Well, we cannot say that we were not warned. As the country hurtled toward the debt ceiling in late May, Fitch, the ratings agency, placed the U.S. government debt (then rated AAA) on rating watch negative, but gave hints that its concerns extended beyond whether the country would crash into its upper limit at that particular moment.
A crisis over the debt ceiling was avoided by a modest deal, but over at his blog, economist John Cochrane notes one particularly troubling feature (especially for investors in treasuries) about that period:
I was shocked that in the debt ceiling debate, the Administration did not say, loudly, “We will pay interest and principal on treasury debt before we pay anything else.” (I was equally shocked that the Federal Reserve did not say, loudly, “we’ll lend freely against treasury debt even if it is in technical default.”)
Bond investors want reassurance that in a crisis, the US government will choose to prioritize debt repayment over everything else.
The pricing of debt is not a precise science, to put it mildly. Nevertheless, that omission by the administration will be remembered by some, and it will feature somewhere in the price that investors will demand for lending to Uncle Sam, especially if we see another debt ceiling crisis, which we will.
Meanwhile on Tuesday, even though the debt ceiling crisis had passed, Fitch cut the country’s rating to AA+. That’s how S&P has rated U.S. debt since downgrading it more than a decade ago. At the time the US debt/GDP ratio was around 65 percent, as against nearly 100 percent now.
Fitch put much of the blame for the downgrade on America’s political dysfunction.
The rating agency on Tuesday said its downgrade reflected “expected fiscal deterioration over the next three years” and “a high and growing general government debt burden”. Fitch also noted an “erosion of governance” over the past two decades “that has manifested in repeated debt limit stand-offs and last-minute resolutions”.
Fitch also cited a growing US debt burden as a concern. The agency expects the general government deficit to rise to 6.3 per cent of gross domestic product in 2023, up from 3.7 per cent in 2022, “reflecting cyclically weaker federal revenues, new spending initiatives and a higher interest burden”.
Growth in the US will be hampered, Fitch said, by a recession it projected for the fourth quarter of 2023 and first quarter of 2024.
While the downgrade contributed to some turbulence in the markets, investor concern over a profound problem that has come even more clearly into view, but which is still some way from a crisis, is likely to be swept aside by other more immediate preoccupations before too long.
There appears to be little danger that investors will be forced to dump Treasuries because a second ratings agency has now taken them below AAA. (Moody’s still rates them AAA). Writing in the Financial Times, Robin Wrigglesworth quotes Goldman Sachs’ Alec Phillips:
We do not believe there are any meaningful holders of Treasury securities who will be forced to sell due to a downgrade. S&P downgraded the sovereign rating in 2011 and while it had a meaningfully negative impact on sentiment, there was no apparent forced selling at that time. Because Treasury securities are such an important asset class, most investment mandates and regulatory regimes refer to them specifically, rather than AAA-rated government debt.
Although, as Wrigglesworth notes:
It should be noted that some investment mandates stipulate minimum ratings based on two out of three of the big credit rating agencies.
The dollar (and, by extension, treasuries) benefit from being seen as the ultimate safe haven. The $25 trillion treasuries market is, in Wrigglesworth’s words, the “bomb shelter of the capital markets” and that’s not likely to change. It’s a reflection of the size and strength of the American economy, and, the indispensable other half of the equation, its military power. As much as the end-of-history and rules-based international order crowds might like to claim otherwise, safe havens need armed guards at the door.
As a result of the above, the dollar is the world’s preeminent reserve currency. Among other advantages, this means that the U.S. can finance itself in its own currency, one manifestation of what an irritated Valery Giscard d’Estaing, then France’s finance minister, described in the 1960s as the exorbitant privilege that came from the dollar’s dominance. French jealousy was ultimately one of the foundation stones of the euro, which was always envisaged as a rival reserve currency to the dollar, but that’s another story.
If America can finance itself with, effectively, its own currency, can it always avoid default? Not necessarily, but that’s not the only issue.
Stephen Miran writing in Capital Matters explains:
While the odds of default are low because the Federal Reserve can always buy bonds with the dollars it prints, the risk of real losses is very high because, as the share of tax revenue required for interest payments increases, the odds of government tolerating much higher inflation increases. And that would mean losses in real terms for bondholders. Indeed, if we reach a state of affairs where Treasury requires printed dollars from the Fed to roll over debt, we are probably facing hyperinflation and severe losses in real terms; the risk of that can be high even if default risk is low. In this sense, the downgrade is legitimate. A triple-A sovereign credit should not have debt ratios in excess of 100 percent of GDP, even if it is the world’s reserve currency.
