The 4 Consequences of the S & P Downgrade

The 4 Consequences of the S & P Downgrade

Getty Images

S&P’s decision to downgrade long-term U.S. debt for the first time in history had more to do with politics than economics.  The debt service load is clearly manageable – we can pay it off if we are willing to do so.   But our willingness to seriously address the long term debt problem is the real issue. S&P is worried that we won’t be willing to cut spending and, even more so, to raise taxes as needed to bring the long-term budget into balance.

And there is another worry as well. The recent debate between President Obama and the Republicans and associated shenanigans over the debt ceiling demonstrates that political dysfunction could cause an interruption in government bond payments. If, for example, the debate over the debt ceiling is repeated next year – as it is likely to be – there is no guarantee that negotiations can be resolved in time to ensure all payments are made on schedule. There is no doubt that the payments would be made eventually, but a delay would cause troubles for investors who depend upon these payments to meet their obligations.

I do not believe we will ever default on bond payments. That would be the last thing the Treasury would choose to do. So, I don’t think the downgrade of long-term U.S. debt from AAA to AA+, along with a negative outlook to the lower AA+ rating, is justified. But I’m not the one issuing the ratings, and the question at this point is what effect the downgrade might have on businesses and consumers.

The biggest concern is that the downgrade might increase the risk premiums attached to interest rates paid on Treasury securities.  If so, that would raise the cost of funds to banks and other financial institutions, forcing financial institutions to increase the interest rates they charge customers  generally. This, in turn would be bad for business investment since borrowing costs would be higher, and it would put a damper on consumer purchases of durables such as cars and refrigerators, and it would further reduce the demand for housing.

Will the downgrade cause interest rates to increase enough to matter? Nobody knows for sure at this point, but my expectation is that the effect will not be large. One reason is that the other two ratings agencies, Moody’s and Fitch, are not expected to follow suit. Thus, even among the ratings agencies there is no consensus that a downgrade can be justified.

Another reason to believe the interest rate effects will be small is that investors have been expecting a downgrade for some time, but interest rates actually fell last week due to the renewed signs of weakness in the economy. Thus, so far there is no sign that investors will demand higher interest rates on dollar denominated government debt issues.

But what about worries that go beyond interest rate increases? Is there more to be concerned about here? A second potential effect of the downgrade comes from its impact on business and consumer confidence. Consumers and businesses could become more pessimistic about the future as a result of the downgrade and, in response, cut back on consumption and investment.

However, while it’s possible this could happen, I think the willingness of both consumers and businesses to consume and invest depends more upon expected growth in output and employment than it does on the expected growth in the debt. The major worry holding back businesses and firms is where the economy is headed – uncertainty has increased in recent months – and this is the major problem we need to solve.

But that’s not to say that confidence does not come into play. A confidence effect is, I think, behind the recent jitters in the stock market. We were promised by the advocates of austerity that reducing the long-term debt would inspire business and consumer confidence and this would help to spark the recovery. But just the opposite appears to have happened. The cutbacks required to reduce the deficit caused businesses and consumers to expect future declines in aggregate demand, and hence to expect a slower recovery, and the plunge in the stock market was a reflection of these increased worry over the pace of the recovery.

A third potential consequence of the downgrade has to do with the ability of state and local governments to finance infrastructure projects. With the federal debt downgraded, it’s hard to imagine that state and local bonds won’t be far behind. If state and local bond issues are downgraded, it could increase interest rates that state and local governments must pay to finance construction projects, and that would reduce infrastructure spending.

A fourth potential effect is an increase in insurance costs. Insurance companies hold considerable quantities of Treasury securities in their portfolios. If state regulators increase capital requirements to compensate for the increased riskiness of the government bonds held as backup against unexpected payouts, insurance costs generally would rise. However, most observers do not expect state regulators to make such demands.

Finally, there is some worry that since some money market funds are required to hold AAA assets in their portfolios, there will be a large selloff of these assets on Monday when markets open and that could be disruptive. But most observers don’t expect much of an effect here, and I concur with this assessment. Similarly, many banks hold government securities as part of their capital requirements, and there was concern initially that they would be asked to add to their capital reserves to compensate for the write down of government assets. But the Fed has indicated that the capital banks currently hold remains sufficient, so there is little to worry about here.

Putting all of this together, my expectation is that while there may be some effects here and there, when it comes to evaluating consumer and business behavior the downgrade by S&P is not the biggest factor to be concerned about right now. Far more important is the outlook for the economy, and getting people back to work ought to be our main priority. This brings me to what I think might be the biggest negative of all from the downgrade. The unilateral move by S&P is dominating discussions in the media and among policymakers, and that is it distracting us from discussing and moving forward on the most important problem we face, putting people back to work.