On Tuesday, August 1, the rating agency Fitch decided to downgrade the rating of the United States, which moves from the highest level of ‘AAA’ to ‘AA+’. This action may have shocked some, but it was seen as inevitable. Especially after Fitch put the US in a negative outlook a few months ago and more than a decade after S&P Global Ratings cut the rating in 2011. Much has been written about this for a long time, and the literature on the subject has increased in recent days. However, I take advantage of this space to make a longer reflection, continuing the article I wrote on June 8, 2023 “Big question in the EU fiscal panorama”, where, among other things, I refer to the risk of your credit profile.
In economic theory, there is a concept called “Ricardian Equivalence,” suggesting that any change in government spending supported by debt issuance will have no long-run effect on aggregate demand. Under an inter-temporal framework, it is argued that at some point in the future, a higher tax must be paid to pay it, and, therefore, there will be a lower recalibration of household consumption (to anticipate such an increase). In this sense, higher government spending is offset by lower private sector spending and higher debt levels do not affect real interest rates, investment volume, etc. This contribution of the famous economist of the 19th century, David Ricardo, and extended to neoclassical economic theory (Robert Barro, among others) has sparked interesting debates over the years. It should be noted that this is not without criticism, mainly because it requires very strict assumptions. But because of what happened in the United States and other countries with a high level of leverage, it becomes important to analyze what may happen in the future and its potential impact (or not) on growth, the economic cycle, and the welfare of the population.
Beyond the reaction of the markets, the recomposition of portfolios, the uncertainty about which measure to use as the risk-free rate in financial models, and many other factors are the subject of extensive discussion in these rating actions. The agencies are warning signs of the urgent need for the United States (and other countries) to exercise greater control over their public finances. And even about the obligation to carry out a far-reaching tax reform.
The financial crisis in the United States has been increasing for decades. The United States has a debt-to-GDP ratio of 127.7%, one of the highest not only among countries with similar credit profiles, economic development, and institutions, but almost worldwide. This strong leverage has been around for a long time but has been exacerbated by strong fiscal stimuli during the COVID-19 pandemic. In fact, in recent years, we have become accustomed to seeing strong struggles between political leaders in North America to increase the debt limit, which is more worrying (such as in 2023, which is one of the reasons behind Fitch’s decision, and in 2011, from S&P Global). The Congressional Budget Office estimates that the debt will be 118.2% by 2033, a very high level.
Despite the debate about what specific steps should be taken to fix this situation, there is a general consensus on the economic problem it represents. Unfortunately, there is little political will in the US to correct this because of the costs it could mean for leaders and parties acting on the matter. Moreover, it will be more difficult considering the current political climate, where all eyes are on the presidential election in November 2024.
Another factor that adds to the complexity is the perception that the United States, by having the exclusive right to the supply of dollars, is able to maintain these levels of debt because it is the most widely used reserve currency in the world. For example, the famous modern Theory of Money” (MMT in English), whose greatest exponents are the economists Warren Mosler and Stephanie Kelton, argue that countries that have control over monetary reserves, such as the US, do not have high confidence in the collection of money to tax or issue debt because they can spend based on more money printing. Consequently, there should not be much concern about increasing leverage levels.
These are just some of the theories or views that make it difficult for the United States to have a more responsible strategy to manage its public finances. Therefore, I found it interesting to contribute to this reflection after the action taken by Fitch Ratings in recent days. The United States and other powerful countries may be forced, sooner or later, to undertake major fiscal reforms for the sake of global economic and financial stability. In addition, it will limit the public policy response to address the risks of recession in many regions.