It’s worth adding that higher inflation, or even the persistence of inflation at relatively modest levels, may well lead potential investors to demand a higher rate of return on the debt they buy in order to compensate for the risk to their real return.
John Cochrane elaborates:
Inflation is the economic equivalent of a partial default. The debt was sold under a 2% inflation target, and people expected that or less inflation. The government borrowed and printed $5 Trillion with no plan to pay it back, devaluing the outstanding debt as a result. Cumulative inflation so far means debt is repaid in dollars that are worth 10% less than if inflation had been* 2%. That’s economically the same as a 10% haircut.
Yes, this is not a formal default. And a formal default would have far reaching financial consequences that inflation does not have. Still, for a bondholder it’s the same thing. It’s as if they said, “well, we promised to repay you dollars, but we didn’t say which ones, so you’re getting Canadian dollars.” Yes, the promise not to inflate is implicit, not explicit. Still, it is the reputation and commitment not to inflate, not to dilute the debt as they did, which supported the very low interest rates at which the US could borrow. Countries that routinely inflate like Argentina have to pay higher interest rates ahead of time.
Yes, that’s in the past, and ratings agencies are supposed to evaluate future risks. But if you only repaid 90% of your mortgage, you can be sure the bank would see you as a worse credit risk going forward. The probability that the US inflates again, that in the next crisis they do the same thing, is unquestionably larger. The world’s appetite for boundless amounts of US debt is unquestionably smaller.
Meanwhile, treasury yields have climbed since the downgrade.
The Financial Times (Thursday, August 3):
The 10-year Treasury yield climbed 0.11 percentage points to 4.19 per cent, extending a rise that began on Wednesday after the US government lifted its issuance target for the coming quarter and strong private payrolls data. Also in the mix, though not necessarily front of investors’ minds, was Fitch’s unexpected downgrade on Tuesday of Washington’s credit rating.
However much of this move was a product of economic news, not the downgrade.
The Financial Times:
Yields were also propped up on Wednesday by stronger-than-expected private payrolls data. That fed into the thesis that the US economy might be able to achieve a “soft landing”, which would erode the chances of interest rates and borrowing costs declining sharply any time soon. That could be a negative for risky assets such as stocks.
A technical issue also contributed to the rise in yields of longer-dated bonds:
The Treasury said it would boost its issuance of long-term debt this quarter, in order to fill the growing gap between tax revenue and government spending. Yields on 10- and 30-year Treasury bonds have jumped since then.
For the most part “technical issues” are, after they work their way through the system, quickly shrugged off, but I couldn’t help noticing the reference to the growing gap between tax revenues and government spending. That’s not meant to happen when an economy is (relatively) healthy.
For a some views on the trajectory we are on, it’s well worth reading the Manhattan Institute’s Brian Riedl (his articles for Capital Matters can be found here), or check out Noah Rothman’s article here or, NRO’s editorial here. If you have not swallowed hemlock by now, keep in mind this from the last of those three:
The other part of what makes the CBO projections so alarming is that they forecast a long-term decline in potential U.S. GDP growth. Slower growth makes all these problems harder, by reducing the amount that the government can sustainably spend without spurring negative consequences such as inflation, and by seeding discontent among voters who might then demand more spending.
I’ll return to the topic of growth later.
For a perspective from across the pond, The Daily Telegraph’s Szu Ping Chan:
Deficits are then projected to average 7.3pc of GDP every year for the next 30 years, more than double the average over the past half-century.
Its report says: “In the past 100 years, deficits have been that large only during World War II and the pandemic.
“The growth in deficits over the next three decades occurs as increases in spending – especially spending on interest, the major health care programmes, and Social Security – outpace increases in revenues.”
As the CBO highlights, persistently higher borrowing implies “substantial” increases in debt. The country’s public debt pile is set to hit a record high of 107pc of GDP in 2029, climbing to 181pc of GDP by the end of 2053.
Fitch’s own projections show debt climbing to 118pc of GDP by 2025. It says the average AAA-rated economy has a debt ratio of 39pc.
America also spends much more to service its debts for every £1 it collects in tax revenues compared with countries with a gold-plated credit rating. In other words, the US stopped behaving like a AAA economy a while ago…
And the dangerously illusory holiday from reality provided by ultra-low interest rates in the last decade is over, not, I suspect, to return, meaning that the burden of the country’s accumulating debt will weigh much more heavily than was once, however unrealistically, hoped.
