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When we get near the end of 2023 and news outlets begin rolling out their “year-in-review” retrospectives, there’s one story that’s sure to be featured prominently: the saga of the debt-ceiling standoff, including how close America came to defaulting on its federal debt for the first time in history.
The government ran up against the $31.4 trillion debt ceiling in January. But raising it proved to be no mere political formality. Republicans insisted that meaningful spending cuts would have to be part of any deal to lift the ceiling. Democrats insisted it should be raised without conditions. Months of wrangling ensued, but a deal remained elusive.[1]
Finally, at the end of May – and just days before the government would have been forced to default – an agreement was reached. President Biden and House Speaker Kevin McCarthy managed to hash out a deal that suspends the debt ceiling through early 2025 and implements a measure of spending reductions.[2]
Even before the dust had settled on the shiny, new Fiscal Responsibility Act of 2023, however, concerns were raised that while default may have been avoided for now, America’s long-term fiscal outlook remains every bit as uncertain as it was before the deal was reached.
On June 5, Reuters published an article with a headline that screamed the “debt ceiling deal ignores US debt time bomb.” The article quotes Dennis Ippolito, a public policy professor and fiscal expert at Southern Methodist University, who said in reference to the agreement, “If you’re worried about the deficit and debt problem, this thing does nothing.”[3]
It seems that Fitch Ratings – one of the “Big Three” credit-rating agencies – agrees. Last week, in a move that practically no one saw coming, Fitch downgraded America’s debt rating from AAA to AA+. Fitch specifically cited the nation’s constantly mounting obligations as well as “a steady deterioration in standards of governance” as the bases for its decision.
As a first reaction, global markets were rattled by the news, but the immediate fallout was less than dramatic. Still, a downgrade of the nation’s debt rating isn’t a nonevent. Even if the initial reaction from the global economy has been more subdued, the message conveyed by the downgrade is as undeniable as it is concerning: As of right now, America’s long-term fiscal outlook may very well be unsustainable.
To fully appreciate that, one has to look closer at the rationale Fitch relied on to make its downgrade decision. We’re going to do that this week. We’ll detail what Fitch was thinking when it took this step, as well as how a handful of interested parties – including another of the major ratings agencies – have reacted to it.
We’re also going to talk about the potential impact of the downgrade. What consequences should we expect to see in the short term? What message, if any, does the downgrade decision possibly send about the prospective stability of America’s fiscal future?
We’ll get to that a bit later. First, though, let’s discuss further what Fitch did…and why they did it.
America’s sovereign debt – the debt issued by a nation’s government to borrow money – has long been regarded as the world’s safest. U.S. Treasuries, backed by the full faith and credit of the U.S. government, are viewed as one of the world’s safest investments, and the Treasury market is widely regarded as the deepest and most liquid.[4]
Ultimately, however, any debtor, even Uncle Sam, is subject to having his creditworthiness evaluated. And in the assessment of Fitch Ratings, Uncle Sam’s credit is no longer quite as pristine as it once was. Last week, Fitch officially said so by downgrading America’s credit rating, cutting it from AAA, which denotes the “highest credit quality,” to AA+, which denotes “very high credit quality.”[5]
“Very high credit quality” still sounds awfully good. But this is America, after all – and the idea that its “full faith and credit” is no longer held in the highest regard by one of the world’s principal credit-rating agencies is something worth noting.
Clarifying the difference between AAA and AA+ in a little more detail may allow us to better understand the significance of the downgrade decision. According to Fitch, a AAA rating implies “the lowest expectation of default risk”; it’s assigned “only in cases of exceptionally strong capacity for payment of financial commitments.”[6]
AA ratings, even with the “+” qualifier, clearly are a step down, even as they’re also representative of significant financial strength and creditworthiness. As Fitch puts it, the AA rating implies “expectations of very low default risk” and indicates a “very strong capacity for payment of financial commitments.”[7]
As for why Fitch decided to downgrade, its summary explanation basically tells the story:
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.[8]
The reference by Fitch to “two decades” of fiscal and governance failings underscores the reality that responsibility for the resulting problems transcends the financial-management misdeeds of any one administration. Fiscal year 2001 is the last time the nation saw a budget surplus, and, in recent years, annual budget deficits under both Republican and Democrat administrations have been well into the trillions.[9]
That said, there’s no denying it was on President Biden’s watch the downgrade occurred…which means that in sampling reactions to it, we probably shouldn’t be surprised that the response from the government’s chief financial officer – Treasury Secretary Janet Yellen – was a bit defensive.
