The US Credit Downgrade Explained

The U.S. Capitol looms behind flags on the National Mall in Washington on Nov. 7, 2022. J. David Ake/AP Photo

Commentary

Bond ratings serve a massively important economic function. They signal to investors the quality of a debt instrument based on the likelihood that it'll be paid. The higher the rating, the more secure it is and the more certain it is to be a reliable investment. The lower it is, the more risk you take. Junk bonds, for example, can earn a huge return but one never knows for sure if the holders will ever see it.

There are three major bond-rating firms in the United States. One of them, Fitch, just downgraded U.S. government debt. The result was absolute fury from the Biden administration. Keep in mind that this downgrading was the tiniest notch imaginable: from AAA to AA+. That’s almost nothing, but it sends an important signal that U.S. debt—the most secure thing in the world to the point that people treat it like cash in the bank—is suddenly in question.

“The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management,” the company stated.

Well, there’s plenty else wrong, namely the loss of any sense in Washington of what causes and feeds economic growth. All the momentum is toward ever more control and intervention.

One might treat this as a temporary setback and really no big deal, but that isn’t what happened. And why? It’s because there’s a widespread opinion on Wall Street, in the financial world, in the corporate world, and in the public generally, that America’s best days are over.

Sometimes, it feels like the whole country is being sacked. We’ve got insanity at the border, censorship in media, rule by the administrative state, a media and government that no one believes anymore, a deprecation of our rights, a loss in the rule of law, the decline of cities, the collapse of health, the ruination of education, the dramatic decline in church attendance, and massive unpayable debt.

It’s so bad that hardly anyone of any serious status is willing to tell the truth.

One bond-rating company finally steps out with a hint of truth and everyone screams. This is for a reason. Actually, two reasons: Donald Trump and Joe Biden. Of course, they’re blaming each other. As usual in Washington, both sides are generally right about each other. This has been a bipartisan hit on U.S. economic health.

White House press secretary Karine Jean-Pierre said, “It’s clear that extremism by Republican officials—from cheerleading default to undermining governance and democracy to seeking to extend deficit-busting tax giveaways for the wealthy and corporations—is a continued threat to our economy.”

OK, that’s utter rot. Mr. Trump never undermined governance. With the lockdowns of 2020, governance never had it so good. As for giveaways, it’s true not of tax cuts but of spending expansions. American history has never seen anything like the Trump deficits. But why didn’t Mr. Biden end them rather than extend the problem and add even more to the debt? (Remember that the deficit is the annual change in the debt.)

Data: Federal Reserve Economic Data [FRED], St. Louis Fed; Chart: Jeffrey A. Tucker

Now, to what extent is the downgrade deserved? Well, that’s a complicated question.

Let’s take a look at state bonds and see where they are. Keep in mind that states don’t have central banks to pay the debt if the money isn’t there. They have to balance their budgets year to year, and the debt they incur is only secured by tax receipts in the future plus whatever returns they get from various investments. Therefore, state bonds provide the most realistic look at valuations.

Right now, bond ratings at the state level are all over the map.

Which states have a AAA rating? Arizona, Delaware, Florida, Georgia, Indiana, Iowa, Maryland, Missouri, Nebraska, North Carolina, Ohio, South Dakota, Tennessee, Texas, Utah, and Virginia. Congratulations! Which states have the worst ratings? New Jersey (BBB+), Connecticut (A), Illinois (A-), Kentucky (A), Pennsylvania (A+), and California (AA-).

These ebb and flow over the years, although some are consistently great, such as Florida, Delaware, Georgia, and Utah. The ratings come and go, and no one particularly panics simply because buyers can choose and beware. Some like the risk and others don’t. But no one doubts the accuracy of the rating simply because none of these states have central banks.

At the same time, not one state in this country has the fiscal disaster of the federal government. Not even close. We might ask what might happen if the U.S. debt were judged fairly and rated by genuine market standards. That would happen if either the Federal Reserve stated that there would never be a bailout (it exists in part to guarantee U.S. debt) or it was abolished completely so that the federal government operated by the same accounting standards as the states.

What would be the result? What would happen to the rating of U.S. debt in the complete absence of the Fed? This is purely speculative, but I’m guessing there would be trouble. We can guess.

• CCC—currently vulnerable to nonpayment • C—highly vulnerable to nonpayment • D—in default

These are considered junk bonds. That’s very likely where U.S. Treasurys would be. To be clear, this would be a complete calamity for conventional finance and send every investor on a mad hunt for value. Gold would soar and so would bitcoin, land, oil, and everything and anything you can put your hands on.

From my perspective, this would be a delight to watch. While the disaster would be immediate, it would also be temporary in the sense that Washington would be forced by markets to live within its means. It would also mean that the United States would be a terrible credit risk for a time, and foreign governments would dump dollar-denominated debt like never before.

You wouldn’t need a balanced-budget amendment. It would happen automatically, as it does in the states without central banks!

To be sure, there’s zero chance of this happening anytime soon. But just thinking about this little mental experiment makes the point. The only reason that the U.S. debt is (or was) rated AAA is because of the firm promise to print unto infinity. If you gave your son a credit card guaranteed to a billion-dollar credit limit, he would be quite beloved even without a job. This is how it is for the U.S. government today.

At the same time, it’s a vulnerable spot to be in, especially with debt running at 118 percent of gross domestic product when it only passed 100 percent in 2019. That simply isn’t sustainable with the Fed’s magic printing machine.

Data: Federal Reserve Economic Data [FRED], St. Louis Fed; Chart: Jeffrey A. Tucker

This is why markets are so jittery about ratings downgrades from major bond raters. It’s like sounding an alarm. The alarm is truth, and the markets today don’t like truth very much. The United States is already in de facto default. The printing press is the only disguise.

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.