Andrew Duehren, writing in the Wall Street Journal:
Net interest costs are expected to reach an amount equivalent to 3.7% of U.S. gross domestic product in fiscal year 2033, according to the Congressional Budget Office. If investors drift away from Treasurys over the long term because of Fitch’s lower rating, borrowing costs could rise further.
Cochrane:
[The prospect of higher interest rates in the future are] really a risk factor, not a projection. If people listen to Fitch, and start demanding higher interest rates, then debt service costs rise, and the fiscal problem gets worse, and people demand even higher interest rates.
Naturally, administration officials and their proxies dismissed the downgrade as meaningless. That’s only to be expected, and in a way it’s their job to say things like that. To believe it, however, is something else, and while those responsible for our debt problem are not to be found on just one side of the aisle, it’s not reassuring to see just how relaxed this administration has seemed when it comes to spending, something manifested in plans that have gone through and, for that matter, those that have not.
Then there’s the question of the new open-ended commitments created by recent legislation.
The WSJ:
The EV subsidies in the hilariously named Inflation Reduction Act were scored at a cost of $14 billion, but Goldman Sachs estimates they will cost $393 billion because the subsidies are open-ended. Goldman estimates the climate spending will total $1.2 trillion—three times more than CBO’s estimate.
That ought to bring back to mind the paragraph from the NRO editorial on the downgrade and growth. There are two ways (and it’s not an either/or) in which the U.S. can get off the path to fiscal catastrophe. The first will be focused on reducing spending, something that, when it comes to entitlements — as it would have to — is anything but straightforward. The second is by stepping up the country’s growth rate. The latter won’t be easy either, particularly in a political climate in which the central planners and class warriors of the left have been joined by “common good” conservatives and class warriors of the right in a war against free enterprise.
This will be especially so if the U.S. persists with a climate strategy resting on policies that destroy capital, foster an overmighty state, and have embedded within them a deep aversion to free markets and, in many cases, the growth that only they make possible. Something similar can be said about a connected phenomenon, the growth of ESG, an investment “discipline” that rests on partly rating companies by how well they score against various environmental, social and (more defensibly) governance measures.
Click here to find (from June 29, 2023):
Sustainable Fitch launches its new Transition Assessment analytical product today.
Sustainable Fitch has developed a methodology aimed at positioning, differentiating and benchmarking companies, specifically in the energy sector, as they progressively transition from carbon intensive to net zero. This builds on the inaugural work of the Sustainable Markets Initiative’s Energy Transition Task Force and its Framework for transitioning companies report, which was launched at COP27.
Sustainable Fitch’s Transition Assessment provides a method to better understand companies on their paths – and recognise ‘‘transition’’ as a key enabler to achieving the aims of the Paris Agreement.
Fitch is not the only ratings agency to be peddling this kind of nonsense, something that will not come as any surprise to anyone aware of the role played by the ratings agencies (with the help of a perverse regulatory structure) in creating the global financial crisis, a disaster which still does much to explain, even in 2023, the mess we are now in, a mess that is likely to get worse.
The Capital Record
We released the latest of our series of podcasts, the Capital Record. Follow the link to see how to subscribe (it’s free!). The Capital Record, which appears weekly, is designed to make use of another medium to deliver Capital Matters’ defense of free markets. Financier and National Review Institute trustee, David L. Bahnsen hosts discussions on economics and finance in this National Review Capital Matters podcast, sponsored by the National Review Institute. Episodes feature interviews with the nation’s top business leaders, entrepreneurs, investment professionals, and financial commentators.
In the 130th episode, David was joined by the new distinguished fellow at the Acton Institute, Dr. Anthony Bradley, for a thorough conversation on family values, sustainable employment, the policy errors that have created the current challenges for family formation (it is different than you think), and so much more.
No Free Lunch
Earlier this year, David Bahnsen launched a new six-part digital video series, No Free Lunch, here online at National Review. In it, we bring the debate over free markets back to “first things” — emphatically arguing that only by beginning our study of economics with the human person can we obtain a properly ordered vision for a market economy.
The series began with a discussion with Fr. Robert Sirico of the Acton Institute. Later guests include Larry Kudlow, Dennis Prager, Dr. Hunter Baker, Ryan Anderson, Pastor Doug Wilson, and Senator Ted Cruz.
