The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Over the past two decades, US debt held by the public has more than doubled from less than 40% of GDP to roughly 100% (Figure 1). Credit rating agencies have largely given US debt a pass, citing superior growth dynamics, institutional and governance strength, the US dollar’s role as a reserve currency, and the high demand for Treasuries. However, I think the deterioration in these mitigating factors during the pandemic and the massive fiscal response have meaningfully increased the risk of a US debt downgrade.
That said, sovereign credit ratings are generally about cumulative action over time, so the pivotal factor may be the ability of Congress to take concrete steps to rein in the deficit in the coming years. In short, the near-term policy path may tell us a great deal about how bumpy the fiscal road could get. But the “to-do list” is long and political considerations will make it arduous to carry out, especially in the coming years when the effects of an aging population on Social Security and other entitlement programs must be confronted. In the end, I think a sovereign debt downgrade in this decade seems likely.
Testing the fiscal limits?
Since December, Congress has provided an additional $2.8 trillion in aid for cash-strapped households and state and local governments, as well as spending on health and related needs. Cumulatively, 25% of GDP has been spent to help Americans weather the pandemic. While spending during a human crisis is an appropriate policy response, the Biden administration is proposing to invest trillions more in infrastructure development and the fight against climate change and economic inequality. This includes a $2 trillion proposal unveiled at the end of March, with a focus on physical infrastructure, research and development (R&D), and support for in-home caregiving, among other areas. And a second proposal aimed at “human infrastructure” (e.g., areas like childcare and paid leave) is expected in coming weeks.
All of this spending, as well as plans for funding it, will be watched closely by the rating agencies. Fitch already placed the US on a negative outlook watch last July, and while Moody’s affirmed its AAA rating and stable outlook for the US in December, that was before the new government came to power. Standard & Poor’s, meanwhile, affirmed its AA+ rating in March (the rating was lowered from AAA in 2011).
This makes the July 31 deadline for raising the debt ceiling (which is likely to bring some conflict between the parties in Congress, with an eye to the 2022 midterm elections) even more meaningful; the US has used up much of its fiscal space in the last 20 years and persistent fiscal expansion is inconsistent with a AAA rating.
Averting a credit downgrade requires a more balanced approach
When it comes to averting a downgrade in the medium to long term (the coming decade), I think the question for the rating agencies is how effective Congress will be going forward at ensuring that spending is both focused on supporting future economic growth (i.e., productive activities as opposed to permanent transfer payments) and accompanied by tax hikes and other revenue-raising measures.
The good news is that recent pandemic-related spending has included many one-off expenditures, which means the federal budget deficit can be reduced quickly if these provisions are allowed to lapse in a timely fashion, as I would expect in many cases. Additionally, current spending proposals related to physical and broadband infrastructure and climate change mitigation could conceivably boost US growth in the future, making them worthwhile investments. However, the plans need to be targeted and at least partly paid for with higher taxes to ensure that the investments continue to pay off over time. Private-public partnerships, user fees for infrastructure projects, and a focus on long-term, innovative R&D, among other ideas, may help achieve the right balance.
Further out, it is important to bear in mind the fact that the deficit was already high prior to the COVID crisis, at 5% of GDP, and poised to rise meaningfully in coming years due to health care costs and the aging of the US population. With health care spending already three times the average of other developed countries, the US faces the additional challenge of a 30% increase in Medicare and Medicaid beneficiaries in the coming decade. In addition, the Old Age and Survivors Insurance Trust Fund (i.e., Social Security) is expected to be depleted by 2031 without additional funding.
Estimates from the Congressional Budget Office (CBO) indicate that the mismatch between federal government spending and revenue will become more extreme in the back half of this decade. The US revenue base lags other developed countries by 6% on average. One example of the factors contributing to this gap: Tax breaks in the US totaled $1.5 trillion in 2019, while total tax revenues (individual and corporate) amounted to $1.9 trillion.1
Interest costs are contributing to the budget challenge, of course. Given the size of the US debt, they are projected to be the fastest growing component of the federal budget, creating a vulnerability to higher interest rates. Today, the average interest rate paid on federal debt is 1.7%, making it important to monitor where bond yields go from here. In its latest projection, the CBO expected Treasury yields to stay below 2% through 2025. If bond yields were to instead surge to 3%, interest costs could double as a share of GDP by 2030.
A path to fiscal consolidation
These challenges highlight the need for fiscal consolidation sooner rather than later. What are the options? Along with large spending plans, President Biden has put higher taxes on the table, including corporate taxes; and it seems likely that higher estate and top income taxes will be pursued as well. The details won’t be finalized until later in 2021, but when all is said and done, I expect some increase in taxes from current historically low levels (Figure 2).
History shows that somewhat higher inflation over a prolonged period or much higher inflation over a short period can also alleviate the strain of high debt. For example, around the time of World War II, the Fed pinned short and long interest rates at low levels and the US twice experienced bouts of very high inflation that brought the debt ratio much lower.
As things stand today, the Fed’s quantitative easing programs have sopped up about a quarter of the debt available to the public, helping to keep rates low. As the economy improves, the Fed will eventually taper its purchases, meaning that Congress cannot rely on the Fed for a low cost of debt forever. But prudent policies can ensure that the fiscal and monetary alignment during the pandemic ultimately drives higher nominal growth, the best antidote to a high debt stock since it makes the debt more sustainable over time.
The specific design of fiscal policy by the current administration will determine the economic outcome. Ideas related to workforce development, education, R&D spending, immigration reform, infrastructure, and innovation will help productivity. Policies that add regulation and cost and increase transfers could push inflation higher.
The eyes of the world — including the rating agencies — will be firmly fixed on these critical decisions. More broadly, the US fiscal situation is likely to be significant over the coming decade given the aging of the baby boom generation and associated liabilities in Social Security, Medicare, and Medicaid. The near-term policy direction will give us an indication of how the US will handle its obligations in the years ahead.