Take Fitch's Downgrade of the US Seriously, Not Literally

The decision by Fitch to strip the US of its AAA credit rating, lowering it one level to AA+, means little in itself. There is next to zero chance the government won’t be able to pay its creditors and the Treasury Department’s access to funding is determined by forces far more fundamental than a few capital letters tied to a ratings report. That doesn’t mean the US’s rising debt burden isn’t a problem.

There are at least three ways in which increased federal borrowing could disrupt not just the US economy and financial markets, but the global ones as well. The first and most worrying is the potential for a so-called debt bomb. Under this scenario, the government’s debt burden -which currently stands at $32.3 trillion - becomes so great that even a small increase in interest rates means the Treasury needs to borrow just to cover the cost of servicing the debt. This leads to a vicious cycle, with the added borrowing discouraging buyers, driving interest rates higher, and forcing even more borrowing. The resulting sky-high interest rates throw the economy into a deep recession.

What’s concerning is that the US may be getting uncomfortably close to such a scenario. The Treasury is on track to spend almost $1 trillion on interest payments alone in fiscal 2023, compared with less than $600 billion before the pandemic and around $425 billion in 2011 when S&P lowered its rating for the US from AAA to AA+.

Expensive Debt

When I examined the potential for a debt bomb in February, the probability was low but quickly rising, based on debt service as a percentage of gross domestic product. Since then, that measure has remained stable, largely because elevated levels of inflation have inflated the nominal growth rate of the economy. This is what economists refer to as “inflating away your debt.” Such a mechanism works ideally in the short run but always comes back to haunt in the long run simply because of the pernicious effects of high rates of inflation over an extended period of time.

Inflation Away Our Debt