On August 1st, the international credit rating agency Fitch downgraded the U.S. government from AAA to AA+. This was only the second downgrade in history for the United States; the first one happened almost to the day 12 years earlier, when Standard & Poor’s did the same downgrade.
This is a serious warning to the U.S. Congress as well as to the president. It seems to have shocked the U.S. political establishment, but it comes as no surprise to readers of the European Conservative. I have repeatedly warned that the U.S. government is heading toward a fiscal crisis:
- Already in October last year, based on trends in the market for U.S. debt, I noted that Congress and the president could find themselves facing runaway debt costs already early in 2023; with a slight time lag, that prediction turned out to be correct;
- In March I expanded on my analysis, pointing to the risk of a Greek-style debt crisis in the United States;
- In June I warned that if the Federal Reserve’s pessimistic outlook for the U.S. economy is correct, then there is a fiscal crisis coming, and soon;
- As recently as on July 19th I explained that there was “trouble brewing in the market for U.S. government debt.”
This credit downgrade falls like a heavy hammer on the narrative that everything is good in the U.S. economy. It shows the dangers of reading economic data with one eye closed. I have repeatedly pointed to the good macroeconomic news, namely that we are not heading into a recession. At the same time, I have also highlighted the abundance of data showing that we are slow-drifting into a fiscal crisis.
The combination of these two trends is perhaps the most damning verdict you can issue over the U.S. economy. As I noted in my aforementioned July 19th article, the U.S. government is borrowing over $150 billion per month. This is happening while the economy is operating at virtually full employment.
A soundly managed government should be reaping budget surpluses right now. That is far from the facts on the ground: as the numbers are right now, it looks as though Congress will borrow at least $1.6 trillion over the 2023 fiscal year (from October 2022 to September this year). If we exclude the pandemic-related borrowing, this is an unprecedented peace-time budget deficit. It comes on top of the equally unprecedented borrowing that took place during the pandemic—an astounding $4.5 trillion in 2020 alone—and, of course, all the other debt that the U.S. government has piled up over time.
Congress is not helping here. By showing a notorious lack of interest in ending their deficits, the nation’s legislators lend credibility to the trend of endless growth of the debt. In fairness, the current Republican majority in the House has shown some degree of fiscal conservatism, but with the Democrats controlling the Senate and a 60% majority needed to pass most bills there, the only way Congress could agree on a budget-balancing plan is if it consisted entirely of tax hikes.
This picture of a structurally deteriorating fiscal problem is a key part of Fitch’s analysis:
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 relative to ‘AA’ and ‘AAA’ rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.
The debt limit comment refers to the Congressional fight that took place this past spring over the terms on which they would remove the statutory cap on how much money the U.S. government could borrow. When they actually reached an agreement at the end of May, it turned out that the debt limit—which had officially prevented more government borrowing since at least February—had not really stopped the government from borrowing.
According to the U.S. Treasury’s own debt database, on June 5th, the same day that the debt ceiling was lifted, the debt increased by $358.6 billion. This uniquely large one-day increase was in reality a conversion of unofficial borrowing that the federal government had been engaging in while the debt ceiling was formally in effect. Nevertheless, it showed that not even a statutory debt limit can stop Congress from borrowing money.
A month after the ‘debt deal’, the Treasury had logged a very high $853.8 billion in new debt. Since then, borrowing has continued. As of August 4th, the total federal debt stood at $32.6 trillion, up from less than $31.5 trillion at the end of May.
In short: the federal government cannot self-police its own fiscal discipline.
This rapid, endless increase in the debt is reason enough for a credit downgrade of the U.S. government. But there are other reasons, one being the rising cost of the debt. When the 2023 fiscal year began on October 1st, the estimated average interest rate on the debt was 1.87%. As of Monday August 7th, the estimated average interest rate is 2.71%, in other words close to a full percentage point higher.
On October 1st, the debt was $30.9 trillion, which means that a one-percent higher interest rate causes $309 billion per year in extra payments to the U.S. government’s creditors. However, since the debt itself has increased to $32.6 trillion, we have to add another $17 billion on top of the $309 billion.
These are annualized figures. They estimate what the cost of the debt is likely to be over a 12-month period if the average interest rate rises by one percentage point as noted. We don’t know yet exactly what the total debt cost will be for the 2023 fiscal year, but based on my own model for analyzing the debt, its structure, and its trend over time, it is probable that this figure will exceed $900 billion for the 2023 fiscal year.
