Standard & Poor’s Rating Service, which regularly evaluates the credit worthiness of all types of bonds, today downgraded its outlook from “Stable” to “Negative” for the U.S. While it reaffirmed that U.S. Treasury securities retain their highest possible AAA rating, S&P said there is a one in three chance that this rating could be reduced if the deficit outlook does not improve materially over the next two years.
The primary concern of the rating agency is that the large gap between Republicans and Democrats could prevent meaningful action to reduce the growth of U.S. public sector debt until after the 2012 election. The U.S. deficit/GDP ratio is already significantly higher than most other nations receiving the AAA status.
Credit agency ratings have often been slow to acknowledge deteriorating conditions, as was clearly evident in the run-up to the financial crisis. The serious debt issue that the U.S. faces has been apparent for a number of years as the entitlement legacy for retiring baby boomers looms.
Nevertheless, markets reacted on the S&P announcement by driving stock prices and Treasury bond prices lower and gold prices higher. This was probably an overreaction as the primary message of a credit rating is to indicate the probability of a major restructuring of a country’s debt or default. While a failure to take rapid and large steps to address its budget problems suggests that interest rates could move higher and/or the dollar move lower in the next few years, the U.S. is not in the same league as Greece, Ireland, or Portugal. Its economy is highly productive, its labor markets are highly flexible, and most of its trade flows and external liabilities are denominated in its own currency. The U.S. will honor its commitments to its bond holders.
Perhaps the S&P rating will serve as the wake-up call to Washington that this is not the time for politics as usual or that 2011 can be the time for positioning for next year’s presidential and congressional elections. Deficit reduction will not be easy, but the cost of not taking significant action will be even more painful.