Implications of US Debt Downgrade

Standard & Poor downgraded the US fiscal position from AAA to AA. This reflects the credit rating agencies belief that the US fiscal position has deteriorated and they are more pessimistic over long term fiscal consolidation in the US. It means that the rating agency feels the threat of US defaulting on its federal debt is greater.

Theoretical Implications of Rating Downgrade

  1. Could lead to higher interest rates. Investors may now be less willing to buy US bonds. This will lead to a lower bond price and higher interest rates.
  2. Higher debt interest payments. In 2009, the US spent $381bn on interest payments. A small increase in interest rates, will increase the debt interest burden, making it more difficult to control debt / GDP.
  3. May put more pressure on government to reduce spending / increase taxes to reduce government borrowing. However, these fiscal cuts could increase the risk of a double dip recession, compounding the US economic problems.
  4. Increase pressure to pursue another round of quantitative easing. US federal reserve could buy more US Treasuries.
  5. Fall in value of dollar. If foreign investors are less keen to buy US bonds, there will be less demand for US dollars, this will cause a fall in the the value of the exchange rate. This will make US imports more expensive, though could boost US exports.

Evaluation

  1. The record of Credit rating agencies is mixed. They gave AAA rating to mortgage loan bundles which proved to be a very bad loan. (misapplied credit ratings)
  2. Japan was given a credit rating downgrade in 2002 by S&P , but bond yields on Japanese bonds remain very low (e.g. 10 year bond is just above 1%) This shows a debt downgrade doesn’t have to lead to higher interest rates. (Japan national debt)
  3. In a liquidity trap, with a rise in savings, investors are still looking to buy bonds because they offer a safe investment.
  4. The US situation is not comparable to countries in the Eurozone. They retain greater flexibility over monetary and exchange rate policy to provide greater flexibility over economy.
  5. The greatest long term challenge to the budget position is not short term spending cuts, but how the government deal with the rise in entitlement spending (pensions, health care). This will be exacerbated as the US population ages (though at a much slower rate than US)
  6. Prospects for debt / GDP depend as much on GDP growth as they do on actual debt. If these spending cuts cause a fall in GDP, the US could be seeing a negative debt spiral.
  7. The US bond market is highly visible and analysed, it is unlikely many investors learnt anything new from the report of S& Poor’s credit rating.
  8. A $2trillion mistake in the S&P gave some ammunition to the US Treasury in ignoring report.

This is not to say the US is immune from future debt problems. The political system with divided house and president really creates problems; it seems very difficult to see strong leadership in dealing with fundamental problems. The philosophical rejection of any tax increases and political difficulty of evaluating entitlement spending means there is a real chance the US could make the long term fiscal situation worse over time.

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