News Column

US AAA Rating Hovers Over Cliff

Jan. 8, 2013

Patrice Hill

Moody's

The United States looks increasingly likely to lose its gold-plated AAA credit rating in the next few months amid warnings by Wall Street rating agencies that last week's $650 billion "fiscal cliff" deal did not go far enough to reduce $1 trillion deficits and stabilize the debt.

Moody's Investors Service, in particular, warned last week that more stringent spending cuts or tax increases will be needed in the next round of budget negotiations if the U.S. is to avoid a second major downgrade of its rating -- one that would definitively kick the nation out of the exclusive club of AAA-rated nations.

The U.S. was knocked down a notch from AAA by Standard & Poor's Corp. after the 2011 fight over the debt limit, but it has continued to claim AAA status because its rating was not changed at that time by Moody's or Fitch Ratings, Wall Street's other two top credit agencies.

That may change unless President Obama and congressional Republicans overcome deep divisions over taxes and spending in the next few weeks.

Republicans are citing the warning from Moody's in demanding that the White House agree to substantial cuts in spending and reforms for Medicare, Medicaid, Social Security and other entitlement programs -- the biggest drivers of the budget deficit -- as a condition of securing an increase in the nation's $16.4 trillion debt limit.

But the White House has shown little inclination to accept their terms while some liberal Democrats have become downright dismissive of the credit agencies, arguing that S&P's August 2011 downgrade did not raise the Treasury's borrowing costs and -- with investors continuing to flock to Treasurys as a safe haven in turbulent global markets -- conditions have never been better for the government to keep borrowing.

Despite the indifference in some parts of Washington, analysts say this time could be different and that a second downgrade by Moody's or Fitch has the potential to cause significant market turmoil and damage the country's privileged financial status, which includes the lowest government borrowing rates in the world and the many prerogatives that go with printing the world's main reserve currency, the U.S. dollar. Subhed.sans: Rebound would be difficult

Economic analysts say that, once lost, it would be difficult for the U.S. to regain its top rating, and the move would confirm in the eyes of much of the world that the U.S. is slowly sliding into second-tier economic status.

"The next step is a very serious cliff that involves the credit rating of the U.S. It doesn't get more serious than that, and one hopes that will cause some to be more responsible than they might otherwise be," said David Kelleher, president of Better Markets Inc. and a former Senate Democratic aide.

"Unfortunately, the last debate over the debt ceiling in 2011 doesn't give much hope."

The downgrade in August 2011 provoked a major drop in consumer and business confidence and prompted a dizzying drop of more than 600 points in the Dow Jones industrial average the day it happened. But the impact proved to be transient, with most losses recouped within a matter of weeks or months, leading many in Washington to question whether another downgrade will have any lasting significance or effect.

"Plus, there are too many saying they are going to hold the credit rating of the U.S. hostage to their policy preferences," Mr. Kelleher said. "If politicians aren't careful, they could actually make everything much worse." Subhed.sans: Sounding the alarm

Some in Congress -- mostly Republicans -- agree that Washington should be worried about the next downgrade.

"America cannot afford for Moody's alarm to fall on deaf ears," said Rep. Tim Huelskamp, Kansas Republican. "In 2011, Washington was given ample notice that America's stellar credit rating was on thin ice, but Washington passed on the opportunity to deliver a solution. Unfortunately for America, the so-called fiscal cliff legislation was another last-minute deal instead of a real solution. There were consequences for inaction last time, and clearly there will be consequences this time around as well."

But skepticism that Washington will rise to the occasion also is plentiful. Liberal groups such as the Economic Policy Institute, a labor-backed think-tank, argue that there is little need to cut the deficit with Treasury's 10-year borrowing rates at all-time lows of less than 2 percent. They say the U.S. should take advantage of such low rates and increase spending on infrastructure, unemployment benefits and other economic stimulus programs.

"Some respected voices on the left believe that a focus on the deficit is an overblown reaction to a manageable problem," said David Hollingsworth, adviser for the Third Way, a centrist Democratic group that is pushing for further measures to reduce the deficit. "They argue that if our debt was really a big deal, investors wouldn't be supplying us with capital so cheaply."

Robert Shapiro, an economic adviser in the Clinton administration, advocates additional measures to gradually reduce spending on entitlement programs and bring down the deficit, but he blames the last downgrade on Republicans, not Democrats, and said it could happen again if conservatives insist on coupling an increase in the debt limit with unpopular spending reforms.

"The last time that House and Senate hyper-conservatives went down that path, it cost the U.S. government its triple-A rating from one of the three major credit-rating agencies," he said, suggesting that Democrats will try to pin any further downgrades on Republicans if it happens again this year, and to use it to political advantage.

"Any political leader or party that helps to bring about such a catastrophe will prove themselves unfit to govern for a very long time," he said. Subhed.sans: Wall Street worries

The growing intransigence on the left and right has led many on Wall Street and Main Street to question whether another agreement delivering more budget cuts will emerge from the latest round of negotiations.

Tom Porcelli, chief economist at RBC Capital Markets, said he expects Republicans to fight hard for spending cuts that eluded them in last week's deal, but the outcome is in doubt.

"In the absence of a grand bargain in the next two months, it is likely that the U.S. is downgraded," he said. "And this downgrade is likely to have a more significant market impact than the S&P downgrade," because it will force investment funds around the world to reshuffle the securities in their portfolios to ensure they are maintaining AAA or other targeted rating levels, he said.

This will cause widespread disruptions in global markets as investors recalibrate their portfolios, causing a "cascade effect" on assets other than Treasurys, he said.

John Browne, senior economic consultant at Euro Pacific Capital, said the damage from further downgrades would affect the U.S. status in the economic world for a long time.

The U.S. dollar is the world's dominant currency, he said, because debt troubles in the eurozone have tarnished the appeal of the euro, which had been ascending as a replacement for the dollar in the past decade.

"This privileged position has conferred on Washington the vital element of time to organize viable revisions to its entitlements," whose uncontrolled growth is at the root of the U.S. debt problem, he said. But political leaders appear to be "squandering" the luxury of time they got from the ongoing European debt crisis, he said.

"The spectacle of American politicians failing to agree on budgets, spending limits or any type of fiscal discipline can affect the credit rating of the U.S. Over the longer term, a major fall in the credit rating is likely to increase U.S. interest rates," he said. But perhaps the greatest impact is to the U.S. reputation.

"The blatant dereliction of duty on display in Washington will diminish national prestige," Mr. Browne said.

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