Sometimes the gods of finance deliver choreography that might make future historians chuckle. This week in America provided one such moment.
On Tuesday, the special counsel Jack Smith announced a blistering new indictment against former US president Donald Trump for allegedly launching “an unprecedented assault on the seat of American democracy”.
And on the very same day, the credit rating agency Fitch stripped America of its hallowed AAA tag, echoing a similar 2011 move by Standard & Poor’s. This means two out of the three big rating agencies have now downgraded treasuries — never mind that these supposedly define the “risk-free” benchmark for global finance.
At first glance, these two announcements might not seem linked — and they were certainly not co-ordinated. But the coincidence is symbolic. For what they collectively signal is that America’s political economy is heading into uncharted waters, with an alarmingly wide range of potential outcomes. Investors should take note, regardless of their views on the wisdom behind the move by Smith — or indeed Fitch.
To understand why, it pays to peruse the details of Fitch’s announcement. In decades past, rating agencies have assessed the creditworthiness of America primarily by analysing its economic and financial fundamentals. For as any student of finance knows, one difference between emerging markets and developed countries is that the former have traditionally been deemed more prone to political risk, and developed countries less so.
In Tuesday’s announcement, Fitch analysts did duly cite some statistics. “We expect the general government deficit to rise to 6.3 per cent of GDP in 2023, from 3.7 per cent in 2022, reflecting cyclically weaker federal revenues, new spending initiatives and a higher interest burden,” they noted, predicting “a further widening to 6.9 per cent of GDP in 2025”.
Meanwhile “the interest-to-revenue ratio is expected to reach 10 per cent by 2025 (compared to 2.8 per cent for the ‘AA’ median and 1 per cent for the ‘AAA’ median”) and the “debt-to-GDP ratio is projected to [reach] 118.4 per cent by 2025 . . . two-and-a-half times higher than the ‘AAA’ median of 39.3 per cent of GDP.” In plain English: America’s debt data is far worse than any other top-rated country, and likely to deteriorate.
Of course, as many economists angrily retorted, America is not exactly a “normal” country. Since it enjoys the (in)famous “exorbitant privilege” of printing dollars, it can always repay its debts — if it chooses.
Moreover, Fitch itself noted that some of those debt statistics have actually improved recently: debt-to-GDP, say, is slated to be “only” 112 per cent in 2023, down from 122.3 per cent in 2020. No wonder that Janet Yellen, Treasury secretary, dismissed the downgrade as “arbitrary and based on outdated data”.
But what many critics failed to realise is that this downgrade has less to do with economics than with politics — or “governance”, to use the polite euphemism the rating agency repeatedly cites. For even if Washington can theoretically pay its bills and cut its debt, that does not mean it actually will; or not with 100 per cent probability. There is a new ripple of policy risk.
One sign of this is that bitter Congressional battles keep exploding over the debt ceiling. And while the last such stand-off was resolved in June, the shouting — and threats about a government shutdown — may return this autumn when negotiations restart over the 2024 budget.
The broader issue, however, is that the political ecosystem is so polarised that it is hard to imagine Congress taking the sensible steps needed to tackle America’s fiscal problems. These include hammering out a bipartisan bill to overhaul social security, reviewing spending and reforming the tax system. There have not been any serious initiatives along these lines since the 2010 Simpson-Bowles commission — and that failed.
That is why this week’s accidental choreography matters. If Smith’s legal onslaught knocks Trump out of the 2024 election race in a way that enables centrist political forces to prevail, it is possible to imagine a future scenario where sensible bipartisan fiscal policies might emerge in Congress to tackle that debt.
But right now Trump is leading the Republican field, by some way, and the indictments are energising his base. At best, this will ensure that the 2024 race is bitterly polarised, making bipartisan initiatives impossible. At worst, if Trump wins back the presidency (which cannot be discounted), this will unleash profound policy uncertainty.
This is a populist, after all, who has vowed to take revenge on his enemies by gutting the civil service. The last time he was in office he threatened the independence of the Federal Reserve, delivered big unfunded tax cuts and failed to trim spending. More recently, he has pledged to block reforms of social security or Medicare, and pledged to extend expiring tax cuts.
So while it might seem fair to question some of the economic logic — as well as the timing — of Fitch’s move, the rating agency’s fears about rising policy risk looks spot on. What the loss of that AAA tag really reveals is that America is being judged less like a developed country, and more as an emerging market. Uncle Sam should weep.