All of the three major rating agencies -- Moody's, Fitch and Standard & Poor's -- have warned the Obama administration that if Washington failed to get spending under control and take steps to reduce the nation's debt they would review the U.S. credit rating for a possible downgrade.
That's what happened on Friday. S&P cut its long-term credit rating on the U.S., to AA+ from AAA and kept a negative outlook.
We had reported earlier that reaching an agreement on the debt ceiling wouldn't have prevented a downgrade on the country's AAA rating. Now, the downgrade assumes some significance because the U.S. has been the world's dominant financial power for at least seven decades. The U.S. dollar is the reserve currency of the world and the debt of the U.S. became the collateral, which supported a wide variety of global financial instruments.
Now, some critics will question how the world's reserve currency, its interest rates and its monetary policy can be tied to the U.S.
"One cannot keep buying U.S. Treasuries to protect against a U.S. Treasury crisis," Rochdale Securities analyst Richard Bove wrote in a recent note to clients. "The risks here are high. The most compelling one is that the U.S. will be forced to utilize its own resources to meet its own debt service costs. That will stress the economy as much as any tax increase might."
In Fitch's opinion, the debt deal was an important first step but not the end of the process towards putting in place a credible plan to reduce the budget deficit to a level that would secure the AAA-credit rating of the U.S. over the medium term.
"We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process," S&P said in a statement on Friday.
With the downgrade comes the end of an era. The U.S. has been rated triple AAA since 1941 and that reputation, even if the rating is restored, is tarnished.
Why the Downgrade?
The key problem the U.S. faces is that at present it has no plan to pay for its expenditures using its own resources.
If it raises taxes, it would slow economic growth and if it cut expenditures to reduce the deficit, it would put millions of people out of work.
The U.S. government recorded a $1.1 trillion budget deficit during the first 10 months of the fiscal year 2011, despite a revenue increase of eight percent, the Congressional Budget Office said on Friday.
For the first quarter of 2011, the U.S. had receipts of $4.107 trillion and expenditures of $5.578 trillion, implying a net deficit of $1.471 trillion, according to the Commerce Department's Bureau of Economic Analysis.
The deficit was covered by borrowing the money in the open market and by the Federal Reserve printing new funds under its QE2 program. (Under the QE2 program, the central bank has been buying up long-term Treasury bonds, in a bid to push down yields; thus, aiming to make it cheaper for consumers and businesses to borrow money.)
Meanwhile, the Treasury Department estimates that the second-quarter actual deficit was $460 billion.
If this scenario continues, it is more than likely that the total debt of the U.S. -- now estimated to be $14.3 trillion -- will rise consistently for the next ten years.
The recent signing of a debt deal also didn't help to preserve the AAA rating. On Aug. 2, President Barack Obama signed a bill to raise the U.S. debt ceiling, preventing a default for the first time in its history. The agreement passed by Congress provides for an initial increase of the debt limit of $900 billion and introduces procedures that would allow the limit to be raised further in two additional steps, for a cumulative increase between $2.1 trillion and $2.4 trillion by the end of 2011.
But S&P wasn't convinced with the effort and said: "The political brinksmanship of recent months highlights what we see as America's governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy."
S&P said despite this year's wide-ranging debate, the differences between political parties have proven to be extraordinarily difficult to bridge, and the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently.
"It appears that for now, new revenues have dropped down on the menu of policy options. In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability," S&P said.
S&P has reasons to say so. The U.S. economy stumbled badly in the first half of 2011 and came dangerously close to contracting in the January-March period. The economy grew at a 1.3 percent annual pace in the second quarter, compared to the 1.9 percent pace that analysts were expecting.
Additionally, growth for the first quarter was revised down to 0.4 percent from the previously reported 1.9 percent rise. As a result of this slower-than-expected expansion, economists' expectations for the fourth quarter dropped to 2.3 percent from 3.1 percent.
Though the Obama administration has criticized S&P for the downgrade, some market observers agreed with the stand of the rating agency.
"There is no likelihood that the U.S. would be able to pay for its expenditures through its own resources; and it is fair to state that no private sector entity with a record of this nature and a projected cash outlook of this type would be awarded more than junk bond status," Rochdale Securities analyst Richard Bove wrote in a note to clients.
"Yet when Standard & Poor's lowered the U.S. to an AA+ rating it was widely criticized as being a political act with no justification. From my perspective Standard & Poor's just shouted 'The Emperor Has No Clothes' and I agree."
Lance Roberts of Streettalk advisors said, "However, at the end of it all, I can't say that S&P was wrong in lowering our rating as I am sure it was a tough call for them to make; but we did it to ourselves."