Debt Downgrade A Too Subtle Warning Of What Is To Come

Courier Herald column for the week of August 6th:

The research firm Fitch Ratings downgraded the quality of the United States debt last week.  They’re arguably the lesser known of the three main agencies that assign letter grades to denote the likelihood a bond issuer will repay their debt. 

A grade of AAA implies unimpeachable credit.  Fitch has now joined Standard and Poor’s, who determined the United States did not deserve a AAA rating back in 2011.  Rating Service Moody’s maintains the highest rating for US Treasuries. 

What does this mean, in practical terms?  Not much, other than a warning that will likely go unheeded.  It’s akin to one of us having a credit score go from 780 to 740.  There are a few who will have iron clad rules that they can’t hold American bonds because they’re not rated AAA, but the rating is still higher than most bonds issued and is several ranks ahead of the level where the debts would fall into “junk bond” status.  Loans, in the form of entities buying US bonds, will still be made.

Naturally, the reaction in Washington was a commitment to sound governance with politicians racing to implement plans to restore fiscal responsibility to our nation’s taxing and spending policies.  Just kidding.  Leaders of both parties blamed the opposition, which seems to be all they know how to do once in D.C. these days.

It’s that lack of seriousness and dysfunction that led to the downgrade. Washington’s inability to agree on even the most basic functions assigned to them add an extra level of threat layered on top of current unsustainable spending. 

Our leaders continue to act like the future will save us from our present selves.  Our future is filled with rapidly escalating entitlement spending on programs like Social Security and Medicare coupled with interest payments rising due to both perpetual deficit spending and increasing interest rates. 

The U.S. isn’t yet at a point where it cannot borrow money, but the downgrade gives us a moment to consider what happens when that day comes.  Bankers consider “capacity” when making their loans, meaning the customer’s ability to actually repay the debt.  Just because a borrower has a good credit history on prior loans doesn’t necessarily mean they’ll be able to pay back the new one.

One thing bankers are trained to evaluate when reviewing loan applications is debt pyramiding.  This is when a customer uses new debt to pay for old debt.  A good and credit worthy customer can go years making all of their payments on time, all the time living a lifestyle above their means by going deeper and deeper into debt.

These customers are often shocked when they go to the bank for yet another loan, only to find out that the music has stopped and there is no more credit available to them.  The pyramid then rapidly comes crashing down as the customer can no longer afford to either pay their outstanding loans nor keep up with their excessive spending habits.

Americans are well aware that our dollar is the world’s reserve currency.  We’ve allowed ourselves the luxury of deficit spending because we know – at least for now – that there is no other country that can step in and take our place in the structure of the global financial system.  The house of cards we’re building has implications well beyond our borders.

The problem we have, is us.  We have two major parties who represent our wishes.  One believes there is no problem that more federal government spending won’t cure.  When new programs are tried and failed, the answer is always we didn’t spend enough.

We have another party who wants government at all levels to get government small enough “to put it in a bathtub and drown it.”  They believe there is no tax at any level that shouldn’t be cut.

Compromise in Washington now means both parties get to deliver to their constituents what they want.  Each will slap the other on the back and call themselves statesmen when they pass a bill increasing spending while cutting taxes.  The widening deficits will be someone else’s problem later.

What is actually compromised in this case is quite literally the future.  We’re fast approaching the point where the fixed portion of the federal budget – entitlement programs and interest on our debts – will be greater than tax revenues coming in.  That would leave no room for defense spending, roads and bridges, or the many other agencies within the federal realm without borrowing all of the money for them.

These compromises will work until they don’t.  Fitch has reminded us that there is a day that is coming if we don’t address the pyramid we’re building.  We’re unfortunately going to need a signal that is less subtle before there is any corrective action from Washington.