Yes, the six-part series now has seven parts.
Enjoy.
The Capital Matters week that was . . .
Electric Vehicles
Were it not for the U.S. government and other political entities demanding a rush job, there’d be no need to gripe about EVs. Normally, EVs would be the province of your uncle, the one who wears octagonal glasses, listens to vinyl through his Magnepan speakers, and adopts all tech early and often — most of which is doomed to be neatly organized and forgotten in his basement after a few weeks. Guys like your uncle help iron out the deficiencies.
So, electric vehicles are undercooked, and that’s to be expected. It’s a young technology — not in the underlying tech per se, but rather in scale and inferiority relative to what it’s replacing, the noble internal combustion engine (ICE). The problem here is one of forced timelines that cannot accommodate the feedback necessary for net improvement…
Economics
A Marxist has taken aim at McDonald’s. Writing for UnHerd, self-proclaimed Marxist Ralph Leonard identifies the fast-food chain as representative of much that is wrong with our economic system — so much so that, as the article’s headline puts it, “McDonald’s made me a Marxist.”
But Marxism is a substitute for working at McDonald’s in the same way cyanide is for water: a lethal one…
Perhaps the genuine motivation for Kelly’s antagonism derives from the size of the “dirty business of advertising.” She provides data regarding the industry’s revenues — $1.8 billion in the U.S. in 2022 — and the share composed of host-read ads — 55 percent in 2021 — at which she takes great umbrage. Responding to these impressive figures, Kelly rhetorically ponders, “When did we collectively decide to accept this level of grift?”
There’s an actual answer: When accepting obvious ads for products whose purchase is entirely optional enabled listeners to hear from heterodox voices at exactly zero cost to themselves…
Energy
Game Changer is Hamm’s first book, and in addition to providing biographical detail, it is an ode to America’s energy independence. This is a particularly prescient topic now that the Biden administration is discouraging the use of America’s resources and is encouraging reliance on Chinese-made wind turbines, solar panels, and electric batteries for mandatory electric vehicles. Worse still, since Congress would not be able to pass such bills and get them signed into law, President Biden is doing an end-run around our elected representatives and putting policies in place through Environmental Protection Agency (EPA) rules.
The book, with 25 short chapters, describes not only the history of the oil industry, but also the benefits that oil has brought to Americans’ standards of living. In addition, it is the story of how one man can successfully start a company from nothing and develop it to a market cap of almost $30 billion…
Central Planning
In the New York Times, Senators Lindsey Graham (R., S.C.) and Elizabeth Warren (D., Mass.) published a polemic against technology firms. Besides whining about “Big Tech,” the senators call for the passage of the Digital Consumer Protection Commission Act (DCPCA) to “create an independent, bipartisan regulator charged with licensing and policing the nation’s biggest tech companies,” supposedly “to prevent online harm, promote free speech and competition, guard Americans’ privacy and protect national security.” But their economic arguments are specious, and their noneconomic arguments are dubious…
That’s $52 billion of your money that this “team of experts” is disbursing. If you don’t remember electing these experts to spend your money, that’s because you didn’t. When I think of successful industries in the United States, heavy involvement from the Department of Commerce in deciding how resources are allocated and investments are made does not come to mind. As Veronique de Rugy has written, most of this money will end up going to large firms such as Intel that were not in financial trouble and could have raised capital privately. But fear not, the “team of experts” is on it…
The “strategic state” is a chilling phrase. It will be much more collectivist than we have grown used to, and countries that fall to this ideology are not likely to be the most pleasant or prosperous of places to live, other than for those in charge. But rather than the old European vision of a socialist state seizing the “commanding heights” of the economy, we are more likely to see economies where the divisions between public and private sectors are blurred, even though the balance of power between the two is clear. The private sector will be subordinated to the public sector, which, one way or another, will try to harness the dynamism of capitalism in order to achieve its social, political, and economic goals. Shareholders won’t count for much, but “stakeholders” will be told that they do. As such, the strategic state will turn out to be an updated testing ground for a variant of fascist, rather than socialist, economics — complete, probably, (these being the times that they are) with the sentimental veneration of “nature” that was another feature in some sectors of the European authoritarian Right a century or so ago.
The Economy
Ron DeSantis has finally started to talk about the economy, releasing his campaign’s “declaration of economic independence” on Monday. Let’s start with the good.
