Wednesday, August 2, 2023

Fitch is right

(Updated to fix numbers.) Fitch is right to downgrade the US. Read the sober report. But there are a few other reasons, or emphasis they might have added. 

  • The inflationary default

Inflation is the economic equivalent of a partial default. The debt was sold under a 2% inflation target, and people expected that or less inflation. The government borrowed and printed $5 Trillion with no plan to pay it back, devaluing the outstanding debt as a result. Cumulative inflation so far means debt is repaid in dollars that are worth 10% less than if inflation had been* 2%. That's economically the same as a 10% haircut. 

Yes, this is not a formal default. And a formal default would have far reaching financial consequences that inflation does not have. Still, for a bondholder it's the same thing. It's as if they said, "well, we promised to repay you dollars, but we didn't say which ones, so you're getting Canadian dollars."  Yes, the promise not to inflate is implicit, not explicit. Still, it is the reputation and commitment not to inflate, not to dilute the debt as they did, which supported the very low interest rates at which the US could borrow. Countries that routinely inflate like Argentina have to pay higher interest rates ahead of time. 

Yes, that's in the past, and ratings agencies are supposed to evaluate future risks. But if you only repaid 90% of your mortgage, you can be sure the bank would see you as a worse credit risk going forward. The probability that the US inflates again, that in the next crisis they do the same thing, is unquestionably larger. The world's appetite for boundless amounts of US debt is unquestionably smaller .

Yes, there is an argument that this was a "state contingent default," appropriate policy for a once in a century shock. (Except we seem to get these once in a century shocks about every 10 years now.) But Fitch isn't judging if inflating away 12.4% of the debt was a good idea, or if inflating it away again will be a good idea in the next crisis. Their job is to simply tell bondholders if they think the event is likely.  It is. 

It is strange that Fitch does not mention inflation. More inflation is surely the prime risk facing a US bondholder. What is the chance that a 10 year or 30 year bondholder gets repaid in full, without another bout of inflation chopping down the value of his or her investment? What is the chance that someone rolling over one year or one month debt does not go through the last 2 years with the Fed holding short term rates substantially below inflation? That chance is surely much higher than it was two years ago! 

  • Debt ceiling shenanigans

The report focuses on whether the US will be able to repay its debts. The larger question is whether the US will be willing to repay its debts. 

Yes, the debt ceiling business was not the debt crisis we have long feared. Even if the debt ceiling had led to a temporary halt on interest and principal payments, that surely would have been temporary, and investors would soon have been repaid in full. It might have been a problem for liquidity, if you wanted to sell debt fast, or for your ability to pledge debt as collateral, but you would have gotten your money back sooner or later. 

But I was shocked that in the debt ceiling debate, the Administration did not say, loudly, "We will pay interest and principal on treasury debt before we pay anything else." (I was equally shocked that the Federal Reserve did not say, loudly, "we'll lend freely against treasury debt even if it is in technical default.") 

Bond investors want reassurance that in a crisis, the US government will choose to prioritize debt repayment over everything else. When it's interest payments to fat-cat Wall Street banks (even if those are just intermediaries to ordinary Americans), to foreign central banks, or pension funds and other institutions, vs. checks to American voters, which will Administration and Congress choose? I phrased it in a way to suggest what we have learned in the debt limit posturing. 

You may even think that this is the right choice, on grounds of distributive justice. The counterargument is that default will ruin the US reputation and make future borrowing much harder and more expnsive. "One time" defaults and wealth grabs are always attractive, but the world does not end, and the US will surely want to borrow in the next crisis, or the subsequent one. 

But again, that's not Fitch's job. Their job is to warn bond investors that losses are much more likely than they once thought; that the US does not seem so interested in the sacrosanctity of its reputation for bond repayment. 

  • Fiscal capacity and risks
For a financial report, Fitch stresses the baseline forecast, but strangely spends less time on risks. (There is a short section on "sensitivities." Bondholders of course mostly get downside risks. Two stand out to me: 

1) Interest costs. The report does mention rising interest costs on the debt, now heading to $1 trillion. 
"Over the next decade, higher interest rates and the rising debt stock will increase the interest service burden... The CBO projects that interest costs will double by 2033 to 3.6% of GDP. "
But this issue is really a risk factor, not a projection. If people listen to Fitch, and start demanding higher interest rates, then debt service costs rise, and the fiscal problem gets worse, and people demand even higher interest rates. 

2) Direct fiscal capacity. At the cost of some repetition, sooner or later something will go wrong and the US will want to borrow. Recessions occasion larger automatic stabilizers -- unemployment insurance -- stimulus, bailouts, and lower tax revenues. Crisis, pandemic, war demands more. Can the US really borrow a lot more? Or will the next unexpected shock come out of the pockets of today's bondholders? The chances are surely much higher, and Fitch is right to warn investors. 

  • Exorbitant privilege and reserve currency

Both Wall Street Journal and Fitch mention this as a positive. Yes, to some extent the fact that the dollar is the world's currency means the US can print up some dollars and dollar debt, and send these pieces of paper abroad to finance trade deficits. (I love trade deficits, but most politicians who extol reserve currency aren't so hot about them!) As a government can print up some money for its own citizens and thereby run a bit of a deficit.

But this is a one time thing. Money demand is a demand, not an infinity. Once people have all the US debt they want, they don't want any more. 

If all the foreigners were waiting to gobble up more US debt, we wouldn't have had inflation in the last 2 years. 

