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Political Economy
Posted at 01:14 PM ET, 04/19/2011

U.S. credit rating downgrade: the Armageddon scenario


Following news that Standard and Poor's had cut its long-term outlook on U.S. debt to negative, the Dow Jones industrial average (INDU) fell 180 points in afternoon trading April 18, settling at the close down 140 points. (Spencer Platt - GETTY IMAGES)
A credit rating downgrade for the United States would spell even more financial trouble for the U.S. government, hampering its ability to borrow money as investors demand higher yields to make up for the increased risk. That would cause its national debt to balloon further and increase the need to hike taxes or make even more painful cuts in spending.

But the real Armageddon scenario would occur when the impact of a sovereign downgrade hit the rest of the U.S. economy.

The U.S. “risks eroding its standing at the core of the global monetary system,” Mohamed El-Erian, chief executive and co-chief investment officer at PIMCO, wrote in a commentary piece for the Financial Times.

Pension funds and investment trusts that are bound by covenant to invest only in AAA-rated debt could be forced to dump U.S. holdings. Banks that do the bulk of their business in the U.S. could themselves face downgrades. Eventually, the dollar could lose its status as the world’s reserve currency.

The ripple effects of Standard & Poors’ decision to downgrade its outlook for the U.S. were already spreading on Monday.

The agency also downgraded its outlook for five AAA-rated U.S. insurance groups: Knights of Columbus, New York Life Insurance, Northwestern Mutual Life Insurance, Teachers Insurance & Annuity Association of America and United Services Automobile Association. In downgrading their outlook from stable to negative, S&P noted that these companies are “constrained by the U.S. sovereign credit rating because their businesses and assets are highly concentrated in the U.S.”

S&P analyst David Zuber and his colleagues wrote that they took into account “direct and indirect sovereign risks—such as the impact of macroeconomic volatility, currency devaluation, asset impairment, and investment portfolio deterioration.”

How likely is this nightmare scenario to happen?

There are 19 sovereigns rated AAA by the S&P. Of those, only the United States has a negative outlook. There are a number of countries that have lost AAA ratings over the past 20 years—including Canada, Denmark, Finland and Sweden—but they ended up regaining them.

Goldman Sachs analyst Alec Phillips wrote in a research note on Tuesday that while he agrees with S&P that the “current trajectory of fiscal policy is unsustainable over the long-term” and that the U.S. “already appears to be on the edge of AAA territory,” he has a somewhat more optimistic view of the U.S. situation over the next few years and assumes that some fiscal tightening is likely to occur.

New York Times columnist Paul Krugman argues that even if a downgrade were to happen it would be “no big deal,” pointing out that when S&P downgraded Japan in 2002 and interest rates did not rise.

Steven Ricchiuto, chief economist with Mizhuo Securities, predicts that S&P’s decision to downgrade the U.S. outlook will be followed by Moody’s and by “additional warnings over the netx six to nine months.” He said that if there is “constructive bipartisan action on the budget could lead to an upgrade back to a stable outlook.” But, he warned “the hurdle is fairly high already and will only get higher with time.”

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By  |  01:14 PM ET, 04/19/2011

 
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