This article was originally published August 6, 2011 on FT.com.
There will be endless debate on whether S&P, the rating agency, was justified in stripping America of its AAA rating and — adding insult to injury — even attaching a negative outlook to the new AA+ rating. But this historic action has now taken place, and the global system must adjust. There are consequences, uncertainties, and a silver lining.
Not so long ago, it was deemed unthinkable that America could lose its AAA. Indeed, “risk free” and “US Treasuries” were interchangeable terms — so much so that the global financial system was constructed, and has operated on the assumption that America’s AAA was a constant at the core, and not a variable.
Global financial markets will reopen on Monday to a changed reality. There are immediate operational consequences, from re-coding risk and trading systems to evaluating collateral and liquidity management. Key market segments will be closely watched, including the money market complex and the reaction of America’s largest foreign creditors.
Meanwhile, for the real economy, credit costs for virtually all American borrowers will be higher over time than they would have been otherwise. Animal spirits, already hobbled by the debt ceiling debacle, will again be dampened, constituting yet another headwind to the generation of investment and employment.
It is hard to imagine that, having downgraded the US, S&P will not follow suit on at least one of the other members of the dwindling club of sovereign AAAs. If this were to materialise and involve a country like France, for example, it could complicate the already fragile efforts by Europe to rescue countries in its periphery.
The future role of rating agencies will also now come under close scrutiny, bringing to the fore the question of who rates the rating agencies? S&P’s action will likely unite governments in America and Europe in an effort to erode their monopoly power and operational influence. This will also force all investors to do something that they should have been doing for years: conduct their own ratings due diligence, rather than rely on outsiders.
More worryingly, there will now be genuine uncertainties as to wider systemic impact of this change. With America occupying the core of the world’s financial system, Friday’s downgrade will erode over time the standing of the global public goods it supplies - from the dollar as the world’s reserve currency to its financial markets as the best place for other countries to outsource their hard-earned savings. This will weaken the effectiveness of the US as the global anchor, accelerating the unsteady migration to a multi polar system while increasing the risk of economic fragmentation.
These factors will play out over time, and will possibly do so in a non-linear fashion. Some of the immediate impact will be forestalled by the fact that no other country is able and willing to replace the US at the core of the global system. Other than a general increase in risk premia and volatility, it is therefore hard to predict with a high degree of conviction how the global system will react. Specifically, will it simply come to a new normality, with an AA+ at its core, or are further structural changes now inevitable?
All of that said, there a sliver of a silver lining — and an important one. America’s downgrade may serve as a wakeup call for its policymakers. It is an unambiguous and loud signal of the country’s eroding economic strength and global standing. It renders urgent the need to regain the initiative through better economic policymaking and more coherent governance.
There is a risk, of course, that different political factions will use S&P’s action as a vindication of their prior beliefs. Democrats would argue that it is recent Republican political sabotage that pushed S&P over the edge while Republicans would argue that we are here due to irresponsible government spending by the Democrats.
For the sake of their country and the wider global economy, both parties should resist the urge to begin bickering. Instead they should seize this potential “Sputnik Moment” — a visible shock to the national psyche that can unify Americans around a common vision and a renewed sense of purpose — that of halting gradual secular decline by putting the country back on the path of high growth, job creation and financial soundness.