If the global financial system is based on the US having a AAA bond rating, and the US is downgraded to AA+, will this play out the same …
Answer by Jake Kaldenbaugh:
There are two sides to the coin. One perspective is that AA+ will just become the new AAA. Given that there is surplus capital in the market and no comparably large, safe places to invest globally on a relative basis as the U.S., the market may ignore the nominal change in rating and maintain a relative economic pricing of risk.
The other side of the debate focuses on the broad effects that an increase in the general risk-free rate would have across the entire market.
For instance, one area where it could have a major impact is in forcing the entire real estate market to devalue by a substantial percentage. Consider that most mortgage loans are based on evaluating the monthly payment versus a person's monthly income. An increase in interest rates means that more of that payment would go to interest rather than principal. Rates are at extreme lows and any substantial systemic increase in rates of more than a couple percent would mean that for a given monthly payment, the amount available to pay principal (the purchase price) would be substantially less. So, if the downgrade caused even a relatively minor increase in rates of three percent, that would almost double the typical prime mortgage rate. The only way the math works assuming that incomes stay the same is that purchase prices would have to fall substantially.
Additionally, given our substantial national debt, any substantial increase in interest rates would divert a large and growing amount of our tax dollars away from needed public and government spending programs (I know the "needed" part can be debated) towards addressing pure interest obligations. This could have a substantial impact on near-term GDP as multiplier gets adjusted from government spending to risk-adverse savers.