Last week’s downgrading of U.S. securities by Standard & Poor’s was a wholly a political message directed primarily at President Obama (though not named, S&P also took a swipe at the Tea Party).  The message was to get serious about the matter of closing budget deficits and reducing the debt.  To the president, this was especially painful because it indicated the strong support he enjoyed from Wall Street in 2008 is now over.  Voters sent a similar message last November.  So what will be the effect of the downgrade on the economy?

As of this writing, the stock markets have gone wild, and what they will do next is quite honestly anyone’s guess.   Over the past three months we have seen some data that showed that growth in the overall economy came to a near stop.  Manufacturing production declined, and consumer sentiment dropped.  This is very worrisome at this point in the recovery.  The bad news here and abroad is enough to lead to a clear market correction. 

In contrast to the bad news and the stock price volatility is a drumbeat of positive indicators.  New car sales are up, retail sales have increased, and the most recent jobs report was as close to a post-recession breakthrough as we have seen, with more than 150,000 private sector jobs created.  Most importantly, gas prices have once again eased off their late spring highs of near $4 a gallon.  There are many reasons to believe the second half of the year will bring a faster growing economy.

Still, uncertainty stalks the markets for labor, goods, housing and financial products.   This uncertainty looms over the predictions of economic models in ways that suggest the recovery will continue to disappoint.  That is why the Federal Reserve has announced interest rates will remain low through mid-2013.  This reduces some of the uncertainty over borrowing costs, and signals the Fed will permit some inflation to see employment rebound.   

There are lessons to be learned from varied policy responses to this recession.  In the U.S. and throughout most of the world, governments that have not amassed large deficits have outperformed those who did.  Of course there is a bit of the chicken-and-egg problem at work.  States and countries that did not suffer heavily in the recession faced less difficult budget problems, yet places as diverse as Germany and Indiana seemed to have pulled off budget miracles while dodging a large manufacturing slump.

In the end, the S&P downgrade matters little outside the political arena—where it likely matters a great deal.  For anyone who recalls its glowing ratings for mortgage backed securities, S&P research is hard to take seriously.  But the real proof is in the reaction of markets.  As the stock prices fell last week, investors poured cash into U.S. securities—the very things S&P downgraded.  In so doing they actually lowered the cost of U.S. borrowing. Ironically, it is the U.S. securities that have downgraded Standard & Poor’s reputation, not vice versa.