  • The report

The report is interesting in this vein, for looking beyond dry budget numbers. The reputation and institutions I refer to here is what they call "governance," 

Erosion of Governance: In Fitch's view, there has been a steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters...The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management. In addition, the government lacks a medium-term fiscal framework, unlike most peers, and has a complex budgeting process. ... Additionally, there has been only limited progress in tackling medium-term challenges related to rising social security and Medicare costs due to an aging population.

That's polite. "complex" budgeting process? There is no budgeting process going on right now. "limited progress" on social security and Medicare? What progress? 

"Governance" is the right word. 

I agree with the Wall Street Journal. They were too kind. 

*The Jan 2021 CPI was 262.6, in June 2023 303.84. That's a 15.6% rise. At 2% inflation, that should have been a 1.02^2.5 = 5% rise. 


  1. it's 11.8% haircut. 1.171 / 1.047. not 17.1 - 4.7.

    just enjoying this nitpicking, obviously :)

  2. "The government borrowed and printed $5 Trillion with no plan to pay it back, devaluing the outstanding debt as a result."

    In 2020-21. Seems to me that the credit downgrade should occur at the same time as the offensive credit event (not three years later).

    1. Couldn’t have jeopardized the midterm and encouraged a red wave!

  3. It's 3.33 years, so 1.02**3.33 is 6.8% expected nominal increase by February 2023. So 1.171/1.682 =9.6% unexpected debasement of dollar caused by fiscal policy after COVID hit.

  4. The number of well known economists, etc who have expressed a dissenting view of what Fitch said which is all too well known in non public pronouncements brings to mind the scene from the movie A Few Good Men: You can't handle the truth!
    Credit analysis is an art, so quibbling as Larry Summers has done by saying the economy is doing well, kinda misses the point: too many metrics seem to indicate that US creditworthiness iso question. Like it or not , all need to pay attention, get their heads out of the sand, and look to address issues that if not addressed sooner than later will result in far more pain then anyone might envision.
    As to Cochrane re Fitch not saying anything about inflation impact on bondholders, that is not their job; their job is to assess ability to repay nominal debt.

  5. The Fitch scenario is for a mild recession in the 4th Qtr of this year and 1st Qtr of next year. Real GDP slowing to 1.2% for this year and 0.5% next year -- by the way, check out GDP Now model on the Atlanta Fed web site.

    Another Employment Report out tomorrow -- likely to be another good one.

    We did inflation numbers either at the end of last year or the beginning of this year -- I can't find it on your blog. We're at 3% right now, where I thought we would be almost a year ago (Nov 2022) while you guys so no end in sight; and no recession, the "Godot Recession". You guys are very negative on our economy; while it is not performing up to par, it is still somewhat vibrant enough to dispel pessimism and cynicism. In other words, change is possible.

  6. "But I was shocked that in the debt ceiling debate, the Administration did not say, loudly, "We will pay interest and principal on treasury debt before we pay anything else." (I was equally shocked that the Federal Reserve did not say, loudly, "we'll lend freely against treasury debt even if it is in technical default.") "

    I agree with your comments about the Administration however disagree about your take on Federal Reserve. Congress determines the budget, and as a result the spending, period. Even the most remote comment from Fed about getting involved in a case of debt ceiling crisis would only serve to strengthen those in congress who are looking to further their political agenda by political brinkmanship. Such an action would give them the confidence to push ahead even strongly and could possibly constitute a moral hazard at that point. Afterall, if they have a problem with the debt level, they are welcome to either increase taxes, reduce spending or do something about the debt ceiling altogether. And leaving game theory arguments to one side, will of the people of the USA is exercised through the Congress. If the people of USA want their country to go into technical default, who is the FED to stop it?

    So, in my opinion, Fitch is completely right when it comes to citing issues with governance. The debt ceiling crisis has become a political tool in that’s regularly exercised to the detriment of all. We can argue that yes, the state authority of the USA would make the bondholders whole one way or another in the case a technical default, however we must accept the fact this process and the debt ceiling itself by its very nature add risk. Even transferring funds from other arms of the government to pay debt obligations is not a panacea since you would risk the health of the state apparatus, thereby increasing risk beyond financial markets, so poor governance no matter what!
    “The government borrowed and printed $5 Trillion with no plan to pay it back, devaluing the outstanding debt as a result. “

    In an unrelated note, would you provide your opinion on the argument on ratio of debt to GDP ratio? I have seen some papers where the amount of debt was the NPV value of the debt (or market value) rather than the par value. So by increasing the interest rates, net present value of all future debt payments decreased accordingly and then calculating debt to GDP ratio of the United States according to their approach came at about 85%.

  7. 1 Trillion, even close to it in interest only makes the financiers rich, fees fees fees in all these transactions is bigger then many GDP's.

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  10. The Fed should increase the size of its balance sheet, and we should run mild inflation.

    Oh, sure, the federal government should balance its budget. I have been saying that since 1971.

    I am saying what we should do given the real situation now.

  11. Fitchian logic should be expanded to the entire global growth-dependent economy. Money has long masked physical resource depletion and the final oil & gas shock (peak shale fracking) will reveal that financiers can't fool nature indefinitely.

    Growthism fails when energy supplies aren't constantly growing somewhere. "Renewables" like Big Wind are just a sprawling veneer on top of the oil that builds them, so don't expect any of that to prevent economic shrinkage.

  12. You may read this and sense there's some trouble
    When a number like this ups and doubles
    But it's money well spent
    We'll get you 20 percent
    Just like any speculative bubble

    (prompted by today's piece in the Post)


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