For the 2023 calendar year, that figure will with practical certainty exceed $1 trillion.
These numbers are frightening as they are, but there is an even more dire message hidden in them. The annual cost of the U.S. government debt has now in itself become a driver of more debt. Not only is the size of the debt itself a problem, but If Congress wants to avoid politically controversial spending cuts on entitlements and government services, they will have to sell more debt just to pay their creditors.
As we all know, paying the bill on one credit card with another credit card is not a very good idea over time.
On top of the fiscal aspects of the debt, Fitch seems to have taken seriously the fact that Congress prefers to idle where action is badly needed. That assessment is unfortunately correct, and the power players in American politics are doing their best to aggravate the situation. Consider, e.g., the reaction from Treasury Secretary Janet Yellen:
I strongly disagree with Fitch’s decision, and I believe it is entirely unwarranted … Its flawed assessment is based on outdated data and fails to reflect improvements across a range of indicators, including those related to governance, that we’ve seen over the past two and a half years.
There is so much wrong with this statement that it is difficult to capture in this limited space, but here are three points.
1. The very fact that Yellen criticizes Fitch is a red flag. It means that she does not take seriously the fiscal deterioration that Fitch is pointing to. Instead of acknowledging the fiscal hemorrhage slowly bleeding the federal government into a fiscal meltdown, she tries to pretend that there is no reason for worry.
2. She gives the impression that Fitch has not looked at any relevant indicators since Trump was president. This is of course a ridiculous idea, and Yellen knows this; her comment about the supposedly outdated data is a cheap attempt at playing politics with the risk for a U.S. fiscal crisis—an issue that should be treated like a threat to our national security.
3. She refers to “indicators” that are “related to governance” as if they have something to do with the federal government’s fiscal problems. This reference makes no sense. I am a Ph.D. political economist with 17 years of experience as a fiscal policy analyst, and 30+ years working in politics and public policy, and I have no idea what “indicators” Secretary Yellen is talking about here.
As if the Treasury Secretary’s comments were not bad enough, President Biden’s administration incredulously tied it to the events of January 6, 2021, when a group of protesters entered the U.S. Capitol after a rally with President Trump. USA Today reports:
The Biden administration lashed out at at [sic] Fitch Ratings’ decision to downgrade the nation’s credit rating, arguing it doesn’t reflect improved economic metrics and that the move was based partially on political polarization stemming from the Jan. 6, 2021, attack on the Capitol.
The newspaper went on to allege that
Fitch also expressed concerns to Biden administration officials about the political upheaval from the Jan. 6, 2021, attack on the Capitol … according to a White House official familiar with the agency’s explanation to the administration.
A Reuters report piles on, claiming that a Fitch representative had confirmed the January 6th reference. That, however, does not make it any more credible that such a reference was actually given, let alone that it had any bearing on the downgrade decision. More importantly, it is nowhere to be found in Fitch’s official statement on its downgrade, which at the end of the day is what counts when we want to know why the downgrade happened.
All in all, the reaction from those responsible for managing the United States government has been exactly opposite of what was needed. Investors and analysts with influence over the market for U.S. sovereign debt are taking notes; the fact that the market did not show much of a reaction to the downgrade—interest rates barely flinched—suggests that those involved in trading U.S. government securities were anticipating the downgrade.
This, in turn, is not surprising: interest rates on Treasury bills, notes, and bonds have been crawling upward since at least early April:
- On April 4th, the U.S. debt instruments with maturities of one year or less paid 4.5-4.9% per year in interest; all the longer maturities, 2-30 years, paid less than 4%;
- By contrast, on August 4th every maturity of one year or less paid 5.3-5.5%, with every longer maturity paying 4.1-4.8%;
A slow upward drift in rates of this kind, spanning across all the maturities, is always caused by an external factor. In this case, it is the realization among investors and analysts that there is no will among leading U.S. politicians to end the growth in their government’s debt. The fact that the upward drift began in early April is conspicuous: that was the time when it started to become clear that a debt-limit deal would not include any structural reforms to end budget deficits.
Based on the reactions to the downgrade from America’s political leadership—deafening silence or defiant denial—we should expect more downgrades in the next 6-12 months. In the meantime, interest rates will continue to drift upward, which in turn will force the Federal Reserve to respond. This downgrade makes it more likely that the Federal Reserve will raise interest rates at least one more time before the end of the year.
It remains to be seen how far increasing interest rates can push Congress before they realize that they, and only they, can stop America from slowly but inevitably drifting into a fiscal crisis.
