In downgrading the United States credit rating for the first time in its history Friday, Standard & Poor's left little doubt that, for the moment at least, America's debt crisis is, in fact, a political crisis
The impact of the S&P decision to drop US debt from its top AAA rating to AA+ will not be more fully known until Asian markets open on Sunday night. But the move has the potential to raise interest rates on the national debt – a move that could have the knock-on effect of raising interest rates across the US economy, from mortgages to car loans.
Some evidence suggests the impact could be minimal, however, at least in the short term. Markets have guessed at a looming S&P downgrade for weeks and many might have already adjusted somewhat to account for it. Moreover, US Treasury bonds have been considered such a safe investment for both American and overseas investors for so long that they have become deeply interwoven into the global economy. Buyers might not want to risk now demanding higher interest rates from the US because of the shock it would send through markets worldwide.
The downgrade by S&P is a major political embarrassment coming less than a week after high-stakes wrangling among Republicans, Democrats and The White House pushed the US to the brink of default.
S&P had threatened the move in July if Washington failed to deliver what it judged to be a serious plan to tackle the country's deficit and last night, after several discussions with administration officials, the agency followed through. The US government's rating was cut to AA+ and the outlook for the debt was kept on negative in a move designed to keep pressure on Capitol Hill to go further than it has in addressing its $14 trillion of debt.
"The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed falls short of what, in our view, would be necessary to stabilise the government's medium-term debt dynamics," S&P said.
By calling the outlook "negative" S&P signalled another downgrade is possible in the next 12 to 18 months.
In its statement, S&P said that it had changed its view "of the difficulties of bridging the gulf between the political parties" over a credible deficit reduction plan.
S&P said it was now "pessimistic" about the capacity of Congress and the White House to stabilise the government's debt.
In an explanation of the decision, S&P said that despite last week's agreement, which raised the $14.3trillion debt ceiling and promised cuts of $2.5 trillion to the deficit over the next decade, the ratio of America's public debt to the size of its economy may climb to 79pc in 2015 and 85pc by 2021. It is understood that an agreement that had delivered a $4 trillion reduction in the debt pile would have preserved the AAA rating.
The US government quickly hit back at the decision, describing it last night as "flawed". The rating agency, which has been the subject of heavy criticism for its role in the financial crisis, informed the administration on Friday morning that it would be taking the unprecedented step of downgrading the US and offered its findings. Officials at the Treasury department said they found a $2 trillion error in S&P's calculations, which the rating agency disputed.
The decision was eventually made public about four hours after the S&P 500 ended its worst week since the financial crisis amid fears the US risks sliding into recession and as Europe's debt crisis again intensified.
The cost of the financial crisis and recession, as well as the wars in Iraq and Afghanistan, have each driven America's debt higher over the last decade and wiped out the surplus the country had under President Bill Clinton. But it's the projected future cost of a number of major health care and pension plans including Medicare and Social Security that has left the country's debt on a path many, including S&P, believe to be unsustainable without further cuts and tax increases.
US government debt is a cornerstone of the world's financial system, is held in large amounts by foreign creditors such as China and Japan and is used as collateral on a daily basis by banks and investors. While the move has been anticipated by markets since last week's deal in Washington agreed a cut of only $2.5 trillion in the deficit, it's unclear how markets will react when they open on Monday. America's debt is still rated AAA by Moody's and Fitch, the two other largest agencies.
Analysts at Capital Economics said the move will "surely rock the financial markets when they open on Monday" but added that any moves are likely to be short-lived because the slowing global economy makes US government debt, or Treasuries, an attractive place for investors to park money. At roughly $9 trillion in size, the Treasury market has advantages and liquidity that rival government bond markets, including Britain's, cannot match.
Despite the threat of the downgrade, the prices for Treasuries are close to their highs for the year as investors seek safe-havens and expectations for economic growth diminish.
Whatever the reaction next week, investors are clearer that the downgrade is a severe blow to America's prestige and is also likely to increase the US government's borrowing costs. JPMorgan this month estimated that such a move could add about $100bn a year to America's funding costs as lenders demand more to compensate for the greater risk. The US spent $414bn last year on interest payments.
"I have a feeling the dust may settle quite quickly," said David Buck of BGC Partners in London. "The US Treasury market is the most liquid in the world."
Either way, it frays nerves further before what was already going to be tense opening of financial markets next week.
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