Freedomnomics

Article published Friday, August 5, 2011 at Fox News.

The S&P Downgrade Is a Wake Up Call for All Americans

By John R. Lott, Jr.

When Standard & Poors downgraded Spain's bonds from AAA to AA+ in January 2009, its interest rates increased from 4.1 to 4.3 percent.

When the same ratings agency downgraded Ireland's from AAA to AA+ in March 2009, their interest rate rose by about 0.4 percentage points.

So what does that mean for Standard & Poors in terms of downgrading the U.S. bond rating?

With our $14.6 trillion in national debt, raising the U.S. government interest rates by the same amounts would eventually add about $29 to $58 billion a year in increased interest costs -- small change when we are already facing a $1.63 trillion deficit this year. And not all of that increase would be immediately felt since we only face the higher interest rate on newly issued bonds.

The problem with these downgrades is that they have a tendency to quickly spiral out of control. Higher interest rates mean that the deficits start getting bigger, and countries then quickly face another downgrade.

Countries facing these higher interest rates haven't responded by immediately cutting spending to offset the costs of the higher interest rates. And those initial downgrades are soon quickly followed by further downgrades.

Spain's downgrade in January 2009 was then followed by another downgrade to AA status in April. Ireland also soon faced another downgrade to AA just three months later in June.

Additional downgrades have since followed. In the time before the initial downgrade until now, Spain's 10-year government bond interest rates have gone up by two full percentage points. Ireland's by 4.5 percentage points. With those increases, we are talking about serious increases in deficits.

Given that world interest rates have been falling over this period, the true cost of the money these countries need to borrow has actually gone up by more than this amount.

For the U.S., such increased interest rates would eventually mean increased interest payments of between $292 billion and $657 billion a year.

What was just an initial irritation has, in the course of just a couple of years, become serious problems for these other countries, and it should serve as a real wake up call for the U.S.

The fact that the recently agreed to budget agreement only cuts $22 billion from next year's projected $3.7 trillion budget should worry everyone. But it was one of the conditions that Democrats demanded for any debt ceiling agreement. Nate Silver of the New York Times recently wrote about the good news for Democrats in the deal.

It should be clear to everyone now that the threat the U.S. faced over the August 2 debt ceiling deadline was not over the false scare tactic claims of default, but over whether the U.S. was willing to actually control the huge deficits that we are facing.

S&P's decision to downgrade the U.S. bond rating isn’t a real disaster yet, but it is a wake up call. And it's one that should force Washington’s politicians to re-examine the debt ceiling deal that they just made.

John R. Lott Jr. is a FOXNews.com contributor. He is an economist and the author of "More Guns, Less Crime (University of Chicago Press, 2010), the third edition of which was published in May.".

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