Update 714 — Downgrading the Debt

Fitch Cut’s Costs, Causes and Cures

The United States received a forewarned but still somewhat unexpected report card — coming in the wake of June’s debt limit agreement — from the Fitch Ratings last week when it downgraded US debt securities by one notch, from a pristine AAA to AA+. Fitch cited the same reasons offered by Standard and Poor’s did in 2011 when it issued the first-ever downgrade of US debt.

The rationales cited — deteriorating governance and increasing federal deficits — are not of commensurable weight and the fiscal reasons for the downgrade are also widely misunderstood as a “spending” problem. Below, we tease out the causes of Fitch’s move and the political and policy path to addressing them.

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How Fitch Justified The Downgrade

Last Tuesday, Fitch Ratings downgraded securities issued by the United States from its top rating AAA to its second highest AA+. They cite two main factors: an erosion of governance and widening fiscal deficits. This rationale matches the 2011 justification used by S&P when that agency issued the same downgrade, leaving Moody’s as the last of the big three rating agencies still giving the United States its top rating.

Market reactions have been mostly muted, with markets following pre-announcement trends. Markets saw a small but noticeable bear steepening in the yield curve, with less demand for longer term treasuries than shorter term ones. While there are a number of explanations for this market behavior, including typically thinner market depth in August, it is consistent with a more dour long-term outlook for Treasuries. Fitch’s decision has been widely panned by important figures across the ideological spectrum:

Overall, critics have deemed Fitch’s decision arbitrary and subjective, citing the credit rating agency’s own logic that the situation has been improving since reaching a nadir in 2021. While that criticism is valid, the downgrade presents an opportunity to examine the long-term crises of governance and finance it raises.

Long Weakening Fiscal Balance

Increasing Debt

While Fitch primarily emphasizes the erosion of governance in justifying its downgrade, discussion of the downgrade seems to revolve around the national debt. As seen in the figure below, following the early 1980s recession, debt held by the public rose until the mid 1990s, when the Clinton Administration put the country on the path towards full elimination of the national debt by the early 2010s. In the second quarter of 2001, debt held by the public hit a relative minimum at slightly under 31 percent of GDP, until the combination of the recession that followed the dot-com bubble, the Bush tax cuts, unpaid-for conflicts in Iraq and Afghanistan, the Great Recession, the Trump tax cuts, and the pandemic took that number to 104 percent of GDP in the second quarter of 2020. While strong economic growth pushed that ratio down to 93 percent in the first quarter of 2023, that is still a staggering increase.

Growing Interest Expenses

Higher interest rates have compounded this problem. Rock bottom rates kept interest costs low during much of the run-up in debt, but since the Fed began its current hiking cycle last March, interest payments – which unlike most federal spending have a very low multiplier – have increased from 2.4 to well over 3.6 percent of GDP.

This problem is worse when looking at these expenses relative to overall government expenditures. While the rapid spikes in government spending during the pandemic distort this calculation, using the fourth quarter of 2021 (a quarter without any major spike in spending) as a baseline, interest expenses have risen by almost 50 percent as a share of expenditures. This puts policymakers in a tricky position. Without addressing these costs, these expenses will themselves require further borrowing.

Low Expenses, Even Lower Revenue

Contrary to popular belief, the increase in American debt has more to do with insufficient revenues than runaway spending. Looking globally, American expenditures are comparable to the 27 OECD countries with easily available data available from 1995 and 2021. In fact, we spend less than many of our peers, but while government spending has consistently been a lower percentage of output than many of our peer countries, our revenue collection lags much further behind.

In fact, plotting revenue collected in a given year against government expenditures for that year, most of the data from these countries show a positive relationship: the more the country spends in a year, the more it collects in revenue. For the United States, however, a negative relationship between government spending and revenue appears. While this relationship is skewed by our greater fiscal capacity to respond to economic downturns with deficit spending, it is still striking. The reason for this relationship is that for most of the 21st century, it has been harder for the federal government to raise taxes than for the government of any other developed country.

The Economic Consequences of the Pledge

That sad statement can almost entirely be attributed to the fact that roughly 85 percent of Congressional Republicans are signatories to Grover Norquist’s pledge, which commits a candidate to “oppose any and all tax increases.” This century, Democrats have held a trifecta in Washington for four years, and for half of that time it was reliant on an evenly divided senate where one member (who has since left the party) was intractably opposed to tax increases on corporations and the wealthy.

In contrast, when Republicans have held a trifecta, they passed tax cuts for the wealthy that switched the long run trajectory of the national debt from a falling debt-to-GDP ratio to a one of steep increases. Even though spending has conformed to a path below 2012 estimates, the revenue relative to earlier projections has come in even lower. Aggravating the problem, the GOP has let their antipathy toward the very idea of revenue collection run to the point that reduced enforcement of tax laws is now an explicit policy priority, to wit, it took them less than 72 hours to go from electing Speaker McCarthy to voting unanimously to gut spending…on the IRS.

Our Declining Democracy

Unfortunately, the challenges detailed in the previous section pale in comparison to the primary driver of Fitch’s downgrade: our declining democracy. While it is one of the more minor areas noted by Fitch, the fact that the Congress has consistently failed to pass a full budget on time for almost all of the past five decades, the frequency with which it fails to even pass a continuing resolution (and the difficulty it has ending the resulting shutdowns) have increased in recent years. Before 1990, the government had never shut down for more than a day, and that year’s shutdown was almost certainly extended by the fact that it mostly took place over a weekend.

The 26 days of partial government shutdowns driven by then Speaker Gingrich’s tantrum over a minor snub represented, at their conclusion, at a minimum 78 percent of all government shutdowns in the more than 200-year history of the United States up to that point. Today they represent less than 30 percent of that period. With the exception of the three day (including a weekend) January 2018 shutdown, the following shutdowns were driven by Republican intransigence. As the prospects for another government shutdown loom, it is unfortunately true that these shutdowns rank among the more minor components of the current degradation of American democracy.

Much more serious are the increasingly dangerous fights over raising the debt limit. While there have been debt limit fights since the 1950s, those that presaged the S&P and Fitch downgrades were unique in their antagonists’ embrace of the possibility of a default. A default would almost certainly have catastrophic results, and yet, these fights are not the most serious Fitch identifies.

That distinction is reserved for the abandonment of democracy by a major political party as exemplified by Republicans’ attempt to steal the 2020 election on January 6th, 2021, a factor cited explicitly by Fitch. While our politics have always been contentious, it was an unprecedented attempt to change the states-certified result of an election.

If we fail to address our governance and revenue problems, the costs will be greater than a demotion from the “lowest expectation of risk” to “very low risk.” As of right now the American economy is the strongest in the world and the dollar remains the world’s reserve currency. But a further decay of the institutions we have built to govern the country threatened to make it functionally ungovernable. In 2022, Democrats managed to impose a small tax increase on stock buybacks, for example, and there are many others for consideration that enjoy broad popular support. Looking at revenue opportunities is the type of work we need to do in order to restore our democracy. So far, only Democrats have shown interest in this type of governance.

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