The real risk to holders of U.S. debt is not the government's heavy reliance on borrowing or the deep political divisions in Washington. It's the weakening U.S. economy.
- Bikinis, Barbecues & Babies: How Stars Are Celebrating the Fourth of July
- Kim Kardashian Takes the Fourth of July to a Whole New Level with Her Patriotic Outfit
- Billy Joel Marries Alexis Roderick in Surprise Wedding at His Estate
- Vanessa Williams Ties the Knot with Jim Skrip
- Plain White T's Tim Lopez Marries Jenna Reeves
Until very recently, most forecasters were expecting the pace of economic growth to pick up in the second half of the year. But despite a surprisingly strong showing from the job market in July, a string of disappointing data has prompted many economists to slash their growth targets.
“Whatever (economic) growth you thought you were going to get as of a month ago, it is quite reasonable to expect less as of today,” Credit Suisse chief econmist Neil Soss said in a weekend conference call with repoters and investors.
The central issue behind the Standard and Poor's decision late Friday to downgrade the government's AAA credit rating was the level of government debt, relative to the size of the U.S. economy.
A rapidly growing economy would help, by effectively shrinking the relative size of the debt without painful spending cuts. The effect is the same as when you get a raise, and it makes your credit card debt suddenly more manageable.
But instead of growing rapidly, the nation's economy is inching ahead so slowly that it has raised concerns about a second recession — the so-called "double-dip" after the recession of 2007-09.
That's one reason S&P has said there is a one in three chance of an additional downgrade over the next six months to two years. Restoring the Treasury's AAA borrowing status, which will not be easy, also would mean getting economic growth back on track.
"It would take a stabilization of the debt as a share of the economy and eventual decline," S&P managing director John Chambers told ABC Sunday. "And it would take, I think, more ability to reach consensus in Washington than what we're observing now."
So far, the government's main response to the downgrade has been to shoot the messenger.
Treasury officials complained bitterly about a technical error S&P made in budget calculations, and Treasury Secretary Timothy Geithner said the agency showed "terrible judgment" by making the downgrade, saying "they've handled themselves very poorly."
"We didn't need (a credit) agency to tell us Washington grdilock has not been constructive," President Obama told reporters Monday.
But some economists believe the rating agencies haven't gone far enough in their assessments of the credit risk posed by the government's heavy debt burden and Washington's dysfunctional political system.
"Given what S&P quoted about looking at the future sustainability and acrimony in Washington, the downgrade to AA-plus seemed generous to me," said Harvard economist Kenneth Rogoff. "The other rating agencies have been cowering not to so the same thing."
The other two major agencies, Moody's and Fitch, have hardly given the government a clean bill of health. Moody's has assigned a "negative" outlook to U.S. government securities, and Fitch said it is waiting to complete its scheduled review until the end of August.
"It is just a matter of time that Moody's and Fitch follow S&P's lead," said former Treasury official Neel Kashkari. "I think anybody that analyzes the U.S. deficit situation and our trajectory has to conclude that we are not truly AAA today."
While stocks sold off sharply Monday, the bond market took the downgrade in stride, largely because S&P had been warning since March that the move was possible.
"They did everything but tow a banner behind an airplane to tell the world what they were most likely to do," said John Kansas, CEO of BankUnited.
S&P officials held another teleconference Monday to answer a firestorm of criticism from Wall Street, Congress and the White House. Following that call, the agency extended the downgrade to bonds issued by dozens agencies that rely on government backing, including mortgage giants Fannie Mae and Freddie Mac. Those downgrades could give pause to mortgage investors, pushing interest rates higher and sending the housing market deeper into recession.
Based on its analysis of the government's recent budget plan, S&P's "base-case" scenario estimates government debt will rise from 74 percent of GDP at the end of 2011 to 79 percent by 2015 and 85 percent in 2021.
A recession would make things worse, sending those ratios even higher.
Economists are divided on prospects for another recession, but many have been slashing their growth forecasts. Nigel Gault, chief U.S. economist at IHS Global Insight, put the odds of another recession at 40 percent.
Despite last week's news that the economy added 117,000 jobs in July, the unemployment rate is still over 9 percent and the economy barely grew in the first half of 2011.
Ordinarily there are two ways the government can try to boost economic growth. Congress and the White House can enact fiscal policies, generally boosting spending and cutting taxes, to help promote growth. The recent display of partisan gridlock has all but eliminated the prospect of any such stimulus.
More on the financial crisis
Fed, with few cards, makes unusual pledge
The Federal Reserve's highly unusual promise — to keep interest rates low for "at least" two more years — comes as the ce...
- Economic uncertainty feels like normal now
- Tough decisions ahead to get AAA rating back
- Economy is a bigger problem than any downgrade
- As market melts down, some are saying 'Buy!'
- EU bank chief: Markets 'in worst crisis since WWII'
- As markets tank, financial planners advise calm
- Fed, with few cards, makes unusual pledge
The other major government tool to boost growth is easier monetary policy, which is controlled by the Federal Reserve. Lower interest rates stimulate growth by boosting consumer spending prompting business expansion.
But with interest rates already at zero, the Fed, which meets this week to discuss its next move, has few options.
One would be to promise to keep rates at zero for longer than investors are expecting. The other would be to use its ability to "print money" to buy hundreds of billions of dollars of bonds, pumping more cash into the financial system. But after two rounds and $2.4 trillion worth of bond-buying with little impact, that strategy doesn't seem very promising.
"It is hard to see any of these options as 'game changers,"' Gault said. "The Fed would be doing them not because it could be sure they would make a huge difference, but because it would feel the need to do something."
© 2013 msnbc.com Reprints