Why Fitch's Credit Downgrade Is A Serious Debt Warning

Fitch Ratings is sending a warning to the United States federal government that its current spending and borrowing habits cannot continue without serious consequences for the national and international economy.

On Tuesday, the London based credit rating, commentary and research firm announced it downgraded the U.S.'s long-term foreign-currency issuer default rating to AA+ from top-tier AAA. On Wednesday, U.S. Secretary of the Treasury Janet Yellen called the move "entirely unwarranted."

In a statement provided to International Business Times by Fitch spokeswoman Elizabeth Fogerty, the company said multiple factors came into the decision, including "political polarization, rising fiscal deficits and growing debt burden."

"There has been a deterioration in governance over the last 20 years, with increased political polarization that has led to repeated brinksmanship over the debt limit," the statement said. "This has lowered our confidence that fiscal and debt matters will be adequately addressed over the medium term, including the significant challenges stemming from Social Security and Medicare."

The downgrade sent shudders through Wall Street, bringing down all three major stock indices — the S&P 500, the Dow Jones Industrial Average and the Nasdaq composite — by about 1% to 2% in Wednesday's trading.

The Fitch move echoes a 2011 downgrade by S&P Global Ratings. In its latest report on the subject, published on March 16, S&P reaffirmed its second-tier AA+/A-1+ sovereign credit rating of the U.S.

In that report, provided to IBT by S&P Global, the agency's analysts said the outlook for the U.S. is stable thanks to its checks and balances, resilient institutions and the U.S. dollar's unique position as the global reserve currency.

S&P cautioned it could lower the rating again in the next two or three years "if unexpected negative political developments weigh on the strength of American institutions and the effectiveness of long-term policymaking or jeopardize the dollar's status as the world's leading reserve currency."

Conversely, it could raise it if "effective and proactive public policymaking results in improved fiscal performance that substantially reverses the recent deterioration in public finances by lowering the sovereign's debt burden."

In its latest note on the topic published on July 13, Moody's Investor Service Inc. reaffirmed its sovereign credit rating of AAA. In that note, provided to IBT by Moody's, the agency's analysts said it could downgrade the credit rating as well if it "were to conclude that policymakers were unlikely to respond effectively in the coming years to the country's growing fiscal challenges."

"On the basis of current policy settings, we estimate that the federal government's debt burden will gradually rise to around 120% of (gross domestic product) over the next decade," the Moody's note said. "However, debt affordability will deteriorate at a much faster rate, driven by materially higher interest payments relative to revenue and GDP.

"The absence of effective policy action over the coming years to mitigate these fiscal pressures would signal further erosion of both fiscal and institutional strength."

A number of economic analysts interviewed by IBT on Wednesday said the downgrade should not substantially impact the country's ability to borrow money or the U.S. dollars' status as a leading reserve currency. Even with a downgrade, U.S. debt continues to be attractive to investors at home and around the world and a default is highly unlikely.

What Fitch is trying to say, Jonathan Welburn, a senior RAND researcher at the RAND Corp. said in an interview, is that Congress should stop negotiating with the debt ceiling. Repeated political standoffs decrease confidence the U.S. will be able to pay its debts.

Romina Boccia, director of budget and entitlement policy at the Cato Institute, said Fitch's announcement is timed — just days after Congress went on is August recess — exactly to send a message that the debt limit deal reached in June is inadequate for fully addressing growing debt issues in the U.S.

Boccia said the deal to raise the country's debt ceiling doesn't solve major spending and revenue issues but rather pushes the debt ceiling negotiations off until January 2025 — after the next presidential election. National debt will continue to accumulate, especially as Medicare and Social Security costs rise with an aging U.S. population.

Justin Wolfers, a professor of public policy and economics at the University of Michigan's Gerald R. Ford School of Public Policy, said Fitch is simply believing what politicians are saying. During the latest round of debt fights in Washington, Republican legislators said they were comfortable defaulting on the debt.

When one party begins to act recklessly with the debt and indicates it may not pay it, Wolfers said, then the creditors will lose confidence. Ultimately, a lower credit rating means the cost of borrowing will likely increase for the U.S. government.

The major current issue with national debt, Richard Stern, director of the Grover M. Hermann Center for the Federal Budget at The Heritage Foundation, said is the interest servicing. The U.S. Department of the Treasury pegged the national debt at $32.5 trillion on Tuesday. U.S. Bureau of Economic Analysis, as of July 27, reported the U.S.' GDP as $26.8 trillion.

Right now, Stern said, 40% of all federal revenues are going to paying back interest on the national debt. The amount of interest paid on federal debt increased by more than 50% in the last three years.

As national debt increases along with the interest on that debt, the U.S. government will need to find ways to cover the costs. That means printing more money, reducing the value of the U.S. dollar, or collecting more taxes, Stern said. National debt is not a new problem and Washington continues to get worse at dealing with budgets as partisanship increases.

Keith Hall, a former director of the Congressional Budget Office and commissioner of the U.S. Department of Labor's Bureau of Labor Statistics, said both the CBO and the Government Accountability Office have warned lawmakers for years about the seriousness of the debt issue. The Fitch downgrade is not a full blown economic crisis, Hall told IBT, but it is symptomatic of a growing loss in confidence in the U.S.' ability to pay its debts.

Since 2007, Hall, now a distinguished visiting fellow at the Mercatus Center at George Mason University, said the U.S. national debt has increased from $5 trillion to its current level. In the next 10 years, the country is likely to add another $20 trillion on top of the current amount.

Hall said the U.S. is currently outspending its revenues by 30% with no signs of changes. On top of that, the U.S. Treasury is not currently paying off debts but rather refinancing them. The government doesn't have a clear plan to pay down its debts, he said.

All of this, Hall told IBT, creates a drag on the U.S. economy. Eventually, this will start to weigh on the economic growth of the country and affect the living standards of the U.S. population.

The experts agreed the U.S. can reverse this scenario by getting serious about the debt. Hall said the latest debt ceiling deal represents good progress on the issue. But politicians have a hard time addressing the general national debt issue unless there is some sort of crisis at hand.

Lawmakers in Washington, Hall said, need to follow through on their progress and find ways to limit borrowing. Boccia said a non-partisan body strictly designed to address the debt issue would be a good way to give the debt the serious attention it deserves.

"(Fitch's) judgement is effectively that our politicians are not taking their responsibilities seriously," Wolfers told IBT. "So what has to change is our politicians have to start taking things seriously."