Trust is always harder to build than it is to destroy, and that is true in financial markets as well. The US has borrowed tens of trillions of dollars and promised to pay it back, but investors are becoming more and more skeptical. On August 1, the US Treasury bonds were downgraded. That means the Treasury is less likely to be able to service its U.S. debt in a timely manner. It will be at the taxpayer’s expense.
The company that led the downgrade of US Treasurys was Fitch, a nationally recognized statistical rating agency (NRSRO). This is not the first time the NRSRO has downgraded US government bonds. Standard & Poor’s did this in 2011, and Egan Jones followed suit in 2012. All three of these downgrades were preceded by high levels of government spending and record levels of government debt.
Fitch’s downgrade is not a big move from an overall rating standpoint, but it has important implications. The drop from AAA to AA+ is still firmly in investment grade territory, meaning short-term defaults are still very unlikely, but shouldn’t be ignored.
Debt downgraded as borrowers wave red flags. The United States has over $32 trillion in debt and continues to add trillions of dollars each year. Annual interest payments on all this debt alone cost about $1 trillion, more than the entire defense budget, and spending continues to grow. It will lead to bankruptcy and eventual default.
Unlike commercial paper (debt issued by a company), there are multiple ways a government can default on its debt. Corporations and governments may simply fail to pay their debts in a timely manner and experience explicit default, but governments may also inflate their debt by devaluing their currencies. That’s exactly what we’ve seen under President Joe Biden.
Since Biden became president, the dollar has fallen 16% of its value, or about 6% a year. If you lend money at, say, a 2% interest rate when the Biden administration takes office, you will actually lose 4% a year after inflation, or 12% of your investment.
Investors knew this long before Fitch announced the downgrade of US Treasuries. Congress and the White House have been spending trillions of dollars over the past three years, and the Federal Reserve is gleeful at printing the money it needs to pay for these overwhelmed budgets.
So yields on U.S. Treasuries, or interest rates, which mean how much compensation investors demand for lending money, have been steadily rising this year. My own empirical research suggests that NRSRO ratings tend to be lagging indicators of sovereign bond yields because investors already know which governments are fiscally sound and which are heading for fiscal oblivion. It turns out there is.
From an impact perspective, higher yields on U.S. Treasury bonds means higher borrowing costs for the Treasury and, consequently, higher interest expense. As with any Treasury expenditure, this cost is passed on to taxpayers. Treasury funding costs have already exploded, quickly eating up nearly everything else in the budget.
In June, the latest month for which we have data, the Treasury Department showed that the U.S. Treasury spent $120 billion on debt interest, spending $650 billion this year to date. . Debt interest now exceeds all items in the Finance Office’s monthly reports, except for the Social Security Administration and the Department of Health and Human Services.
And the problem is getting worse as the government continues to run huge deficits. In the first nine months of the fiscal year, the federal government has already racked up more deficits than the entire previous fiscal year, but there are still four quarters to go.
Congress and the White House need to get their finances in order immediately. If we don’t, we’ll be back on the inflationary roller coaster and more hidden Treasury defaults.
That would mean a veritable death spiral of higher yields, higher interest payments, and even more rapid debt growth. Time is running out before we reach the point of no return.
EJ Antoni is a financial economist at The Heritage Foundation and a Senior Fellow on the Commission on Unleashing Prosperity.
