Nearly everyone wonders about the long- and short-term effects of the recent U.S. credit downgrade. America’s Moody’s rating remained intact with a warning, while Standard and Poor’s actually downgraded the U.S. credit rating because of the national debt crisis. To understand what this credit rating downgrade means, it is necessary to explore more basic areas such as the meaning of credit ratings and sovereign debt in general.
What Is the National Debt?
While America’s debt is often referenced in public discourse, few have any understanding of what the debt actually means other than a big number on the U.S. debt clock. It is important to distinguish between:
- National Debt is the amount of money the federal government owes to its creditors, largely in the form of bonds.
- National Deficit refers to the discrepancy between how much the government spends and how much it takes in during any given year. Thus, the national deficit is the degree to which the national debt increases in any given year.
The national debt is owned by a variety of creditors, with $4.45 trillion or roughly one-third of all the debt owned by foreign central banks. This represents a dramatic increase from 13 percent in 1988.
S&P Ratings and Moody’s Ratings
Standard and Poor’s and Moody’s are two of the biggest credit rating agencies in the world. Moody’s is actually two companies: Moody’s Analytics and Moody’s Investor’s Service, the latter of which is the credit rating agency.
Credit rating agencies, or CRAs, determine the value of what a debtor owes. They evaluate how likely it is the debtor will continue making timely payments on outstanding debt.
This rating helps lenders determine how good an investment the debtor is. Similarly, it helps bond traders determine the relative value of bonds, as well as credit default swaps. The latter is a type of insurance (and often an exotic investment) protecting a creditor when a debtor defaults on a loan.
Moody’s did not downgrade the U.S. credit–it was S&P who issued a U.S. credit downgrade. Still, Moody’s issued a stern warning, concerned that the national debt was out of control. S&P downgraded the U.S. credit from AAA to AA+, the first U.S. credit downgrade in history.
Effects of the U.S. Credit Downgrade
The short answer to the potential effects of a U.S. credit downgrade is that no one knows for sure. Stocks took a hit after the news that America’s debt rating was downgraded on S&P ratings. Still, this was largely an example of perception being reality.
While conceding no one knows for sure the long-term effects of the downgrade (if any), some potential effects of the increasing U.S. debt and related downgrade include:
- Credit: Credit will almost certainly be affected in some way or another. Some predict a spike in interest rates.
- Mortgage Rates: Mortgage rates might be especially impacted, because Freddie Mac and Fannie Mae also had their S&P ratings downgraded. These companies underwrite or own about 50 percent of mortgages in America.
- Price of Oil: Oil hit its lowest price all year following the credit downgrade, though it is hard to tell to what degree this is a direct result of the downgrade. Some economists consider a reduction in the cost of oil to be comparable to a tax cut.
- Economic Recovery: The federal government has less power to build the economy up with monetary policy. This might mean a further slowing of the American economy or, at the very least, an even more sluggish recovery.
- Credit Freeze? Nearly no one expects a credit freeze of the kind that plagued the economy during the onset of the 2008 recession. Barring a meaningful increase in unemployment, banks might slow lending or increase interest rates, but no one is predicting a freeze on credit.
As this is the first U.S. credit downgrade in history, the economy is really entering Terra incognita. Only time will tell precisely what the downgrade in America’s S&P ratings and warnings from Moody’s will mean.
Preparing for the Future
While no one is sure what will happen as the U.S. debt clock ticks ever higher, you must prepare for the future. Some ways to weather the storm of mounting U.S. debt include:
- Paying Down Your Debt: If interest rates climb, even your existing debt will be more and more expensive.
- Live Within Your Means: Whether you’re thinking of your family or your business, try not to take on new debt. Credit might be hard to come by or prohibitively expensive in the future, so don’t expect to rely on it.
- Invest in Durable Goods: Again, businesses and families would do well to invest in durable goods. These are items with value independent of credit or inflation. Without taking on more debt, now might be the time to purchase the furniture and home appliances you’ve been considering buying.
With a little forethought and planning, you will be able to deal with the effects of the U.S. credit downgrade with little to no pain and suffering.
