On Aug. 1, Fitch Ratings, which together with Standard & Poor’s Global and Moody’s Investor Service comprises the “Big Three” of nationally recognized statistical rating services, announced that it was downgrading the credit rating of the United States by one notch from “AAA” to “AA+.” S&P Global lowered its U.S. rating to “AA+” in 2011 and has never since reversed that decision.
David Andolfatto, professor and chair of the University of Miami Patti and Allan Herbert Business School Department of Economics, and Indraneel Chakraborty, professor and chair of the Department of Finance, assessed the reasoning and resonance of the rating knockdown.
Fitch cited three factors for its decision—erosion of governance, fiscal deterioration, and growing government debt burden. Please assess each briefly.
Andolfatto: Erosion of governance refers to the political wrangling and last-minute resolutions associated with increasing the debt limit. Fitch is worried that one day a timely resolution may not occur, forcing the U.S. Treasury to postpone making scheduled payments—including payments of interest and principal on maturing U.S. government bonds.
Fiscal deterioration refers to the ability of the fiscal authority to service its debt. This means rolling over maturing debt and making scheduled interest payments.
Growing government debt burden refers to growing costs of servicing the debt—that is, the growing interest expense associated with managing a large stock of debt.
The U.S. government response, voiced by Treasury Secretary Janet Yellen, termed Fitch’s decision “arbitrary and outdated.” Which perspective is most accurate?
Andolfatto: The Treasury secretary's views are the most accurate. The U.S. economy is still a juggernaut, and the U.S. dollar and U.S. Treasury securities remain the global reserve currency. The U.S. is a monetary sovereign, which means that it need not ever default on its debt. The primary concern with excessively large debt and deficits should be excessive inflation. These ratings do not measure inflation risk, they measure default risk—which is minimal. The stakes are just too large for that to happen. On the other hand, I suppose one should never say that the risk is zero.
What’s the purpose of these ratings agencies?
Chakraborty: Ratings agencies provide credit quality information to bond investors. Bond investors purchase debt of issuing companies, municipalities, and sovereign nations in this case. Ratings provide quick information to investors who do not know much about a company or municipality. Rating agencies now serve two main purposes: they provide information to investors and regulators who monitor the amount of credit risk financial institutions are taking.
This is not an applicable concept when it comes to the U.S. credit rating as most large investors understand the U.S. quite well. With the downgrade and the factors that Fitch identified, they’re sending a message that the U.S. should exhibit more fiscal responsibility.
How should we interpret their announcement? What message is Fitch sending?
Chakraborty: It’s not the credit quality of the United States that’s being called into question; no one believes that the U.S. will default on its debt. The announcement signals that the U.S. is getting too close to the deadlines in making decisions regarding the debt ceiling. This creates some uncertainty in the markets. In the recent episode, short-term treasury yields spiked a bit around the expected deadline for payments.
The other purpose is that the U.S. has been running significant and increasingly larger federal deficits since the early 2000s and the downgrade seeks to motivate the U.S. to begin a robust discussion and generate a plan to address the deficits and create more long-term fiscal balance.
What do you see as the impact of this announcement?
Andolfatto: In the short term, it appears to be negligible. AA+ is still a very attractive rating, so it’s doubtful that the change in rating would prompt any automatic changes in the portfolios of intermediaries. I don’t foresee any great impact. The market assesses default risk independent of what the bond rating agencies believe. Often, it seems that the rating agencies follow what the market thinks.
The announcement in some—possibly most—ways reflects concern for the ballooning federal deficit, which clocked at $1.39 trillion for the first nine months of the year, up 170 percent for the same period last year. How concerned should we be?
Andolfatto: Ballooning budget deficits may manifest themselves as higher interest rates and higher rates of inflation. There is reason to be concerned about such developments, but they have little, if anything, to do with the prospect of default, which is what the Fitch downgrade reflects.
What can/should the government be doing to address the ballooning federal deficit?
Andolfatto: Much depends on how the federal government employs its purchasing power. Higher deficits are fine if the spending is on much-needed public infrastructure. If the growth in government spending in non-capital projects is deemed desirable, then higher tax rates may be needed. Or the government can take measures to slow the pace of its spending increases.
Is there any collaboration between the agencies, i.e., that if they were to make a joint announcement downgrading the United States’ rating that might send an even stronger signal that something needs to be done to address the ballooning debt?
Chakraborty: There’s no coordination between the agencies by design. But they’re all looking at the same data and so are in lockstep in that they reach the same conclusions. It’s not like the information is surprising.
It’s not the job of the agencies to tell us what to do, but it would behoove us to listen to the signal that something needs to be done and that a plan is needed.
Australia, Germany, Singapore, and Switzerland reportedly all have top ratings from the three firms. China gets a A+, three notches down from the top. The overall number of countries with top ratings is declining. What factors are contributing to this decline?
Chakraborty: On one hand, the U.S. provides the bedrock of the global financial system. It will continue to do so. All these markets depend on the dollar denominated system supported by U.S. economic and security guarantees. Hence, the relative downgrade doesn’t make a lot of sense in that these other countries do not have stronger credibility than the U.S.
On the other hand, the knockdown does make sense, in that we should be generating a plan to address the federal deficit and exercise some fiscal discipline. Many nations worldwide are grappling with higher debt and hence top ratings are declining. That, however, should not be a source of complacency. The U.S. must introspect to its own fiscal situation. One party may say we need more taxes, the other may call for cost-cutting and tightening purse strings. The message here is for fiscal discussions—part of the messy and lengthy, yet necessary process of a democracy—to begin in earnest.
