Fitch, a credit-rating firm, recently reduced the rating on United States Treasury bonds one notch, from the top AAA designation to AA+. The move made waves. Stock prices fell in the U.S. and around the world. Bond prices also dropped, pushing up yields on Treasury bonds as well as bonds generally. The same thing happened in 2011, when S&P’s credit-rating service similarly took the rating on Treasury debt down a notch. Back then, the shock wore off quickly, and markets soon began to behave as if nothing had happened. The same outcome is likely this time. Nonetheless, Fitch’s move, like the S&P move before it, does make an important political-economic point.
The firm justified its action by noting a “steady deterioration in the standards of governance.” It cited as evidence the January 6, 2021, Capitol riot and how the recent debt-ceiling crises had brought the federal government to the brink of default. Fitch’s spokespeople also noted that government debt levels have already risen to an almost unprecedented 113 percent of the nation’s gross domestic product (GDP), and that in just the past three months, estimates of this year’s budget deficit have climbed from $733 billion to $1 trillion, making it reasonable to expect debt levels in the not-too-distant future to rise to 170 percent of GDP.
Commenting on the downgrade, JPMorgan Chase CEO Jamie Dimon added observations that might well have factored in Fitch’s decision. He, too, noted how public debt levels have grown, emphasizing as a cause the Biden administration’s green-spending initiatives as well as stepped-up military outlays connected to the war in Ukraine. He criticized Federal Reserve policy, both its lax monetary posture as inflation mounted in 2021 and the more recent tightening policies, especially the Fed’s decision to sell its holdings of Treasury bonds. Notwithstanding all these points, however, Dimon described the downgrade as “ridiculous,” concluding that it “doesn’t really matter that much.”
Much of Fitch’s reasoning is as weak as Dimon says. The January 6 riot never threatened the stability of the government. The debt-ceiling fight may have stymied Washington’s ability to borrow, but it never threatened default. Tax revenues, though inadequate to run the entire government, were always more than adequate to meet Washington’s debt obligations. What is more, the debt-ceiling debate was a demonstration not of government failure but of Congress’s ability to meet its constitutional obligations by debating political agendas and reaching a compromise.
And even in light of Fitch’s more sober concerns about debt levels, the downgrade is financially meaningless. Bond ratings are supposed to inform bond investors of the likelihood that the issuer—usually a corporation or a local government—will fail to pay the interest and principal due on the bond. Aside from the above point on the debt ceiling, the U.S. government is not likely to default because all the debt is denominated in dollars, and the Fed—for these purposes, an agent of the federal government—controls the creation of dollars. In a pinch, the authorities can run the metaphorical printing press to pay the bond holders the amounts contracted on each bond. Of course, that action would lead to inflation, so the bond holders would be paid in dollars that had less real buying power than they had expected, but the government would honor its contracts. Fitch is not asked to warn about inflation but default, and the chances of the latter are nil.
Fitch’s action nonetheless makes a worthy political-economic point, as did S&P’s 2011 downgrade. Debt is piling up faster than the economy’s ability to support it in real terms, inviting inflation if not default. Indeed, Fitch’s point may be more significant than S&P’s. Twelve years ago, when S&P made its move, the country faced the legacy of the Great Recession, an economic emergency that justified an otherwise excessive use of debt. In the following years, Washington regained a measure of control over the budget, and deficit flows abated. Today, a huge flow of red ink persists even as the pandemic has passed and the economy, though not without problems, seems to need little help. In contrast to 2011, today’s budget policies and excessive spending are of more concern.
The debt issue has three possible outcomes, all of which depend on electoral politics. One is the status quo. Debt will continue to outstrip the economy’s ability to meet the government’s obligations in real terms. More downgrades will occur that, even if absurd in strictly financial and legal terms, will point the way to future financial problems, including endemic inflationary pressures.
A second option is Congress raising taxes, cutting spending, or both. That might head off the problems to which the downgrades point, but it would do so by constraining the economy, effectively implementing a financial solution but increasing unemployment, slowing income growth, and destroying wealth.
A third option would shift Washington’s tax, spending, and regulatory policies in a direction that promotes growth: tax cuts that favor production and investment, spending priorities that encourage work, and regulatory efforts that avoid needless interference in the production process and business formation. That way the economy could in time shoulder the debt burden more easily.
With this downgrade, Fitch has stepped outside its own business model. Jamie Dimon’s criticisms—almost mockery—speak to that fact. But if this move makes these three choices clearer to the voting public, Fitch will have done the nation a service, even as it has embarrassed itself.
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