Credit is the life blood of the American economy. It gives the chance for people who previously could not afford thousand-dollar homes a chance at the American dream. Mortgages, credit cards, leverage are all based on credit.

On a larger scale, debt takes the form of treasury bonds and bills. Since US is the largest economy in the world, its bonds are considered “risk-free”. This perception is quantified through the use of a credit rating system. The US sovereign credit rating currently stands at the highest possible level at Aaa and AAA. This credit rating has been given by Moody’s Investors and Standard & Poor, respectively.

The current economic crisis faced by the US has pushed economists to question this long standing belief. Should the US’s credit rating be downgraded?

Last week, the S&P downgraded the outlook on the UK economy, changing it from “stable” to “negative”. This downgrade resulted from the UK government’s rising debt level, which is reportedly inching closer to 100% of its GDP. A high debt burden naturally corresponds to a higher risk of default or inability to pay off debt. Also last week, Moody’s lowered Japan’s credit rating two notches to AA, after a prior downgrade from S&P and Fitch’s. Japan’s poor financial condition and economic outlook rendered it unlikely to pay off its debt, which has reached 170% of its GDP.

One reason why some focus has been shifted to the US is because, like the UK, the US has been incurring large debt. The US government's $787 billion economic stimulus package and $700 billion bank bailout fund pushed the estimate for this year’s deficit to a record $1.8 trillion, equal to about 13% of the nation’s GDP. Estimates of the deficit continue to skyrocket to more than $2 trillion for 2010, which is a nearly 30% increase in just a few months.

The Obama administration dismissed the possibility of a credit downgrade, saying that the government will continue to do whatever it takes to boost the economy. This belief is shared by many investors, analysts and economists from prestigious firms like JP Morgan Asset Management and Deutsche Bank. Many believe that a credit downgrade will not happen until 2011 at the earliest. In fact, Moody’s has said that they are okay with the US’s AAA rating.

But what if there is a downgrade?

A credit downgrade implies that the debt issuer (US government) would be more likely to default on their loans. Therefore, there will be pressure for the US to increase their interest rates in order for investors to be compensated for “extra” risk that they are bearing. In addition, yields on US debt would also rise and existing securities would devalue to match the new higher yields.

An increase in the interest rates would also undermine the government’s stimulus package and the Fed’s monetary and quantitative easing measures. Cost of credit will rise both for the government and the private sector as an effect of a credit downgrade.

Furthermore, foreign investors with large investments in US debts may want to diversify their portfolio and sell off “junk” assets. Investors like China, who have over $1 trillion in US treasuries, may sell part of their holdings and proceed to move their funds to other “safer” assets. Recall that China’s officials have already grumbled over the safety of their US investments.

Lastly, a credit downgrade would make US assets less attractive in comparison to other potential investments, which would weaken demand. Since investors need US dollars to place investments in the US, decreased demand for US investments instruments leads to lower demand for the greenback. This will put downward pressure on the valuation of the dollar. With higher interests to pay for its loans, the Fed may resort to “printing” more dollars and thus cause a further dollar depreciation.