Fitch last week was the second rating agency to downgrade the U.S. government’s long-term debt rating from AAA to AA plus – Standard and Poor’s had already done so in 2011 and only Moody’s remains at the highest level. But the U.S. debt to GDP ratio has risen by nearly half since 2011, and the Social Security and Medicare systems have swung from small annual surpluses into massive deficits. Maybe, when looked at rationally and free from political pressure, the U.S. Treasury is barely an investment grade bond issuer, whose long-term debt rating should be BBB minus.
For those not familiar with the jargon in the international debt business, a few words of explanation are in order. The quality of international debt is assessed by several specialist “rating agencies” throughout the world, of which the three major U.S. agencies Standard and Poor’s, founded in 1860, Moody’s, founded in 1909 and Fitch, founded in 1914, are the most important. All three agencies rate long-term debt on a scale, of which AAA is the highest rating, least likely to default, then AA, A and BBB, all of which may be accompanied by + or – signs, and all of which collectively are referred to as “investment grade” to which certain large investment institutions are restricted. Below that level are BB and B ratings for debt that is not yet in default, followed by CCC CC C and D for debt that is in arrears of payment or worse (I have used the Standard and Poor’s symbols; Moody’s and Fitch have minor differences).
In the words of Standard and Poor’s, a sovereign debt rating, “reflects our analysis of institutional and governance effectiveness, economic structure and growth prospects, external finances, and fiscal and monetary flexibility.” The other rating agencies’ criteria are similar; in practice there are usually only minor differences between the three agencies’ ratings and methodology; after a century of experience this has become a pretty well-trodden path.
That does not mean the ratings are accurate. In the 1980s Standard and Poor’s rated Venezuela AAA because of its oil revenues, without making appropriate deductions for the country’s ill-established democracy, strong tendency towards socialism, wild corruption at all levels, excessive and poorly controlled government spending and lack of significant companies outside the oil and finance sectors. Political pressure can also play an unfortunate role; when Standard and Poor’s downgraded the United States in 2011 after one of its incessant “debt ceiling” default crises, the thuggish Obama Department of Justice opened an investigation into it. This is doubtless why Moody’s has not downgraded the United States and Fitch has waited 12 years to do so.
I have some experience in the operations of rating agencies. In 1996-97 as U.S. Treasury advisor to the Republic of Croatia, I played a modest advisory role in that country getting its first credit rating and then making its first issues of euro-dollar and euro-kuna bonds. We regarded it as essential to get an investment grade rating, so approached Fitch before the other rating agencies – Fitch at that time had the reputation of being a slightly more generous rater. The process was greatly helped by the diligence of the Ministry of Finance’s economics staff in producing the necessary mountains of statistics; under Finance Minister Božo Prka (later my boss at Privredna Banka Zagreb) the Ministry was a model of efficiency and tight budgetary control.
My own role was largely limited to reassuring the agencies, especially the dragon-lady from Moody’s, that the Ministry had a U.S. Treasury advisor who was familiar with both international debt markets and rating agencies’ needs, despite his funny English accent. Anyway, I am delighted to say that Croatia got a BBB minus rating from all three rating agencies. (Today, 27 years later, Croatia’s rating has improved only modestly, to BBB+ at Standard and Poor’s and Fitch, with Moody’s still being dragon-lady-ish, giving it a rating of Baa2, equivalent to BBB. The country is now an honored member of both the EU and the eurozone, but alas has amassed a much higher level of debt than in 1996.)
In assessing the true credit risk in U.S. Treasuries, we should follow the Standard and Poor’s methodology for credit risk assessment, while taking Croatia 1996 as a benchmark (since that country ended up being rated BBB minus by all three agencies).
