Meet Sam. He’s pretty young, as far as these things go, a good guy, fairly well-liked by his peers, and very, very rich. But he’s made some questionable decisions lately, and money problems are very much on his mind: he’s been borrowing profusely to finance a nasty spending habit, and most of his financial commitments—taking care of his parents and grandparents, for example—aren’t going away anytime soon. He’s not sure how to handle his growing debt.
Sam, of course, is today’s United States of America. Powerful, rich, and influential, but in a serious financial mess. Both are spending more than they have; both have burdensome long-term financial commitments; and both need a plan to address their mounting debt. And now, to make matters worse, both are getting calls from credit rating agencies.
Earlier this year, Moody’s Investors Service and Standard and Poor’s, two of the Big Three credit rating agencies, threatened to downgrade the U.S. federal government’s credit rating from a pristine Triple-A rating if the government failed to take action to correct the mounting debt. Both agencies said that even a potential downgrade of the federal credit rating was at least a year away. But as the government’s level of debt fast approached the debt ceiling—the maximum amount of money the federal government is allowed to borrow—and the government risked defaulting on some bonds, a downgrade was not inconceivable.
And then, in August, even after the government passed legislation raising the debt ceiling, S&P announced that it would downgrade the U.S. credit rating for the first time to a AA-Plus. The agency cited the government’s faulty management of its finances, describing it as “less stable, less effective and less predictable.”
What does a downgraded federal credit rating actually mean? The issue of the federal government’s credit rating had only even popped up on the popular radar this year, and the ultimate implications of a downgraded federal credit rating are still unclear.
Think of it in the context of Sam the individual. When his credit score sinks, it indicates that Sam is less likely to pay back his debts. Giving him money becomes a riskier investment. The same lessons apply to the federal government.
According to Dr. William G. Gale, chair in Federal Economic Policy and former vice president and director of the Economic Studies Program at the Brookings Institution, “In both situations, there is a direct link between ‘creditworthiness’ and interest charged on borrowing. Individuals with lower credit scores, or checkered credit histories, pay higher interest rates to lenders. In the same fashion, a downgrade in the credit rating of U.S. government debt would result in higher interest costs for the Treasury.” The difference, though, is that a downgraded federal credit rating could ripple negatively across the entire economy rather than, in the case of Sam, just across one household. Interest rates could be higher across the entire economy; Mortgages, auto loans, and credit card debt could become more expensive; interest rates on student loans could increase; small businesses could pay more to borrow; and banks might be less reluctant to lend, Gale says. Taxpayers might also be forced to foot a larger bill from financing the federal debt, either in the form of higher taxes or lower government spending on other programs. Moreover, a lower credit rating for the federal government could make US Treasury securities—a form of government debt issued by the government—a less certain asset. “Investors,” Dr. Gale says, “use these Treasuries to park cash when they are uneasy about the markets or simply want a secure investment.”
So has it all come to fruition? It’s still early, but S&P’s unilateral action has not had the expected impact. Investors still seem to consider Treasury debt to be an ultra-safe investment.
According to Bo Becker, an assistant professor of business administration at Harvard Business School, it’s not so much the lower credit rating as the pressures underpinning it that spell trouble for the economy and individual citizens alike: “The increased budget deficits and debt that cause a downgrade are big problems,” Becker says. “These factors may limit U.S. growth going forward. Government spending will have to be restrained, and interest rates may go up for borrowers.” Trouble at the highest level of economic policy will inevitably travel downward to affect the entire economy.
So should the U.S. ignore what that rating agencies think? Probably not. Gale describes the worst-case scenario of a downgrade: “interest rates spike, and investors lose confidence that Treasury debt will be repaid with certainty. Foreign central banks and other large investors try to unload of a portion of their Treasury debt, which depresses Treasury prices further and sends interest rates soaring. Borrowing slows substantially, and economic growth subsequently stagnates.” The upshot: a double-dip recession.
It seems unlikely that the other two main rating agencies will follow S&P’s lead in the immediate future. But even one AA-plus rating shocked the financial world and provided yet another wake-up call to legislatures. Now comes the search for a solution. It’s going to take tough choices and sacrifices—spending cuts and tax hikes—to get the federal budget on a sustainable path. But just as Sam could never hope to deal with his debt by continuing to spend more than he makes, neither can the federal government. For his sake, and for ours, let’s hope they both find a solution.
Design by Melissa Wong