The Standard and Poor’s (S&P) Debt Downgrade: What It Means

Tuesday, August 9, 2011
By Paul Martin

From AAA to AA+

by Dr. Paul Craig Roberts
Global Research
August 8, 2011

On Friday, August 5, the credit rating agency, Standard & Poor’s, downgraded US debt from AAA to AA+.

Gerald Celente’s view that S&P’s downgrade of the US Treasury’s credit rating reflects a loss of confidence in the political system was confirmed by the rating agency itself. S&P explained the downgrade as the result of heightened political risks, not economic ones. The game of chicken over the debt ceiling increase and the GOP’s ability to block tax increases indicate that “America’s governance and policymaking is becoming less stable, less effective, and less predictable”

The reduction in the government’s credit rating to AA+ from AAA is a cosmetic change. It remains a very high investment grade rating and is unlikely to have any effect on interest rates. It is revealing that despite the downgrade, US bond prices rose. It was stocks that fell. The financial press is blaming the stock market decline on the bond downgrade. However, stocks are falling because the economy is falling. Too many jobs have been moved offshore.

Interest rates could fall further as investors flee into Treasuries from the euro because of sovereign debt worries, flee equity markets as they continue to tumble, and as large banks charge depositors for holding their cash. Indeed, the latter policy could be seen as an effort to drive people with large cash holdings out of cash into government bonds. Japan has a lower credit rating than the US and has even lower interest rates.

More hard knocks are on their way. As the economy weakens and the economic outlook darkens, new deficit projections will elevate the debt issue.

The psychological effect of the S&P’s downgrade is likely to be larger than its economic effect. Many will see the downgrade as an indication that America is beginning to slip, that the country might be entering its decline.

There is no danger of the US defaulting on its bonds. The bonds are denominated in US dollars, and dollars can be created without limit. Moreover, the problem with the debt is less with the size of the national debt, which remains a lower percentage of GDP than during World War II, than with the large annual budget deficits. If equities continue to fall, if flight continues from the euro, if bank fees drive people out of cash, it is possible that the inflows into Treasuries can finance, for awhile, the large annual deficit, removing the need for the Federal Reserve to monetize the deficit via Quantitative Easing.

On the other hand, the weakening economy, given traditional policy views, will likely lead to a renewal of debt monetization or QE in an effort to stimulate the economy.

Continued debt monetization threatens the dollar. Investors will move out of Treasuries and all dollar-denominated assets not because they fear default, but because they fear a fall in the dollar’s exchange value and, thus, a fall in the value of their dollar holdings.

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