The “institutional and governance effectiveness” of the United States has declined sharply since 2001. The government is funded every year by a “continuing resolution” and no proper control is exerted over public spending. The last commission to examine the budget’s long-term future, the Simpson-Bowles Commission of 2010, had its recommendations completely ignored. The Budget prepared each year by the Office of Management and Budget is waste paper the moment it arrives in Congress, with even the President’s top priorities, such as President Trump’s relatively cheap border wall in 2017-18, having no certainty of being funded by Congress, even when it is of the President’s party. Spending bills are written in secret and emerge as thousand-page monstrosities which as Speaker Nancy Pelosi said: “you have to pass to find out what is in it.”
In Croatia in 1996, there were only five years of history since the country had only been independent from Yugoslavia since 1991. However, Božo Prka was a finance minister more capable than any U.S. Treasury Secretary since Andrew Mellon, and under his firm hand budgetary controls had been instituted that were effective if not fully complete. Nevertheless, as subsequent history has shown, budgetary management became less capable once Prka left office in 1997, and since then the main control mechanism has been Croatia’s wish to enter the eurozone, achieved last January. As a eurozone member, Croatia will be unable to print money to finance its deficits, the principal leakage mechanism in the United States. Advantage: Croatia, by a modest margin.
In terms of economic structure and growth prospects, the United States at first glance appears to have major advantages over Croatia. Its economy is far larger and more diversified and it has a much deeper reserve of natural resources of nearly all kinds. In addition, in 1996 Croatia’s principal export earner, tourism, was in a deep recession from the aftereffects of the 1991-95 Yugoslav war, from which recovery did not occur until after 2000. The U.S. advantage is greatly lessened, however by the combination of reducing revenues from outsourcing and increasing costs from importing low-skilled immigrants, many of them illegal. U.S. productivity growth has been negative for the last couple of years, and was anemic for a decade before that; the economic base to repay the inordinate mountain of U.S. debt is thus much weaker than it looks. Conversely, Croatia’s growth prospects from 1996 were excellent; apart from a fine center-right government under the great President Franjo Tudjman, it had a wage structure far below that of the European Union, to which its entry was already effectively guaranteed. Advantage: U.S., also by a modest margin.
In external finances, Croatia in 1996 had the great advantage of not having inherited most of the former Yugoslavia’s debt; its debt to GDP ratio was thus only 25% (today it is around 70%). The United States, on the other hand, has a debt to GDP ratio of 118% and climbing rapidly. More dangerous, it has a current account deficit of $905 billion in the last 12 months, over 4% of GDP, and it has been running similar current account deficits (in terms of GDP) for the whole of the 21st century. The country has been protected by the “exorbitant privilege” of the dollar being the world’s principal reserve currency, which has allowed its governments to continue running the grotesque budget deficits that have distorted its balance of payments. However, there is every sign that, through a combination of the Biden administration’s penchant for making enemies (Russia) the rise of a powerful adversary in China, and the country’s declining relative economic status, the dollar’s position as the world’s reserve currency may be seriously eroded over the next decade. Possible replacements for the dollar include the euro, the renminbi, and even, as the BRICS group is currently attempting, a revised gold standard. Advantage: Croatia, and it’s not close.
Finally, in terms of fiscal and monetary flexibility, Croatia in 1996 had limited ability to finance a large fiscal deficit, but its deficits were being held in check by the admirable Prka. Monetarily, the kuna was a weak currency, but skillfully managed by the National Bank’s Adolf Matejka, under the firm rule (proposed by U.S. advisors from the I.M.F.) that under no circumstances should the National Bank provide long-term financing to the government.
In the United States, on the other hand, the Congressional Budget Office currently expects the budget deficit for the fiscal year to September 2023 to total $1.7 trillion, about 7% of GDP, at a time when unemployment is near a 50-year low. The Federal Reserve has been financing this budget deficit in monstrous quantities since around 2010, although it has temporarily ceased doing so. Consequently, the U.S. fiscal and monetary position is dire, and there is little prospect of improvement until one is forced upon the country. Advantage: Croatia 1996, by a very long way indeed.
In summary, assigning the United States a credit rating of BBB minus, the same as Croatia in 1996, errs substantially on the generous side. Holders of Treasury bonds and other U.S. creditors should beware!
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)