollar as the world’s No. 1 currency. Countries like Russia and China have been calling for a new reserve currency for several years. With the U.S. financial position on the decline, those calls are only likely to get louder. A blistering editorial from China’s state news agency on Saturday made this very point:

The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone. It should also stop its old practice of letting its domestic electoral politics take the global economy hostage and rely on the deep pockets of major surplus countries to make up for its perennial deficits … International supervision over the issue of U.S. dollars should be introduced and a new, stable and secured global reserve currency may also be an option to avert a catastrophe caused by any single country.

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This Chinese tirade is a case of people in glass houses throwing stones. Beijing has been guilty of quite a bit of fiscal irresponsibility itself, and concerns are rising about China’s level of government debt. But China also has reason to be angry. It is the largest foreign holder of U.S. Treasuries, with nearly $1.2 trillion of them. That makes China highly vulnerable to U.S. fiscal policy. However, that vulnerability is to a great degree its own fault. China’s entire economic model has been run to benefit from the global U.S. dollar-led financial system, and the country is just one which has abused that system to gain over its competition. By manipulating its currency, China has amassed an incredible hoard of U.S. dollars. The country boasts currency reserves of more than $3 trillion, and though the central bank doesn’t reveal an exact breakdown of those reserves, it is widely believed that about $2 trillion are in U.S. dollars. That leaves China no choice but to continue holding U.S. dollar assets like Treasuries. What else would Beijing do with all those dollars? Beijing can’t swap them into other currencies — that would be destabilizing and undermine the value of its own assets — and even if China were to do that, where would it put all that cash? So China is stuck with the U.S., its dollars and its downgraded debt.

The solution for China is to reform its own economy. That’s yet another way in which the S&P downgrade signals a coming change in the world economy. Countries that have run their economies for decades based on a firm U.S. foundation are now going to have to find ways of adapting to the new reality. For China, that should lead to currency reform, to allow the yuan to float in order to limit the growth of new dollar reserves, and more aggressive efforts to boost domestic consumer spending to rebalance the economy. Chinese leaders have been blabbering about the need for such reforms for some time, but little progress has been made. Perhaps the S&P downgrade will put added pressure on Beijing to finally move forward.

Or maybe not. The challenge the world faces with a downgraded U.S. is that there is nothing to take America’s place at the center of the world economy. What the downgrade heralds is a messy, uncertain transition into — well, we don’t know what. And that’s truly scary.

Michael Schuman is a correspondent at TIME. Find him on Twitter at @MichaelSchuman. You can also continue the discussion on TIME’s Facebook page and on Twitter at @TIME.

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