A key credit agency issued an unprecedented warning to the United States government Monday, urging Washington to get a grip on its finances or risk losing the nation's sterling credit rating.
For the first time, Standard & Poor's lowered its long-term outlook for the federal government's fiscal health from "stable" to "negative," and warned of serious consequences if lawmakers fail to reach a deal to control the massive federal deficit.
An impasse could prompt the agency to strip the government of its top investment rating in the next two years, S&P said. A loss of the triple-A rating would ripple through the American economy, making loans more expensive and credit more difficult to obtain.
The downgrade was interpreted as a rebuke to President Barack Obama and congressional Republicans, admonishing them to put politics aside and come up with a long-term financial plan as soon as possible.
"This is a warning: Don't mess around," said Robert Bixby, executive director of the Concord Coalition, a nonpartisan group that is pushing for deficit reduction.
Analysts at S&P have never before used the outlook to cast doubt on the nation's credit worthiness.
In response, stocks suffered their worst slide in a month. The Dow Jones industrial average plunged 245 points before recovering to close down 140 points for the day.
"The credit quality of U.S. debt is sacrosanct, and legislators will do everything within their power to avoid a downgrade," said Jack Ablin, chief investment officer at Harris Private Bank.
The government is on pace to run a record $1.5 trillion deficit this year, the third consecutive deficit exceeding $1 trillion.
But so far, S&P sees little chance that the White House and Congress will agree on a deficit-reduction plan before the November 2012 elections, and the rating agency doubts that any plan would be in place until 2014 or later.
Obama and congressional Republicans are sparring over how to reduce the nation's red ink. If Congress refuses to raise the nation's debt limit this spring, and the U.S. Treasury lost authority to borrow additional money, the government would not be able to pay its bills and would default on its debt.
Although it's a worst-case scenario that's highly unlikely, default by the government means anyone owning federal debt of any kind — bills, notes, bonds — could go unpaid.
Both sides have proposed cutting $4 trillion from future deficits over the next 10 to 12 years.
The White House wants to reduce the deficit through spending cuts and by ending the Bush-era tax cuts for the wealthy. Republicans reject that, calling it a tax increase. They seek instead to narrow the deficit largely by overhauling Medicare and cutting spending elsewhere.
The credit report called the two proposals a "starting point" of the process, but warned that the gap between the parties remained wide.
S&P took no position about how to reduce the deficit or how to change spending and revenue plans.
"But for any plan to be credible, we believe that it would need to secure support from a cross-section of leaders in both parties," S&P said in its report.
A lower credit rating would drive up the government's borrowing costs. It could lead to higher interest rates on everything from mortgages to car loans and threaten to slow U.S. economic growth.
Ablin said the credit worthiness of the country is the underpinning on which all other asset classes are valued.
"If all of a sudden the credit quality of U.S. Treasurys isn't as high as people perceive, we could see erosion of confidence," he said.
For now, S&P continues to give the U.S. government its top investment ranking. That means S&P believes that the U.S. government can and will repay its debts and that Treasury investments are virtually risk-free. But the agency says the U.S. faces a one in three chance of a downgrade in the next two years. That would likely happen if the White House and Congress could not come up with a credible plan for reducing debt.
The other major credit agencies — Moody's and Fitch Ratings — did not match S&P's outlook warning.
S&P gives its top investment rating to just 19 of the 127 countries it analyzes. But it says Britain, France and Germany moved much faster to contain deficits after the 2008 financial crisis and 2007-2009 recession, which cut tax revenues and forced governments to spend more on unemployment benefits, aid to the poor and bailouts of the banking system. Those countries also have top-notch investment ratings.
S&P noted that the U.S. deficit grew to 11 percent of economic activity in 2009, a risky percentage. The deficit averaged less than half that percentage in the previous six years.
The government was beginning to run surpluses at the end of the Clinton administration. But deficits returned after President George W. Bush's tax cuts, a 2001 recession, wars in Afghanistan and Iraq, and a massive expansion of Medicare's drug coverage.
The deficit widened even more after the Great Recession started in 2007, depleting tax revenue and raising spending to stimulate the economy and provide benefits for the unemployed and the poor.
In the past, credit warnings have jolted politicians into action.
In May 2009, Standard & Poor's downgraded its long-term outlook on the United Kingdom to negative, saying that the country's debt could double in four years.
Prime Minister David Cameron and his Conservative-Liberal coalition government laid out plans to cut nearly 500,000 jobs and reduce welfare spending. Britain's economy also posted modest gains, and the ratings agency changed its outlook in October back to "stable," noting the government's "political resolve."
In recent months, at least two countries — Portugal and Greece — have had their credit ratings downgraded as they endured financial woes of their own.
The Obama administration embraced Monday's warning as a welcome call for cooperation among the two political parties. Press secretary Jay Carney said the White House believes the political process will outperform the agency's expectations because the president and Congress recognize the problem.
A budget showdown is likely in the next few weeks. Treasury Secretary Timothy Geithner has said the government will reach its debt limit no later than May 16. He can juggle funds to keep the government running until about July 8, after which the government could not pay its bills.
On Sunday, Geithner said Republican leaders have privately assured the Obama administration that Congress will raise the government's borrowing limit in time to avoid an unprecedented default on the nation's debt.
But Rep. Eric Cantor, the No. 2 Republican in the House, took a hard line Monday, calling the S&P announcement "a wake-up call to those in Washington asking Congress to blindly increase the debt limit." He said Republicans would only agree to raise the debt ceiling if the White House agrees to "serious reforms that immediately reduce federal spending and to end the culture of debt in Washington."
A bipartisan deficit-reduction commission appointed by Obama recommended late last year that about $4 trillion be slashed from budget deficits during the coming decade.
Under the commission's plan, roughly two-thirds of the savings would come through spending cuts and one-third through increased tax revenue. Although overall tax rates would decline, dozens of popular tax breaks would be scaled back or eliminated, including the child tax credit, mortgage interest deductions and deductions claimed by employers who provide health insurance.
Obama praised the panel for its work, but embraced few of its recommendations, and none of the major ones on new taxes.
For now, U.S. politicians are at a stalemate. "There is bipartisan agreement on the need to reduce the debt by $4 trillion over roughly the next decade," said Sen. Charles Schumer, D-N.Y. "Now we just need to resolve how to do it."
Associated Press writers Pallavi Gogoi and Janna Herron in New York and Derek Kravitz, Andrew Taylor, Jeannine Aversa and Ben Feller in Washington contributed to this report.