US government bonds are considered by the investment community to be “risk-free.”  They are low risk to be sure, given the ability of the US government to both tax and print money, but risk-free with our current fiscal trajectory seems a stretch.

So, Fitch, the bond rating agency called it as they saw it: the fiscal position of the US government is deteriorating.  S&P did a similar rating downgrade on August 5, 2011.  The stock market at that time fell 7% on that news and then the story gets lost to history.  However, it is noteworthy that two of the three major bond ratings agencies have now downgraded US debt.

Treasury Secretary Janet Yellen, on whose watch as both FED chairman and Treasury Secretary many fits of fiscal abuse have occurred, was quick to suggest the downgrade was a mistake.  She called the action “entirely unwarranted” and pointed to what she sees as improvement under Biden.  Like most defenders of Biden, she ascribes the recovery from the unprecedented Covid lockdown to the wisdom of Joe Biden. This is like a doctor taking credit for a patient’s recovery because the esteemed doctor quit standing on the patient’s throat.

CNN predictably called the downgrade a “black eye” but not much more.

Actually, if you read the Fitch analysis, they were not so much pointing to the present as they were the immediate future, the next three years or so.

In the very first paragraph which critics seem to conveniently overlook, they said:

“The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA-rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.”

How dare they suggest the emperor has no clothes!  We have gone year after year with massive deficits and Congress has been so dysfunctional we have not even had a formal budget for years and have been running on “continuing resolutions”.  Often at midnight, it seems, every pork barrel idea is loaded into the hopper and pushed into an “omnibus budget”, wherein the whole glop of spending must be approved with no ability to discriminate between the necessary and wise and the unnecessary and profligate.  It is either vote for this fiscal mess or risk shutting down the government. It is not a process that engenders confidence.

But deficits no longer produce much political backlash. So, politicians gain more from spending than they lose by running up deficits.  That is because the political benefits are concentrated on important political constituencies in the present and the economic pain is dispersed and pushed back in time into the ethereal future.  Eventually, though, the future becomes today.

The result is spending has been rising much faster than revenue and the US government now had a debt-to-GDP ratio of 122%, meaning our debt burden is now more than the entire output of the economy.

Now it has improved a bit since the Covid crisis but still stands far higher than it did in the past and large deficits remain in the pipeline.  And some improvement should be expected after the economy was allowed to operate. What is remarkable is how little it has improved, in terms of overall trends.

We have pointed out before that about 80% of US spending is now on “automatic pilot” and does not even get voted on.  The partisan bickering is now over a relatively small slice of the budget.  The bulk of spending is “baked in the cake” in giant demographically driven programs like Social Security and Medicare.

So unlike Fitch, we would suggest it is not so much current political gamesmanship,  as it is a structural deficit, built into the system years ago.  Believe it or not, much of it goes back to August 15, 1971, when President Nixon “temporarily” broke the Bretton-Woods treaty, the last remnant of the gold standard which disciplined the US government from spending too excessively. The gold standard put the government in a fiscal straitjacket of sorts, and much of our recent political history is the President and Congress wriggling out of every constraint put on their spending. Still, it is remarkable that so many long-term negative trends can be traced to this event, that there is a whole website devoted to the problems created downstream from this decision.  It is worth a visit.  Here is just one chart, that is somewhat dated, that shows the trend since “the crime of ’71” through 2015.  Incidentally, if updated, FED inflation just exceeded 3,000%!

While Fitch is surely correct about our political dysfunction, demographics play a critical role because these systems were designed years ago as a “pay-as-you-go system.”  That is, what you pay into programs like Social Security wherein your contributions funded your parent’s benefits, and your children are funding your current benefit.  There is no trust fund or “lockbox”.  In fact, what is being paid out today is more than is coming into the system, causing the trustees of Social Security to become net sellers of treasury bonds and running negative cash flow.

