How politics can ruin America's AAA credit rating

On Oct. 15, the Fitch Ratings agency put the United States' sterling AAA credit rating on negative credit watch, a warning that the rating could be downgraded in the coming months. Fitch did so because of political gridlock on Capitol Hill — the president and Congress could not reach a deal to end the government shutdown and lift the debt ceiling until hours before the Oct. 17 deadline. Thanks to the agreement, the U.S. Treasury is able to fund the government through Jan. 15, and the federal debt ceiling, the cap on total federal debt established by Congress, has been raised until Feb. 7. Had the deadline been missed, the Treasury would have been able to pay bills for only a few more weeks.

The government's bills include Social Security payments, tax refunds, military salaries and interest on the national debt, but revenues are falling short of spending. To bridge this deficit, the Treasury borrows money by issuing Treasury bonds, notes, bills and Treasury Inflation-Protected Securities (TIPS); collectively, these are known as Treasuries. The rating on the U.S. government addresses the likelihood that it cannot pay its debt because it either has no money or is not willing to pay. Although this likelihood is low at the moment, congressional politics have caused uncertainty about the resiliency of the U.S.'s AAA rating.

Investors consider Treasuries and the U.S. dollar to be what are called safe-haven assets. During a domestic or global financial crisis, investors sell their riskier assets, such as equities and low-credit bonds, and buy assets with minimal risk of default, like Treasuries, or they hold stable currencies that are unlikely to be devalued, like the U.S. dollar.

The U.S. economy is the largest in the world, with a gross domestic product of about $15.5 trillion in 2012, according to the Office of Management and Budget (OMB), and with more debt and currency in circulation than any other country. Since the dollar is the world’s reserve currency, the United States benefits from cheaper import prices and lower borrowing costs.

Despite these strengths, rating agencies can downgrade the U.S. rating or warn of a possible downgrade in the face of an impending event. The inability of Congress and the president to agree on a course of action for the country's financial situation was such an event. At the heart of the extreme political posturing between the White House and congressional Republicans is a growing long-term fiscal crisis — one that will not be solved by renegotiating the debt ceiling and budget every few months. Maintaining the country's rating will require significant concessions about revenues and spending to reduce the deficit and balance the budget.

The U.S. government has carried debt from its birth in Revolutionary War expenses and throughout most of its history. To limit the amount the government owes, Congress votes on a debt ceiling. Rarely, if ever, is there political gridlock about the budget resulting in a government shutdown. Yet government spending to stem the financial crisis during the Great Recession and to stimulate economic growth, coupled with worries about entitlements such as health care and Social Security, has become a concern.

At the beginning of the recession, the deficit tripled to $1.4 trillion in 2009 from 2008, according to the OMB. While the deficit has come down slightly, to $1.1 trillion in 2012 — about 7 percent of GDP — the total national debt has grown from about 62.1 percent of GDP in 2007 to 100.5 percent in the second quarter of 2013, according to the Federal Reserve Bank of St. Louis and the OMB.

In other words, the nation's debt is growing at a faster rate than the economy.

Fitch maintained the country's AAA rating throughout the Great Recession because of qualitative factors. The U.S. government can sustain its debt in part because of the dollar's role in the world economy and its financial flexibility: The U.S. is able to tap the financial markets to refinance its debt. Treasuries have a wide investor base and have been resilient in the face of most economic and political shocks. While interest rates are a measure of risk, rates on Treasuries are very low in comparison to those of many other investments.

Had the debt ceiling remained unchanged, default would have been caused by the U.S. government's unwillingness to pay. The government would not have run out of money per se, because the Treasury can always print more. Rather, Congress was refusing to pass legislation so the Treasury could issue new debt to pay bills.

Despite the political crisis, investors did not expect a default. Treasuries rallied in the beginning of October, as yields on 10-year Treasury bonds dropped about 40 basis points from mid-September. Investors continued to buy bonds, which drove prices up and yields, or interest rates, down.

Treasuries do not have a grace period; payments are due when they are due. Had the Treasury paid investors a few days late — what is referred to as a "technical" default — the U.S. government's rating would have been downgraded. The impact of a technical default on the global and domestic economy would likely not have been as severe as other scenarios that could play out many years from now. Although some countries have debt that far exceeds their GDP, their economies are nowhere near the size of the U.S. economy.

No one knows for sure the potential consequences of a U.S. government default from an inability to pay its debt. There could be a spike in rates, with inflation rising in step, as investors sell Treasuries and move out of holding dollars. This would cause the government to either raise taxes or print money. Either way, potential effects would be a slower economy and a devalued dollar.

Fitch plans to review the government's credit by the first quarter of 2014. The company will assess the impact of the recent debt ceiling crisis and government shutdown, as well as the prospects for reducing U.S. public debt over the medium to long term.

Fitch does not provide guidance on whether the government should raise taxes or cut spending, but will react to new legislation. To date, the government passed the Budget Control Act to end the debt ceiling crisis and lower the deficit in August 2011 and raised taxes with the American Taxpayer Relief Act, passed on Jan. 1 of this year, but more needs to be done so the economy can grow out of debt.

The U.S. recovered from similar debt levels after World War II. It most recently had a budget surplus during President Bill Clinton’s second term, and, with compromise in Congress, it will likely do so in the future. But there is another worry: If other countries tire of the shenanigans in Washington and begin to lose faith in the U.S. government, they may decide that Treasuries are no longer a safe haven and that there are better options for currency reserves, such as the euro, the Swiss franc or another currency that is not pegged to the dollar. The U.S. would also lose its preferential treatment regarding trade and borrowing money — imports would become more expensive and interest rates would rise.

Political risk stemming from the budget debate has jeopardized the U.S. rating. Even though the rating benefits from the country's unique strengths, an inability to implement an effective economic policy could affect the government's access to the capital markets. Three weeks after the latest showdown, little or no progress has been made toward a balanced budget. When the debt ceiling extension expires in a few short months, these issues will again come to the fore unless a viable solution is reached well before the deadline.