Fitch shot a rocket at Treasuries that turned out to be a dud, in the form of its downgrade of US debt from AAA to AA+. This leaves Moodys alone among major rating agencies scoring Treasuries as AAA.
One might think, given all the hand-wringing about US debt, that the press and investors would be in a funk over this action. After all, when S&P threatened to downgrade Federal obligations from AAA to AA+ in 2011, business commentators, nearly all analysts, and the press spoke with one voice that this would be a meteor-wiping-out-the-dinosaurs-level event, an end of the financial universe as we knew it. Your humble blogger was virtually alone in disputing this view.1
Unlike S&P in 2011, Fitch did not broadcast its plans in advance. Even though investors and commentators seemed surprised, and the White House predictably got huffy, Mr. Market shrugged. Not only did the usual Democratic party economists like Larry Summers, Paul Krugman, and Jason Furman come out swinging on Twitter, but so to did highly respected, perceived-as-nonpartisan analysts like Mohamed El-Erian.2
Treasury yields fell, meaning investors were buying more, not fewer Treasuries at the margin, and the softening of the dollar is expected to be fleeting:
The dollar’s weakness following Fitch’s downgrade of the US is unlikely to persist, according to analysts https://t.co/plSmHNFFNE
— Bloomberg Markets (@markets) August 2, 2023
The financial press didn’t even give the story prominent billing this morning. The latest Trump indictment was the hot news:
At the Wall Street Journal, the Trump story is given so much real estate that the Fitch downgrade is below the fold (admittedly, it is the top story on the left once you scroll down):
So what exactly happened here?? As we’ll explain, one element of Fitch’s critique is correct, that the ugly and too frequent debt ceiling and budget cliffhangers are a sign of political dysfunction and raise the specter of a disastrous miscalculation.3
But the big reason for the collective yawn is Fitch’s economic case was weak and contradicted by recent data. We’ll turn the mike over to Twitterati as representing common views among the economist and investor cohorts:
Strange timing from Fitch. US debt to GDP is heading down, the term premium is negative (suggesting strong demand for long-term bonds), and the only likely point of bipartisan consensus in this Congress is to avoid a an avoidable default …
— Brad Setser (@Brad_Setser) August 1, 2023
The fiscal deficit perhaps should be a bit lower in an ideal world (Congress passed on easy opportunities to increase the tax paid by US MNEs and lower US pharma costs … ) but it clearly has come down a lot.
— Brad Setser (@Brad_Setser) August 1, 2023
The US government is the highest income generating entity in human history and issues the dominant reserve currency. If the US govt isn't AAA rated then nothing is. https://t.co/AlfdBjd5nm
— Cullen Roche (@cullenroche) August 2, 2023
Note that Zandi is super orthodox and we have criticized him regularly on this site, so for him to blow the downgrade off is telling:
Fitch’s downgrade of U.S. Treasury debt to AA+ is off-base, IMHO. They rate the sovereign debt of a rather lengthy list of countries AAA. Really? Ask global investors whose bonds they would rather own if push comes to shove in the global economy – it’s those of the U.S. Treasury.
— Mark Zandi (@Markzandi) August 1, 2023
And just because Jason Furman is an administration defender does not make this argument wrong:
A year ago Fitch upgraded the US AAA credit rating outlook from "negative" to "stable". It also set out the criteria for a downgrade:
1. "Significant and sustained rise in… debt/GDP ratio." DIDN'T HAPPEN
2. "Deterioration in governance quality" HARD TO SEE MUCH CHANGE, IF… pic.twitter.com/NXoLeyLOLx
— Jason Furman (@jasonfurman) August 1, 2023
Mind you, none of these arguments rely on the MMT point, that the US can always meets its Federal obligations. As a currency issuer, it cannot run out of money. It can engage in net fiscal spending (aka deficits) in excess of economic capacity and generate too much inflation.
The one way Fitch was correct is the US could make a voluntary default due to failed debt ceiling negotiations. But with the US economy showing pretty good groaf and inflation weakening (according to the Fed’s preferred measures), the idea that the US situation is worsening and therefore debt wobbles are becoming more likely is not an imminent worry.
Another way the debt critics could be correct, but it is an argument that is virtually never made, is that deficits should not be as big a worry as where the spending goes. If net fiscal spending is directed significantly to investments and programs that increase the productive capacity of the economy, like infrastructure, basic R&D in high potential sectors, education, cheaper broadband, the deficit spending will pay for itself via higher GDP growth.
Now if you want to make a case for poor US prospects, there is plenty of grist for that argument: falling US lifespans; rentierism by the health care, higher eduction, real estate, and arms sectors, which hurts productivity and competitiveness; rising partisanship; and as we and others (see Andrei Martyanov, for instance) a serious and accelerating fall in strategic and operational capability on a widespread basis.
But even with the US in decline, it is still faring better than Europe and some other areas of the world. And the elites are very good at preserving their interests even as the prospect of decline looms. Recall that even in the Dark Ages, the nobility did not fare too badly. Archeologists have found evidence they still were able to procure luxuries from around the world, like spices and fine china.
So the US sell-by date is coming but it is not imminent. That does not mean the US will not take yet more self destructive action, but the charges Fitch made largely did not stand up to scrutiny.
Remember Y2K? The world was gonna end because there was tons of legacy code that couldn’t accommodate the rollover to the new century. I know people in who went into survivalist mode, stocking up months of supplies, and others who took less extreme precautions, like having lots of cash on hand in case ATMs were disrupted.
As we now know, January 1, 2000 came in without major incident, since the widespread publication of this software threat to End the World as We Know It led to lots of preventive action. Perversely, the big effect of the Y2K scare was that it accelerated tech spending, since many firms bought new systems and upgraded hardware as part of their overhaul. That increased the severity of the post-bubble economic downturn….
It isn’t yet clear what the impact of the S&P downgrade of the US to AA+ will have. There are good reasons to believe, despite the media hyperventilating, that it won’t add up to much, and may perversely hit wobbly stock markets more than Treasury yields.
But there is a much bigger issue, namely S&P’s highly questionable conduct, the lack of any analytical process behind this ratings action, and the political implications.
2 For instance: Mohamed El Erian says Fitch downgrade of the US is a strange move, likely to be dismissed ForexLive.
3 Cynical and seasoned observers know that this debt/budget game of chicken is in large measure a play act and the principals won’t precipitate a default. Congresscritters if nothing else have too much in the ways of investments to be in the net worth self-harm business. However, given the way the US acting against its self-interest by escalating with China while things are not going at all well in Ukraine, it is not impossible that some ideologues down the road will get their hands on the wheel and not steer out of a crash.