On Aug. 1, Fitch Ratings downgraded U.S. government debt from AAA to AA+ and warned that the “rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance.”
Among the three major Western credit rating agencies (S&P, Fitch and Moody’s), only Moody’s still maintains a triple-A rating for U.S. sovereign credit. In fact, in a world drowning under a rising tide of public debt, only nine countries retain a triple-A rating from all three agencies.
Given its status as the world’s most liquid and important sovereign bond market, any significant change to the outlook or risk of U.S. Treasury securities matters enormously.
Some critiqued the odd timing and questioned the rationale behind the ratings downgrade announcement. Officials from the Biden administration vociferously condemned Fitch’s action, with Treasury Secretary Janet Yellen calling the downgrade “entirely unwarranted.”
Did Fitch err in its decision?
To the contrary, a ratings downgrade was probably long overdue.
The extent and nature of American political polarization (exacerbated by gerrymandering and highly polarized primaries), alongside declining confidence in American institutions, lend credence to the notion that the U.S. is suffering from an “erosion of governance” that goes far beyond the occasional debt-ceiling standoff.
From the controversial 2000 presidential election (recall the “hanging chads” debacle) to the Jan. 6 riot, the U.S. political system has suffered multiple blows to its reputation.
Much-needed, bipartisan reforms to American welfare programs are unlikely in the current political environment, as is the needed overhaul of the overly-complicated tax system. Barring a fiscal crisis, the proverbial can will just keep getting kicked down the road.
A country can fall into a debt trap when its debt-to-GDP ratio rises persistently and reaches a level high enough to generate concerns about the government’s ability to refinance its debt. Large, persistent primary deficits (deficits excluding net outlays for interest) have been the primary driver of the growth in the U.S. debt-to-GDP ratio.
The absence of a bipartisan consensus on raising tax revenue and curtailing spending on popular but costly social insurance and welfare programs suggests that there will be no primary surplus any time soon. In fact, the aging of the population and the growing strategic competition with China and Russia suggest that budgetary outlays for Social Security, Medicare and national defense will only continue to climb in coming decades.
Until recently, interest payments on existing debt were relatively small. But we may be entering an era where rates remain elevated. CBO is conservatively projecting a doubling of annual net interest costs for the U.S. government over the coming decade.
Long-term debt sustainability crucially depends on whether the cost of refinancing the debt is persistently above or below the economic growth rate. In the aftermath of World War II, the U.S. relied on a combination of interest rate distortions (including financial repression), primary surpluses and relatively rapid economic growth to reduce its debt burden.
Given unfavorable demographics and subpar productivity growth, it is hard to imagine the U.S. replicating the 1948-1973 boom. CBO projects an annual real potential GDP growth rate of just 1.8 percent between 2023 and 2033.
In the absence of primary surpluses and rapid real economic growth, bond investors should be wary of interest rate distortion. They will seek an additional term premium on long-dated treasurys.
Investors should not underestimate the potential for fiscal dominance of monetary policy. As Markus Brunnermeir recently noted, “Central banks would like to hike interest rates to rein in inflation, whereas governments hate higher interest expenses. They would prefer that central banks cooperate by monetizing their debt — that is, by purchasing government securities private investors won’t buy.”
Furthermore, there is substantial duration risk on the consolidated balance sheet of the Treasury Department and the Federal Reserve. Similar problems exist in the Euro Area, United Kingdom and Japan.
Raghuram Rajan recently observed that “long periods of low interest rates and high liquidity prompt an increase in asset prices and associated leveraging…. Central banks compounded the problem by buying government debt financed by overnight reserves, thus shortening the maturity of the financing of the government and central bank’s consolidated balance sheets. This means that as interest rates rise, government finances — especially for slow-growing countries with significant debt — are likely to become more problematic”.
Some have argued that the world faces a safe-asset shortage problem, and, consequently, foreign demand for Treasurys will remain robust. This notion has rightly been criticized. In fact, many foreign central banks are actively attempting to diversify their reserve holdings.
Previously, China and commodity-rich economies were willing to plough their current account surpluses into U.S. Treasurys. That is no longer the case. China has quietly been shifting its reserve holdings into gold. Growing wariness that Russia-style sanctions might cut them off from their assets has caused others to reexamine their dollar exposure.
More generally, overreliance on economic and financial sanctions by the foreign policy establishment and the ongoing geoeconomic fragmentation are actually threatening the viability of the dollar-centric global monetary order.
As Thomas Hoenig recently observed, “the fiscal projections for the U.S. are so stunning that reform must occur. The U.S. government must discipline itself and adjust its spending and tax programs. The monetary authorities must cease enabling the government’s excess spending. It is that simple and that difficult.”
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.