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A year later, S&P downgrade of U.S. looks like a dud

WASHINGTON — The rating agency Standard & Poor’s stunned the world a year ago by stripping the U.S. government of its prized AAA bond rating.

The downgrade of long-term U.S. Treasurys threatened to sow chaos in financial markets, driving up U.S. interest rates, pushing the dollar down, scaring investors away from stocks and into that traditional refuge for the fearful: gold. The Dow Jones industrials dropped 635 points in panicked selling the first day of trading after the S&P announcement.

A year later, S&P’s historic move looks like a non-event. Long-term interest rates are sharply lower, the Dow industrials reversed course and is now up more than 1,600 points. The dollar has rallied, and gold prices are down from where they were when S&P lowered the boom.

Rival rating agencies Moody’s and Fitch have said they might downgrade the U.S. government’s blue-chip rating, too, though neither has followed S&P’s lead.

It is difficult to imagine a more decisive repudiation of S&P’s warning that the U.S. government might not be able to pay its bills.

But things aren’t so simple. After all, the rating agency downgraded federal debt largely because it feared that America’s dysfunctional political system couldn’t deliver credible plans to reduce the federal government’s debt. S&P decried American “political brinksmanship” and concluded that “the differences between political parties have proven to be extraordinarily difficult to bridge.”

A year later, the two political parties are still as deadlocked as ever. They can’t agree how to reduce the annual gap between what the government spends and what it collects in taxes. That deficit is expected to be $1.1 trillion in the fiscal year that ends Sept. 30. Each year’s deficit adds to the federal government’s $11.1 trillion in accumulated debt.

The White House and congressional Republicans last year came up with a plan designed to force themselves to compromise. If they can’t reach a budget deal by the end of the year, $600 billion worth of spending cuts and tax hikes — far more draconian than anything either side would agree to — will kick in Jan. 1. The shock of those measures would push the U.S. economy over the so-called “fiscal cliff” and probably into a recession, the Congressional Budget Office warns.

Despite S&P’s warnings and the political stalemate, investors still want U.S. Treasurys. Given economic turmoil in Europe and uncertainty elsewhere, U.S. government debt and U.S. dollars look like the safest bet around.

Worse problems in Europe

That is why the interest rate, or yield, on 10-year Treasury notes has fallen from 2.58 Aug. 5, 2011 to 1.57 percent Friday. The Dow Jones industrials, which initially fell after S&P’s move, are up 14 percent since the downgrade. The dollar is up 6 percent against the currencies of America’s major trading partners. And gold prices have dropped 3 percent to $1,609.30 an ounce over the past year.

Eleven countries still carry S&P’s AAA rating, including Britain, Germany and Australia.

But the United States owns what amounts to the world’s currency. Global business is largely done in dollars, which keeps demand for the U.S. currency high and reduces the likelihood of a dramatic drop.

And as bad as things are in the United States, they are worse elsewhere, particularly in Europe. For the United States, the day of reckoning over the federal debt is probably years off: America’s budget problems will worsen gradually as the Baby Boom generation retires and starts collecting Medicare and Social Security benefits.

“We have a fiscal challenge that is massive, but it’s a little ways away,” says Phillip Swagel, a University of Maryland economist who served in President George W. Bush’s Treasury Department. “With Europe, the fire is at their doorstep.”

Bond investors are demanding punishingly high interest rates from Spain and Italy. They fear that Spain can’t afford to rescue its troubled banks and its debt-ridden regional governments. And they worry that Italy can’t generate the economic growth and the tax revenue necessary to keep up with the cost of caring for its aging population.

The larger worry is that financial pressure will eventually force countries like Spain and Italy to abandon the euro currency. The breakup of the 17-country eurozone could cause financial chaos as countries replaced sturdy euros with local currencies of dubious value.

So investors have fled Europe for the safety of U.S. Treasurys.

The Federal Reserve has also helped blunt the impact of S&P’s downgrade. Under its Operation Twist, which began last year and will continue through the end of 2012, the Fed has been selling its holdings of short-term Treasurys and buying $667 billion in long-term Treasurys, pushing long-term yields lower.

Investors also shrugged off S&P’s warning because the rating agency doesn’t know anything they don’t. “S&P has no monopoly on wisdom,” says Nigel Gault, chief U.S. economist at IHS Global Insight. “The market will make its own judgment on U.S. debt … Ultimately, the pressure (to bring the federal debt under control) will come from the markets, not from the rating agencies.”

But Gault reckons that S&P might have done some good by sounding a warning and focusing attention on the need to tackle America’s debt. “I suppose (S&P) laid down a marker and perhaps made it more likely that we won’t forever kick the can down the road,” he says.