Blackstone’s Schwarzman: “Regrettably, the Numbers Justify” the Downgrade Decision
“I strongly disagree with Fitch Ratings’ decision,” Yellen said in a statement following the downgrade decision, adding that “the change by Fitch Ratings announced today is arbitrary and based on outdated data.”[10]
Yellen continued her criticism of Fitch in subsequent public appearances, saying, “Fitch’s decision is puzzling in light of the economic strength we see in the United States. I strongly disagree with Fitch’s decision, and I believe it is entirely unwarranted.”[11]
Unsurprisingly, the Republican-chaired House Budget Committee had a different take, one that made reference to the recent debt-ceiling negotiations:
In reality, the credit ratings were downgraded not because Congress debated cutting spending with the debt limit, but because the resulting spending cuts and broader reforms that the President would agree to were not significant enough to change the fiscal outlook of the country.[12]
For his part, Steve Schwarzman, CEO of Blackstone, the world’s largest manager of alternative assets with $1 trillion under management, seems to think that a “big-picture” glance at America’s fiscal reality tells the story of why Fitch did what it did.[13]
“The numbers justify it, regrettably. We’ve had an explosion of debt since the global financial crisis. We don’t appear to have a lot of discipline, going forward; we’re running huge deficits now.”[14]
In truth, Fitch’s reference to the nation’s two-decade-long run of poor fiscal governance, along with Schwarzman’s suggestion that potential fiscal instability has been growing in earnest since the financial crisis, might even raise the question not of why Fitch downgraded America’s credit rating…but, rather, why it took the agency so long to do it.
It may, in fact, be a question that analysts at another of the “Big Three” ratings services – Standard & Poor’s (S&P) – are asking.
Here’s why.
As it turns out, the move by Fitch isn’t the first time America’s debt has been downgraded. In August 2011, almost exactly 12 years before the Fitch downgrade, S&P took it upon itself to downgrade America’s debt rating from AAA to AA+.
What made the decision by S&P so noteworthy is that it was, in fact, the first downgrade of America’s debt rating in the nation’s history.
As with the Fitch downgrade, the S&P downgrade followed shortly after the resolution of a fight over the debt ceiling. As in the case of the most recent downgrade, S&P analysts in 2011 decided the spending reforms that emerged from that debt-ceiling negotiation were not representative of the savings they said would count as a good “down payment” on fiscal reform. A short time later, S&P proceeded with the first-ever downgrade of America’s credit rating.[15]
Nikola Swann, S&P’s primary analyst for its sovereign credit rating at the time of the 2011 downgrade, said he feels “vindicated” by last week’s Fitch move. Swann and the rest of his team caught a healthy dose of grief from both media outlets and the Obama administration – in office at the time of the downgrade – who accused them of making their decision on suspect bases that included political bias and unsound economic modeling.[16]
But Swann says the Fitch downgrade is validation that he was on to something more than a decade ago.
“The weaknesses we then pointed to, compared to AAA countries, in terms of Washington’s ability to build bipartisan consensus on key policy questions in a timely manner, especially regarding fiscal management, have only worsened since,” Swann said. “The same is true of U.S. fiscal outcomes.”[17]
America’s credit rating now has been downgraded by two of the world’s leading ratings agencies twice in a little more than a decade. On the surface the immediate, direct consequences of the decisions seem to be little more than economically “cosmetic,” including some short-term volatility reverberating throughout global markets.[18]
But what may not be merely cosmetic is what the downgrades potentially say about the long-term fiscal outlook of the nation – an outlook that even several U.S. government agencies have characterized as “unsustainable.”
I don’t believe that significant consequences will arise in the short term because of the downgrade decision. There’s an undeniable symbolic power to an official declaration that America is not as creditworthy as it once was, but, honestly, the fraught nature of the country’s fiscal outlook has been well known for years. As we discussed, S&P saw fit to cut America’s credit rating more than a decade ago, and several government agencies recently reaffirmed longstanding outlooks of what they believe to be America’s fiscal unviability over the long term.
The Congressional Budget Office (CBO) is among those federal agencies that continue to see things in such a way. “The warning is that the fiscal trajectory is unsustainable,” CBO Director Phillip Swagel declared tersely in the wake of his agency’s February report that projected the ratio of federal debt held by the public is on track to reach nearly twice the nation’s GDP over the next three decades.[19]
The Government Accountability Office (GAO) sounded a similar alarm recently. In early June, GAO Director of Strategic Issues Jeff Arkin testified before Congress about the precariousness of the nation’s fiscal path, which he called “unsustainable over the long term.”[20]
Even the Treasury Department – in what appears to be a contradiction of Treasury boss Janet Yellen’s strong objections to the Fitch downgrade – recently suggested the nation is traveling an “unsustainable fiscal path” and declared “that current policy is not sustainable and must ultimately change.”[21]
So, against the backdrop of standing criticisms and even warnings about the nation’s potentially fragile fiscal future, the Fitch downgrade by itself may not qualify as an earth-shattering event. Rather, it’s one more highly credible voice of authority – in what has been a steady stream of such voices – willing to publicly declare that America’s long-term fiscal outlook is unviable.
But maybe that’s where the significance of the Fitch downgrade really lies, and why it should be taken so seriously; because it may enhance the credibility of a narrative that suggests America, at least for now, could be traveling toward very rocky fiscal roads.
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