As recently as 12 years ago, the international credit rating agency Standard & Poor’s downgraded U.S. debt from AAA to AA+, marking the first time in the 70-year period from 1941 to 2011 that the U.S. Treasury lost its top rating of AAA. And in the S&P ratings, U.S. government debt has remained at only AA+ for the 12 years from 2011 to the present, never regaining AAA, so it is puzzling why the White House and many others were so critical when Fitch, another credit rating agency, likewise downgraded U.S. debt from AAA to AA+ last week.
What was most controversial about the Fitch downgrade was not its justification, but rather the timing of its announcement. U.S. President Joe Biden and Secretary of the Treasury Janet Yellen began by stating their disapproval of the downgrade, the Biden administration emphasizing that, at this point in time, the U.S. economic recovery was the strongest of any major country in the world, a fact about which Fitch has been contemptuous.
Criticizing Fitch for ignoring the latest information and use of “outdated data” as absurd and without foundation, Yellen stressed that the U.S. labor market was booming, and that the unemployment rate was at a 50-year low of 3.6% or less. She also claimed that international investors would not take Fitch’s rating into account, question the U.S. government’s ability to repay its debts, or change its investment behavior and sell off U.S. debt.
These responses, while strongly worded, miss the point. What a bond’s credit rating assesses is the ability to make interest payments on time and repay the principal according to schedule. Yellen declared that investors would not question the U.S. government’s solvency; however, it was only two months ago (in May of this year) that she wrote to the U.S. House of Representatives, stating several times for the record that if the debt limit could not be raised or if restrictions on borrowing could not be suspended, it was highly likely that the U.S. government would run out of cash to make payments by June 1 this year, or by June 5, at the latest.
The specter Yellen raised of the government running out of money may seem outlandish to many countries, but in the U.S. it actually happens once in a while. This is because the U.S. is in a long-term fiscal deficit and needs to borrow each time to make up for the funding gap, but the amount of borrowing is subject to a legal limit. Therefore, once the debt increase hits the upper limit, the law must be amended again to raise the borrowing limit; otherwise the U.S. government will not be able to operate as a result of cash flow problems.
However, as the political face-off between the two U.S. parties has become more and more acute, every amendment to the law has resulted in offensive and defensive brinkmanship, putting forward conditions that are unacceptable to the other party as a prerequisite for agreeing to said amendments. As a result, the political wrangling between the two parties has repeatedly given rise to a state of nervous tension in the global financial markets. Even though there has not yet been a default on U.S. debt that resulted in the nonpayment of interest, the failure of bipartisan negotiations has blocked and made impossible the raising of the debt ceiling within the allotted time frame. What is more, there have been a number of cases in which the government has had to suspend its operations due to a lack of funds. Since 1976 there have been 22 instances in which the government has implemented a partial suspension of operations due to cash flow problems.
In its report on the downgrading of U.S. debt, Fitch explained that the downgrade was not due to short-term considerations but was focused more on structural problems in U.S. public finance. It believes that, in addition to the deteriorating fiscal deficit and ballooning debt (the current debt-to-GDP ratio in the U.S. of 118% being the third highest in the world, after Japan and Italy), tax cuts and increased government spending in recent years have been sources of fiscal distress. In the face of an aging future, the U.S. has not yet put forward any concrete plan on how to support the expenditure on contributions to Social Security and Medicare.
Furthermore, since last year the U.S. has raised interest rates to combat inflation, with interest rates reaching their highest levels in 40 years. The interest cost of borrowing has increased as a result, adding additional pressure for debt to continue to soar in the future. More importantly, Fitch stressed that the current deadlock between the two parties has eroded confidence in the ability of the U.S. to manage its finances and has damaged trust in U.S. public debt. On the face of it, Fitch’s downgrading of U.S. debt does not seem to have had much of an impact on the markets, but the structural problems in U.S. finances pointed out by Fitch warrant consideration.
The author is managing director of Bellwether International Group in Hong Kong and adjunct professor at National Taiwan University’s Department of Finance.