Antitrust
Last month’s congressional hearing featuring Federal Trade Commission (FTC) chairwoman Lina Khan uncovered a troubling state of the agency. Khan’s answers to questions from the House Judiciary Committee demonstrated that she conflates the FTC’s responsibilities with her long-held ideology that fuses politics and antitrust, undermining the power of consumer choice and the principles on which a free economy thrives. Her allocation of resources to questionable investigations and potential speech regulation further erodes confidence in the agency’s intentions. And the FTC’s attempts to expand its regulatory authority through strategic lawsuits and pressure on Congress set a dangerous precedent…
There is, of course, plenty of scope for debating what “consumer welfare” should mean and does mean, but what that test does do is act as a valuable brake on the abuse of antitrust enforcement by regulatory authorities, particularly those who, like the Soviet planners of old, believe that bureaucratic fiat is a better way to shape the structure of an economy than the operation of free markets. That’s not to say that there cannot be a role for (a light touch of) regulation, but looking at the historical record, the freer the market, the greater the prosperity is a principle that has stood the test of time.
Unfortunately, the FTC seems set on imposing a centralized, ideologically driven template on the American economy.
The Biden administration has unveiled a draft version of new merger guidelines, courtesy of the Federal Trade Commission and the Department of Justice. This is a big deal. Antitrust regulators review all proposed mergers above a certain size and can veto the deals. The guidelines are not binding law, but they do signal to companies whether a deal is likely to pass muster, saving time and lawyers’ fees. The proposed new merger guidelines stack the deck against mergers by politicizing market definitions, presuming guilt, and adding uncertainty to the process.
The Debt Downgrade
High and growing debt is correct. According to CBO’s most recent long-term budget outlook, the federal government will add $119 trillion in additional deficits over the next 30 years to reach 181 percent of GDP. In 2053, spending will consume 29.1 percent of GDP up from 24.2 percent in 2023. Revenue as a share of GDP is projected to increase slightly from 18.4 to 19.1 percent.
We are entering uncharted territory under fairly rosy assumptions: relative prosperity (though growth rates are slowing down as a result of debt accumulation), relatively low interest rates, and moderate inflation. In other words, expect things to look worse than this…
[T]he downgrade is absolutely merited, because the debt dynamics of the United States are becoming increasingly untenable amid Washington’s wildly reckless overspending. While the bipartisan Fiscal Responsibility Act to raise the debt ceiling curtailed a small amount of deficit growth, the Congressional Budget Office still expects federal-government debt held by the public to reach 115 percent of gross domestic product in a decade, up from the current level of 93 percent. Treasury’s own projections indicate debt reaching around 250 percent of GDP by the middle of the century, and almost 600 percent of GDP by its end; compounding interest works great for savers but horribly for borrowers. These are nearly incomprehensible levels of indebtedness, and unless we tax the economy into oblivion, they’d end up requiring almost all revenues to be dedicated to interest payments on the debt, leaving nothing left for government functions…
Protectionism
The conceit of the prospective economic planner is to believe that if only he were in charge, things would work out better. This is ordinarily a hypothetical exercise, but not in Lighthizer’s case. He was U.S. trade representative for all four years of the Trump administration, serving under a president who was sympathetic to his views. The trade war happened, with Trump unilaterally raising tariffs to counteract so-called unbalanced trade. And what was the result? Gregg records it: “The overall US merchandise trade deficit during his tenure actually grew from $792.3 billion in 2017 to $904.4 billion in 2020.” Even by the protectionists’ own misguided metric, the Trump administration’s trade policy failed…
The SEC
With baseball season in full swing, we’re all used to the sight of an umpire calling strikes. But any baseball fan would be horrified if the umpire showed up to the field wearing one team’s jersey. The umpire’s job is to neutrally enforce the rules, so the teams play a fair game.
Unfortunately, today’s U.S. Securities and Exchange Commission — the umpire of the American business world — is wearing one team’s colors. When it comes to shareholder concerns about hot-button social issues, the SEC has been anything but neutral…
Electric Vehicles
Like many major pieces of legislation, the IRA was crafted to achieve multiple goals, from making EVs more affordable and sparking sales to encouraging onshoring. But if sales from the first half of 2023 are any indication, the law likely has subsidized tens of thousands of buyers who would have purchased an EV anyway and created a leasing work-around that undermines many of the legislation’s key objectives.
As we approach the first anniversary of the Inflation Reduction Act, it’s a good time to question whether the benefits of the EV-tax-credit program outweigh its unintended consequences. The evidence suggests not.
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