FITCH DOWNGRADE

On August 1, Fitch’s, the rating service, downgraded U.S. Treasury debt from AAA to AA+.  This one-notch downgrade, while largely symbolic, seems to have been intended to send a warning shot across the bow of our great (?) nation, which moves as slowly as a large cruise ship or supertanker when it needs to take a giant turn in course.  

One might ask what this has to do with a legal organization’s blog?  While this post may not be strictly about legal issues, it does have to do with laws that need to be passed by lawmakers.  And, many lawyers labor in the fields of capital markets, where ratings, interest rates, legal opinions and debt issuances all come together.  While this is less true for Treasury than other debt securities, the fact is they are all ingredients in a stew.

The reason for the Fitch downgrade, of course, was how close we came to defaulting on our debt this past spring, when the artificial crisis over raising the federal debt ceiling went on too long and got too close for comfort.  I blogged about that crisis, and some of the legal arguments being bandied around about how the debt ceiling could simply be ignored, back at the time.

While the debt ceiling has been raised to a level sufficient to keep us in the money until sometime in 2025, after the next federal election, Congress seems to be headed towards a federal government shutdown this fall, over the difficulties, and, frankly, grandstanding involved in reaching a budget agreement.

This isn’t the first time that Treasuries have been downgraded.  S&P did it roughly a decade ago after similar debt and budget episodes.  While they subsequently relented and upgraded when the immediate crises were past, our overall fiscal situation hasn’t improved.  I said in my last blog post on this subject that we were on an unsustainable path.  

The problem, of course, is our deadlocked political system.  Our federal budget deficit right now is running about 7% of GDP.  That’s not 7% of total federal spending.  It’s 7% of GDP, or almost 25% of federal spending.  Our GDP is roughly $25 trillion; the federal government spends $6.5 trillion and collects less than $5 trillion, monetizing the rest by printing money (not really literally printing…the Fed buys securities from the U.S. Treasury, creates a bookkeeping credit…that’s the “printing” part…and credits the U.S. Treasury which then has fiat cash to spend).  There are times when that’s OK from a macroeconomic perspective.  We had one recently during the Covid pandemic when that federal cash was key to keeping the economy from crashing into a major recession if not an outright depression.  We can even run a structural deficit of maybe 2 or even 3% of GDP without triggering substantial risk.  But 7% of GDP is just too high.   The money we will have to print to meet deficits of that level will be inflationary.  We can’t continue to grow debt at 7% when the underlying rate of economic growth is more like 2%.

Right now our total federal debt is $32 trillion, or more than 120% of GDP.  And it’s trending higher, at more rapid rates.  With the increase in interest rates we’re also being forced to pay more just to service that debt; right now debt service costs are more than 10% of all federal spending.  That increase in interest rates from the artificially repressed levels following the 2008 financial crisis was necessary, but it puts additional pressure on the public fisc.

So what is to be done?  First, we need to bring Social Security and Medicare spending under greater control.  A complete description of how to do that is well beyond the scope of this blog post.  But certain elements are clear.  We need to continue with efforts, already started, to slowly increase the Social Security eligibility age as life expectancies continue to increase, with some allowance for persons whose jobs have physical requirements that are difficult to satisfy by their mid- to late-60s, as compared to white collar and professional employees who can extend their working lives if they so wish and need.  And second, we should increase, if not end entirely, the annual income caps on contributions, i.e., FICA taxes, that operate as a tax benefit for high income earners.

The magnitude of the problem is easy to see.  Social Security alone is more than $1 trillion per year, and growing rapidly as we Boomers retire.  That’s roughly 5% of GDP, 15% of all federal spending and 20% of all federal revenues.  Add onto that $750 billion for each of Medicare and Medicaid, and you have total spending for those core social programs totaling close to 40% of all federal spending and more than 10% of GDP.  Add in debt service and military spending and you’re at $6 trillion, more than 90% of all federal spending and $1 trillion more than we collect in tax revenues.  There’s no room for anything else.  (When you listen to the spending rhetoric that we’ll be hearing again right after Labor Day, keep these basic facts in mind.  Any politician who doesn’t acknowledge them is a charlatan.)       

Second, as part of limiting Medicare spending, we need to address our healthcare system.  Again, a full description of how to do that is beyond the scope of this blog.  But right now we spend almost 20% of GDP on healthcare, which is roughly double of what the rest of the developed world spends.  In most countries the range is 9-11%, so we spend substantially more, for demonstrably worse results.  Roughly half our healthcare spend is government-funded, via Medicare and Medicaid.  The rest is “private” insurance, which feels to most of us just like another bureaucracy.  In most other developed countries, the healthcare spend is almost entirely public.

If we could bring our healthcare spend down to comparable levels in other countries, we’d have enough left over that we could fund the liberal dream of becoming more like Scandinavia.  But because every dollar of that spend is somebody’s income, the fights to get there will be challenging, to say the least.  It will take over a decade to get there, if we even can, requiring congressional and political leadership which has proven to be in short supply.

Third, we need to take a hard look at taxes and tax policy.  People used to assume that Republicans were fiscally conservative but that is simply untrue.  The Trump tax cuts were not matched by any spending restraints.  Quite the opposite.  Trump recognized that major portions of his MAGA supporters lacked the financial resources to retire or survive without Social Security or Medicare (I remember a pro-Trump poster in the 2016 campaign that said “Keep the Government’s Hands Off My Medicare!”).  As a result he quashed the traditional Republican efforts, never successful in the first place, to cut spending on those programs.  But if we’re not going to restrain the growth in our biggest spends, we need to look for more revenue.

Fourth, as part of the need to look for revenue growth, we need to look at liberalizing immigration.  Admitting more potential taxpayers, at all income levels, will contribute to tax revenues.  That is true at low and high income levels both.  The high income level is obvious, which calls for things like more H-1B visas; but even at lower income levels taking people out of the illegal underground cash economy and putting them into paying jobs on payrolls with tax contributions makes perfect sense.  (In fairness, many people here illegally are already on payrolls, using phony Social Security numbers, contributing revenues but not entitled to any benefits at the other end.  That could be ended with the stroke of a pen, by requiring employers to use the e-Verify system to check the Social Security numbers, but when Ron DeSantis tried to force employers in Florida to do that there was an outcry that he was increasing employer payroll costs.)  But that would require admitting that we’re not in fact going to deport the over 10 million people who are here illegally, and instead we’re going to admit more people, to make sure we have a growing, rather than shrinking, labor force in relation to our retiree population.  Canada has the right idea in this regard, and we can look to them as a model.

How likely are any of these things to take place given the divided state of our politics and nation these days?  To accomplish any of them would require leadership, careful policy-oriented thought and compromise over at least a decade to put us on a sustainable path.  Possible, yes.  But not gonna happen.

Hence the downgrade.

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