In 1940, shortly after the program began, about 42  people were working for every Social Security recipient.  Today it is below 3:1 and headed toward 2:1.  We have very large and expensive elderly populations which must now be supported by an ever dwindling number of young people.

Because of this, both Social Security and Medicare are heading toward insolvency.  Social Security under current economic assumptions, will run out by 2033.  Medicare is expected to run out as well.  Part A in Medicare is expected to go cash flow negative by 2025 and run out by 2031.

Fitch does not even mention much of this problem, but they hint at it by the expectation of constant growth in deficits.  If these giant systems go negative, the US government will either have to borrow or print vast sums to make up the difference.  Hence, deficits are structurally on a path to grow rapidly.

Does that sound like a sound financial system to you?  Was Fitch out of line to point much of this out?

Look at the trends in deficits that have occurred well before our “entitlement” systems go bust.

Notice that a return to “normal” being touted by the Biden defenders, leaves us with a deficit about where it was during the height of the financial crisis in 2008-2009.  That does not say a lot of good things about “normal” when normal is equal to the greatest financial crisis of our era.

In the marketplace, lower-quality borrowers normally have to pay more to borrow than higher-quality borrowers. They are a greater risk. Hence, this move by both rating agencies likely means the US government will have to pay more to borrow.  With rates already high, interest cost will soon be the largest budget item, eclipsing defense.  The sheer volume of government borrowing risks “crowding out” the needs of the private sector for funds as well.

It is important to note that higher rates not only make it more difficult for the government to borrow but for all the rest of us in the private sector.  As rates rise, we run the risk of recession, and during that event, deficits run wild.  Revenue coming into the government collapses while “social entitlement spending” soars as people fall into the social safety net.  We are literally getting to the point where we can’t afford to run the risk of recession.  But since politicians can’t outlaw the business cycle, an even more severe deficit crisis looms ahead.

To be fair, both parties are responsible for where we are financially speaking.  Republicans used to tout themselves as “fiscally responsible”, but on the rare occasions they have held sway in both Congress and the Presidency, they could not reform government either.  Balanced budgets, which used to be a staple of conservative rhetoric, never seemed to be argued with the urgency it deserves.  Legacy conservative leadership has learned to lose gracefully and the insurgent MAGA movement has avoided the subject.

Democrats have been more at fault, particularly their demagoguing of any attempt at entitlement reform. It always seems a variant of “pushing grandma off a cliff.”  Even worse, with full knowledge of the financial weakness of these key programs upon which millions depend, they have advanced even more new programs, spending and wasting billions.  It would seem at the least, if you are going to make people dependent on the government, you better be damned sure the government is well-run and solvent.

Unfortunately, that is not the case.  Barring major reform, fiscal trends in the future do look quite negative.

The latest number from the Congressional Budget Office suggests that US debt is now on track to rise $5.2 BILLION per DAY for the next 10 years.

By 2033, US debt is projected to hit a record $50 trillion.

Likely over 20% of government revenue will go toward interest expense. This will expose the silliness of the expression, ” We owe it to ourselves.”

Between bankrupt entitlement systems that will have to be funded and soaring interest costs, there won’t be much left of the budget to fight over.

charts courtesy of the Kobeissi Letter

The “deficit problem” is really a derivative of a spending problem.  There would be no borrowing excess without a deficit, and there would be no deficit with excessive spending.

Today, government spending, as a percentage of output, during peacetime, hovers at the peak of World War II.  After WWII, the country was united, we had a Baby Boom, and the US stood dominant in the world markets.  We also had some conservative governance as chronic deficits did not start until the 1970s.  We were able to pay down the debt.  Now we face a demographic catastrophe and fierce competition from China.  We won’t have favorable circumstances to pay down our debt.  On the contrary, it will get worse.

How the world that uses US Treasury Bonds and the US dollar as their “banking reserve” will take all these negative trends remains to be seen.  Maybe they will want a reserve that can’t be inflated into oblivion.

No, Fitch got it right.  The US government is no longer a AAA credit.