From AAA to AA+

Posted: August 6, 2011 in International political economy, Paul Krugman, United States, US debt crisis

A last minute compromise between Democrats and Republicans last week may have averted a debt crisis and bankruptcy in the United States last week.  

However, it was enough to stop Standard & Poor’s, the ratings agency, to downgrade US debt paper from a pristine AAA to AA+ (with a negative outlook),  the first downgrade in U.S. history and a vote of no-confidence in the world’s largest economy and its political leadership.

The ratings agencies

The move is likely eventually to raise borrowing costs for the U.S. government, companies and consumers.

By calling the outlook “negative,” S&P signaled another downgrade is possible in the next 12 to 18 months.

It was another ratings agency, Moody’s which assigned the AAA rating in 1917.

Moody’s and Fitch, the two other ratings agencies retained the AAA rating but Moody warned it has a negative outlook for the US.  This means that a downgrade is possible in a year’s time.

S&P intoned:  “The downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges.”

The ratings agency put forth a blistering view of Washington partisanship, adding that “we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy.”

One lawmaker offered an equally biting retort.

Rep. Barney Frank (D-Mass.) angrily denounced the ratings downgrade, saying S&P was “trying to justify their reputation” after failing to spot problems in the nation’s financial system before the economic crisis of 2008.

Rep. Barney Frank (D-Mass)

“These are some of the people who have the worst records of incompetence and irresponsibility around,” Frank, the top Democrat on the House Financial Services Committee, said on MSNBC.

Writing at the New York Times, Paul Krugman ironically pointed out that it’s hard to think of anybody less qualified to pass judgement on America than the ratings agencies given their previous endorsement of sub-prime mortgages.

Paul Krugman

The Obama administration attacked the credibility of the analysis underlying Standard & Poor’s decision to downgrade the United States’ top credit rating on Friday, saying it had found a $2 trillion error.

S&P was forced to remove the number from its analysis after Treasury officials discovered that the rating agency’s estimates of the government’s discretionary spending was $2 trillion too high.

There was evident dismay, and some anger, within the Obama administration at S&P’s decision to downgrade U.S. debt despite the errors officials said they had found in the calculations.

“A judgment flawed by a $2 trillion error speaks for itself,” a Treasury spokesman said after S&P cut the long-term U.S. credit rating by one notch to AA-plus on concerns about growing budget deficits.

The comment marked the first time the U.S. Treasury had publicly chastised S&P. Administration officials have privately grumbled that the rating agency’s understanding of the U.S. political system was unsophisticated.

Notwithstanding S&P’s past record, its downgrade of the US credit rating has made its mark.  Across the world, stock markets crashed amid fears of economic slowdowns in both the US and the Eurozone.  Asian bourses were not spared and the Philippine Stock Exchange gave up 1.42 percent in last Friday’s trading.  

The country’s financial authorities are also concerned since we hold about US$26 billion in US securities, and most of our gross international reserves (GIR) are also in US instruments. The US market itself is a major export destination for Philippine manufactures and the appreciation of the Philippine peso vis-a-vis the US dollar will dampen American demand for Philippine products.  

China, the US’ biggest creditor,  said Washington only had itself to blame and called for a new stable global reserve currency.

“The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone,” China’s official Xinhua news agency said in a commentary.

Peoples' Republic of China--the US' main creditor

In the Xinhua commentary, China roundly condemned the United States for its “debt addiction” and “short sighted” political wrangling and said the world needed a new stable global reserve currency.

“China, the largest creditor of the world’s sole superpower, has every right now to demand the United States address its structural debt problems and ensure the safety of China’s dollar assets,” it said.

It urged the United States to cut military and social welfare expenditure. It also said further credit downgrades would very likely undermine the world economic recovery and trigger new rounds of financial turmoil.

“International supervision over the issue of U.S. dollars should be introduced and a new, stable and secured global reserve currency may also be an option to avert a catastrophe caused by any single country,” Xinhua said.

S&P blamed in part the political gridlock in Washington, saying politics was preventing the United States from addressing its deficit and debt problems.

British business minister Vince Cable backed China’s call for a new stable global reserve currency but said that for the moment the U.S. dollar remained key.

UK business minister Vince Cable

“Frankly, the American legislators made a terrible mess of things a few weeks ago, they have now got back on track, they have undertaken to manage their debt in a prudent way,” Cable said.

Cable’s remarks may be bitter pills for China to swallow.  As the US’ largest creditor, China has the most to lose with the downgrade of US credit ratings.  Indeed, American legislators have a played a part in the latest crisis.  However, China shares some of the short-sightedness herself.  America’s economic woes did not arise overnight yet China chose to continue investing in US treasury bills.  Prudence should have cautioned her to diversify her investment portfolio.

The markets are in for a ride in the weeks to come.

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