U.S. downgrade raises economic anxiety

The real danger from the downgrade of U.S. government debt by Standard & Poor's isn't higher interest rates. It's the hit to the nation's fragile economic psyche and rattled financial markets.

S&P's decision to strip the U.S. of its sterling AAA credit rating for the first time and move it down one notch, to AA+, deals a blow to the confidence of consumers and businesses at a dangerous time, economists say.

The agency is "striking at the heart of what makes the global economy tick," says Chris Rupkey, chief financial economists for the Bank of Tokyo-Mitsubishi UFJ. "It isn't just dollars and cents."

One economist, Paul Dales of Capital Economics, worried Saturday that the downgrade could even trigger another financial crisis that sends Western economies back into a recession.

The timing could hardly be worse for the U.S. The economy added 117,000 jobs in July, more than expected. But other economic indicators, including manufacturing, consumer spending and overall growth, are getting weaker.

And the markets just came through their most harrowing two weeks since the financial crisis of 2008. The Dow lost about 10 percent of its value on fears of a new recession and Europe's spiraling financial problems.

In normal times, in another country, a downgrade in a country's sovereign debt rating probably would force its government to pay higher interest rates to convince investors to keep buying its debt.

If that happened, it would drive up the rates that consumers pay on mortgages and auto loans, which are often tied to the government's interest rate.

But the United States is a special case. Treasury debt is considered the safest investment in the world — even after the downgrade. Investors don't doubt the U.S. government's ability to repay the $9.8 trillion it owes.

They also know they can easily buy and sell Treasury bills, notes and bonds. Rupkey calls Treasurys the "strongest, deepest, most liquid" market in the world.

"Anytime there's a problem anywhere on the planet, investors come to the safety of the U.S., and they don't go anywhere else," says Mark Zandi, chief economist at Moody's Analytics.

Despite worries about the U.S. government's huge debts and rumors of an impending downgrade from S&P, the yield on 10-year Treasury bonds was still a low 2.56 percent Friday.

That's because investors, worried about the weak U.S. economy and debt troubles in Europe, saw American bonds as a safer place to put their cash than, say, stocks.

"Where else are you going to put your money?" says Joe Libin, a Salt Lake City mortgage banker. "We're growing anemically. We've got a debt problem. But at least we're bobbing along. We're best-looking of the ugly kids at the prom."

U.S. banking regulators also moved quickly to reinforce the security of Treasury debt after S&P announced the downgrade Friday night. Regulators said they would continue to view Treasurys as a zero-risk investment and would not force banks to hold more capital against their Treasury investments.

There had been fears that some financial institutions with obligations to hold only top-rated investments might suddenly sell U.S. government debt on the open market — forcing the price down and the yield up, and leading to higher interest rates.

The vote of confidence by the bank regulators lessens the risk. In addition, the other top rating agencies — Moody's and Fitch Ratings — have maintained top ratings on U.S. government debt.

The S&P downgrade also doesn't apply to short-term U.S. securities — Treasury bills that mature in a year or less. It applies to government debt that matures in more than a year — Treasury notes and bonds. That means the downgrade shouldn't rattle money market funds that invest in short-term Treasuries.

Mark Vitner, senior economist at Wells Fargo Securities, agrees that the S&P downgrade is unlikely to drive up interest rates right away. But he says that's partly because the economy is so weak that borrowers aren't competing for money and driving rates higher.

In three-to-five years, he says, loan demand will be higher. When that happens, a U.S. Treasury with a dinged credit rating will be vying with private borrowers for loans and investments, and rates will likely rise.

"The greater consequences are going to be in the intermediate and long-term," he says. "If it didn't mean anything, S&P wouldn't have downgraded us."

The Obama administration made its displeasure known quickly after the downgrade was announced. The Treasury Department said S&P had acted on an analysis that had a $2 trillion error.

On Saturday, the administration appeared to soften its tone. White House press secretary Jay Carney, without referring directly to the downgrade, said President Barack Obama believes Washington "must do better" tackling the federal budget deficits.

Already, there were signs that the downgrade itself would become a volatile political issue.

Senate Majority Leader Harry Reid, D-Nev., said the S&P decision showed that Democrats' preferred solution to long-term debt, a mix of tax increases on the wealthy and budget cuts, was the right answer.

House Speaker John Boehner, R-Ohio, said he hoped Democrats would learn they can't "tinker around the edges" of the U.S. debt problem. And Republican presidential candidates for 2012 laid blame on Obama.

S&P had called for $4 trillion in U.S. deficit reduction. The deal cut by Congress early last week called for only about $2 trillion over the next decade. S&P said it wasn't enough to address America's debt problem.

The rating agency also said the decision reflected its loss of confidence in the U.S. political system. Republicans and Democrats didn't reach a deal on debt reduction until hours before the federal government's borrowing limit was to expire, which would have triggered a U.S. default on its debt or massive, immediate government cuts.

Economists say the downgrade, the first since the U.S. received the top rating from S&P in 1941, will rattle consumers and businesses already worried about the weak economy and the U.S. political system's inability to handle the country's problems.

Some fear the Dow Jones industrial average, which fell 512 points on Thursday alone because of fears about the economy and Europe, will plummet Monday when investors get to vent their anxiety.

An early sign of what's to come may emerge Sunday evening in the United States when Asian markets open.

America's reputation has already taken a hit abroad. China, the largest foreign holder of U.S. debt, on Saturday demanded that the United States tighten its belt and overcome its "addiction to debt" in the wake of the S&P downgrade. China's central bank holds an estimated $1.16 trillion in U.S. debt.

The state-run Xinhua News Agency declared: "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."

"It's going to be tougher for the U.S. to attract capital," Vitner says. "If you're a business and you're deciding where to invest your earnings and investors' capital, you're looking around the world. The U.S. suddenly looks riskier."