The long-term implications of a US downgrade

By Felix Salmon
July 28, 2011
The Economic Word, asks a very good question via email, about the implications of the US losing its triple-A rating:

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David Boucher, of The Economic Word, asks a very good question via email, about the implications of the US losing its triple-A rating:

I was wondering if the state-level impact of a debt downgrade would be different, more severe.

From my understanding, Illinois and California have the two lowest ratings of the US states; if the US were to be downgraded and so would a couple of trouble states, would it have an impact on the ability of the Federal Government to lend a hand to those in trouble? And as a result create a Euro-ish type of debt crisis within the US?

There’s certainly a general understanding, in the markets, that California is too big to fail: if push came to shove, the federal government would bail it out rather than let it default. But David raises a good point: is the moral-hazard trade going to get weakened if the US loses its inviolability?

The way that credit ratings work, any municipalities which currently have triple-A ratings would almost certainly lose those ratings were the US sovereign to be downgraded. As far as I know, there’s no precedent for a sub-sovereign entity to have a higher rating than the sovereign, except in extreme cases where the sovereign is actually in default.

That said, I don’t think there’s much of a trickle-down effect. When you get to states like California or Illinois, which have single-A ratings and are therefore many notches below triple-A already, a downgrade of the sovereign does not mean an automatic downgrade of the state. California and Illinois are being rated on their own merits, or lack thereof — they don’t just have a rating x notches below the sovereign.

So if the sovereign downgrade hurts the likes of California and Illinois, it will be where it hurts, in the markets, rather than immediately in their own credit ratings. There’s some number between 0 and 1 which is the probability of the existence of an implicit federal guarantee on each state’s debt. That number will almost certainly fall when the US gets downgraded. And the lower that number, the more expensive it becomes for either state to borrow money.

When the federal government is strong and can step in to save the day with little harm to itself, it’s wont to do so. But the lesson of countries like Ireland is that you have to be very careful whom you bail out, lest you hurt your own creditworthiness. And the message of the US sovereign downgrade is very much that the government can’t just spend as much money as it likes without worrying about the effect on its own creditworthiness. A bailout of California would be extremely expensive, and would also set a very dangerous precedent for other states which might run into trouble.

The worst effects of a US downgrade, then, might not be felt for years, until the point at which a big state starts running into fiscal difficulties that are so serious that it faces difficulty repaying its bonded debt. At that point, in the olden days, the markets would expect some kind of federal aid; post-downgrade, they might just run chaotically for the exits instead, leaving the state’s citizens holding a bunch of paper worth less than half its face value.

The bottom line is that a US-double-A is a more brittle and fragile place than a US-triple-A: if and when things go wrong, they will go wrong more dramatically and drastically than if the undisputed global hegemon was always understood to have the ability and inclination to smooth things over and sort things out. If bond yields don’t rise much in the wake of a downgrade, don’t for a minute think that means the rating doesn’t matter. It just means that the rating doesn’t matter yet. In extremis, the markets really do care about this kind of thing. And remember too that the first downgrade is always the hardest. Once the ratings agencies have stripped the US of its triple-A rating, they’re going to find it much easier to make subsequent downgrades. There’s a lot of danger associated with a downgrade, even if there doesn’t turn out to be a big and immediate market sell-off.

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