On August 5, after markets had closed, Standard and Poor's stripped the
U.S. of its triple-A rating. In the days leading to the downgrade, many had
predicted that a downgrade would result in a broad sell off Treasuries,
and a corresponding increase in yields. These predictions proved to be wrong.
The next trading day, August 7, the yield on the 10-year Treasury note fell from
2.56 percent to 2.34 percent, and three days later the Treasury sold $24 billion
in 10-year notes at a yield of 2.14 percent, the lowest on record.

These forecasts overlooked the nature of markets, or more specifically, the fact that investors are forward looking. Prices reflect information as it becomes available, and the market had already discounted the potential for a downgrade. Prior to Standard and Poor's formal announcement, it was hard to avoid media speculation regarding a downgrade and the impact it might have. The subsequent fall in yields was in reaction to new information that emerged; in this case bad from Europe emerged before the market reopened, driving investors to flee stocks in favor of the perceived safety of U.S. Treasuries.

This episode is instructive not only for investors, but perhaps also for Congress and the President and the Fed as they contemplate policies for fostering economic growth. Now that agreement has been reached regarding the U.S. debt ceiling, debate has shifted to what the federal government might do to spur economic growth.

Many are calling for even more government spending in order to create jobs and boost household income. In theory, such "pump priming" will increase aggregate consumer demand for goods and services, which in turn will spur business investment and further expand the workforce. But consumers, like investors, are forward looking and react to news as it emerges. Households may in fact refrain from spending to the extent they conclude that higher deficit spending by the government portends lower private sector investment or higher taxes in the future.