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Another U.S. Credit Downgrade Is Coming--And it Won't Matter

Rick Newman

Not long ago, it was unthinkable that the United States would lose its top-shelf credit rating.

Then it did.

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Now, with further downgrades likely in coming months, the attitude among investors seems to be, ho-hum.

The first downgrade came in August of 2011, when Standard & Poor's cut America's AAA rating by one notch, following the failed negotiations between Democrats and Republicans to come up with a plausible plan to reduce gaping U.S. budget deficits. Markets reacted with alarm. The S&P 500 index fell by nearly 7 percent on the first trading day after the downgrade.

With politicians in Washington trying once again to tackle the nation's mountain of debt, the U.S. credit rating is in further jeopardy. The looming "fiscal cliff" requires lawmakers to take action on a range of thorny financial matters, or else tax hikes and spending cuts totaling more than $600 billion will hit the U.S. economy, probably causing a fresh recession.

There's no good scenario. Lawmakers could take new action to prevent some or all of those austerity measures from going into effect, which would be a relief for the economy in the short run. But that would perpetuate the debt problem and demonstrate a continued inability in Washington to carry out the basic requirements of governing.

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Moody's, which still gives its top rating to U.S. Treasury securities, has warned that it's "unlikely" Washington will keep that rating. The only way to do so, Moody's said in September, would be for lawmakers to approve a "large, immediate fiscal shock" that sharply cut deficits. But austerity of that magnitude would trigger the recession that many business leaders are worried about, which makes it politically implausible and probably foolish as well. So passing a less disruptive set of measures, while tolerating a credit-rating downgrade, seems like the best option among bad choices.

A second downgrade would further tarnish America's battered political reputation--but economists think that might be the extent of the damage this time around. "Credit rating adjustments, in and of themselves, I don't think are important," says Nigel Gault, chief U.S. economist at forecasting firm IHS Global Insight. "To a large extent, downgrades simply confirm what financial markets have already seen."

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Markets tanked after the first downgrade, in 2011, for two basic reasons. First, it had never happened before, so nobody was sure what the ramifications would be. Second, a lower rating on debt usually reflects a higher risk of default, which forces the issuer--in this case, the U.S. Treasury--to pay more to borrow. Had that happened, rising borrowing costs for Washington would have made its whole debt problem even worse.

But that's not what happened.

"When the United States got downgraded, interest rates went down, not up," says Alan Levenson, chief economist for investing firm T. Rowe Price. The drop in rates reflected other problems elsewhere that had nothing to do with the U.S. credit rating. Europe's own debt crisis was smoldering, China's economy was slowing, and investors still felt U.S. government securities were the safest place to park their money. "We're winning the ugly contest," Levenson says.

So if Moody's and a third rating agency, Fitch, do in fact cut the U.S. credit rating, it will no longer be unprecedented and it won't come with the automatic assumption that U.S. borrowing costs--which help determine the interest rates many consumers and businesses pay--will promptly go up. It will also come at a time when the U.S. economy is stronger than it was in the summer of 2011, since the housing market has finally bottomed out, consumers have been paying down debt and many companies are in strong condition.

Traders joked after the 2011 downgrade that since borrowing costs fell, maybe the rating agencies should cut the U.S. rating all the way to junk status, so Washington could pay nothing to borrow. But further downgrades could still be dangerous, especially if Washington policymakers demonstrate continued ineptitude and the U.S. national debt continues to swell unabated. If Europe or Japan ever became healthy, their currencies could become a viable alternative to the U.S. dollar as the currency of last resort. At some point, China may be considered a safe enough investment to divert investment dollars from U.S. Treasuries. America may not win the ugly contest forever.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

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