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Impact of credit rating downgrade rests with actions by Fed, Congress

Chicago Sun Times - Terry Savage  		   Can We Help
     

Standard & Poor’s downgraded the United States’ credit rating. That is not a surprise. It’s not as if the Oracle at Delphi came down with a pronouncement that changed everything. In fact, the global market has known about — and priced in — the debt problems that plague the United States.

 

And despite those debt problems, the U.S. dollar has remained the safe haven for scared money up to and including last week’s European debt crisis and the huge decline in the stock market last Thursday.

 

The credit rating downgrade may be an excuse for another round of volatility in the stock market today, but it won’t be a surprise to the markets.

 

Yes, it’s humiliating to have the Chinese lecture us on getting our house in financial order. That’s exactly what happened over the weekend, when the official Chinese news agency said: “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.”

 

Humiliating, yes. But how smart are the Chinese, since they hold $1.2 trillion of our debt?

 

And it’s embarrassing for the United States to lose its AAA credit rating, when countries ranging from Australia and Canada to Hong Kong, Guernsey, and the Isle of Man all are rated AAA.

 

Embarrassing, yes. But the United States is still the world’s largest economy, and its currency remains the standard for world trade. No one is suggesting that the euro or yen or Chinese reminbi is ready to take its place.

 

The impact of a credit rating cut

Yes, credit ratings are important. Your credit score is very important, because it determines the price you will pay for credit. But even when your credit score drops, you manage to go on living, albeit paying more for everything from car loans to mortgages.

 

It’s the same thing for the United States. The lower credit rating could cause the U.S. to pay a higher interest rate on all its borrowings. If that were to happen, you’d feel the impact immediately if you have a floating rate home equity loan or credit card debt. Higher rates might take a while longer to show up in your adjustable rate mortgage or next car loan.

But the real impact of higher rates caused by a credit downgrade would be in the business economy. Right now businesses are leaving money in the banks at very low interest rates, rather than put the money to work in an uncertain economy. If rates move higher, they’ll have even less incentive to invest in growing their business and creating new jobs. Higher rates would slow the economy and offer a tempting incentive to let the money just earn a bit more in the bank.

 

Winners and losers

Although it’s likely that rates won’t jump too much as a result of the downgrade, the winners would be those who have savings, since the Fed has kept interest rates artificially low, penalizing savers. And winners would be those who had locked in fixed rate, 30-year mortgages under 5 percent.

 

Higher interest rates penalize those who have lots of floating rate debt. And certainly higher rates might be bad for the stock market, competing to attract investors’ dollars in the short run, as well as causing an economic slowdown.

 

But in the longer run, the real winners and losers will be determined in the next three months — by the Fed and by the congressional committee of six.

If Congress can avoid another Christmas crisis over the debt ceiling, the world will heave a sigh of relief and stick with the dollar. If only this new congressional committee would meet after Labor Day and come out quickly with a solution to our debt problems.

Then the economy could start growing again, creating tax revenues — and helping us pay down our debt. The alternative is more delays, more uncertainty, and more economic weakness. This committee is in a tough spot — politically as well as economically. And they can’t expect much help from the Fed.

 

The Fed is in a tough place. They don’t want to see another recession. And they’ll be tempted to start another round of “quantitative easing” — the modern term for “money printing.” But now the world is watching. Any signs of “too much credit creation” will be a signal that inflation is on the horizon, destroying the value of the dollar. If that happens, we’ll really see the world demand higher interest rates as a bribe to buy our debt.

 

There are two triggers for higher interest rates: a decline in the quality of our credit rating, and fears of money creation — inflation.

The global markets might not react too sharply to the credit rating cut. But once the world loses faith in the dollar, retribution will be swift in the form of higher rates.

 

Credit ratings tell you what happened in the past. (Or at least, they’re supposed to. Don’t forget that the rating agencies kept giving AAA grades to mortgage-backed securities, right up until they defaulted!)

 

But the next steps taken by Congress will tell the world what’s likely to happen in the future. And nothing in the past is nearly as important as that next signal from Congress. We must tell the world we are getting serious about our finances — and soon.

 

Or it will be too late to do anything at all to stop the flight from the dollar and the destruction of our future. And that’s the Savage Truth.