Will U.S. Soon Lose Its Top Credit Rating?

Unless the U.S. economic recovery meets expectations, there is concern that the U.S. will lose their top credit rating.  Contrary to popular belief, the U.S. is currently not broke despite recent annual deficits topping over a trillion dollars.  This is because our economic activity exceeded $13 trillion in Real GDP last year.  However, it is essential that the U.S. acts relatively quickly in addressing future deficits that are projected to balloon due to rising entitlements from Social Security and higher health care costs.  If Congress fails to act soon, then it is quite possible that we will lose our Aaa rating soon.

Currently, the U.S. is taking a different tact from Europe in dealing with debt reduction.  While Europe's crisis involving Southern Europe has forced them to curtail government spending and raise taxes, it appears that the U.S. is primarily focused on cutting government spending to achieve the goal.  When looking at the extension of the Bush tax cuts for both the middle and upper income classes, this actually increased projected budget deficits because previous budget estimates assumed that the tax cuts would expire at the end of 2010.  Actually, a reduction in government spending and increasing taxes will negatively impact economic activity in the short run, but both actions might be necessary to ensure that interest rates do not rise in the future for businesses and households.

A downgrade of our credit rating will have ripple effects on our economy in the future.  Its first effect will be increasing the cost of deficit spending for the U.S. Treasury.  As has been the case historically within the U.S. with limited exceptions, we have spent more than we have collected in tax revenues.  Therefore, the U.S. has to issue U.S. Treasury debt.  With a Aaa rating, interest costs are minimized.  If Moody's or S&P credit agencies downgrade the U.S. credit rating, then it will be more expensive to issue debt.  When that occurs, then we could see a rise in interest rates that will dampen both consumer and investment spending. 

One only has to look at Japan to see the effects of damaged credit status.  In the 1980s, they were seen as a major threat to U.S. economic supremacy.  However, weaknesses within their credit underwriting caused their banking and financial industries to collapse.  That led to a severe recession and deflation that exists to this day.  Starting in 2002, their credit rating from Standard & Poor's fell to from AAA to AA.  Now they just recently experienced a reduction to AA-.  While they remain the third largest economy to China and the U.S., their high debt levels and corresponding borrowing costs are hampering their current economic growth efforts.

Referring back to the U.S., their immediate fate will probably depend on the status of our current recovery.  As of right now, U.S. Federal Reserve Chairman Ben Bernanke still believes that the prospects for 2011 will be better than 2010.  If that occurs, we should expect growth rates to be around 3%.  On the other hand, slower than expected economic growth will cause tax revenues to fall with jobs not materializing.  That will exacerbate our budget deficits and lead to an undesirable result.