The Shock Downgrade of the U.S. Economy

Last week, U.S. debt holders got a big shock as they read the news headlines: Fitch, one of America's three big credit ratings agencies, stripped the U.S. government's AAA rating, downgrading them to double A plus. They cited some pretty scathing reasons in their press release too, from expected fiscal deterioration over the next three years to a deterioration in the U.S. government's standards in dealing with their debt situation, to lacking a medium-term fiscal framework to correct their financial position.

With this downgrade, Fitch now becomes the second big U.S. credit ratings agency to downgrade the United States after Standard & Poor's similarly downgraded them from Triple A to double A plus back in 2011. Moody's, the third big U.S. credit ratings agency, still has the United States at AAA rating for now. But what does this actually mean for America? Is this downgrade in the long-term foreign currency issuer default rating actually a problem? Stay tuned, because we're also going to take a look at what both Ray Dalio and Jamie Dimon have to say on this issue towards the end of the video. Thank you.

So, what actually are credit ratings agencies and why do they exist? Well, in the United States, there are three main independent credit ratings agencies: Standard and Poor's, Moody's, and Fitch. What they do is they assess the credit risk of individual companies, stocks, government, corporate or municipal bonds, mortgage-backed securities, credit default swaps, and collateralized debt obligations. What does that mean? It means they scrutinize these investments and assess how likely the borrower is to default on their obligations to repay a loan.

So if you're buying some U.S. government bonds, they're providing a rating on that investment to give you a better insight on how likely you are to get paid back by the U.S. government. Triple A, double B plus, C; these are all ratings that credit ratings agencies might assign. Triple A is the least likely to default, and then the ratings go all the way down to D, with D meaning they're already in default. Anything below double B is considered a speculative grade investment. So, big institutional investors tend to stick to investments rated higher than that.

So what happened in the case of Fitch is they decided to downgrade the United States government from AAA rating to double A plus, which is the second-highest rating you can get. As you might expect, this doesn't actually mean all that much in reality, as both ratings mean an extremely low likelihood of default. But what was more interesting is Fitch's explanation of why they lost some confidence. They noted three key reasons: expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to double A and AAA rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.

So, a fair bit of beef around how the U.S. has handled themselves recently when it comes to their debt. This release goes on to say, in Fitch's view, there has been a steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters, notwithstanding the June bipartisan agreement to suspend the debt ceiling until January 2025. The repeated debt limit political standoffs and last-minute resolutions have eroded confidence in fiscal management. In addition, the government lacks a medium-term fiscal framework, unlike most peers, and has a complex budgeting process.

These factors, along with several economic shocks and tax cuts and new spending initiatives, have contributed to successive debt increases over the last decade. Additionally, there has been only limited progress in tackling medium-term challenges related to rising Social Security and Medicare costs due to an aging population. So this is Fitch essentially saying they've lost some confidence in the U.S. government's ability to manage their finances, which is leading them to take on more and more debt.

The key problem here is that the U.S. spends more than it earns, but in Fitch's view, it isn't trying hard enough to course-correct. When a country spends more than it earns in a year, it's called a deficit. When a country runs a deficit, the difference between their expenses and their income is paid for by taking on debt. The thing is, however, if you have a deficit year after year and the deficit only gets worse, then, as you might expect, the debt pile keeps getting bigger. But this can point towards a debt crisis because, of course, loans do need to be paid back.

The other problem the government faces right now is that with interest rates high, taking on more and more debt is a much bigger commitment because of the interest payments. But fundamentally, the main problem with the U.S. is that they've been running a deficit basically since the turn of the century, and the trend is that the deficit is worsening over time, not improving. That's the main problem Fitch is seeing that's causing them to downgrade the credit rating.

The U.S. has this issue but is continually letting it worsen and isn't putting in the medium-term plans it needs to reverse course. Have a listen to this clip from Richard Francis, one of the high-ups at Fitch, explaining exactly this point: "In 2007, general government debt was less than 60 percent, and now it's 113. So there's been a clear deterioration. Furthermore, we're expecting fiscal deficits to rise over the next three years, and we expect them to continue to rise over the next three years. Furthermore, because of the higher interest rates, and the higher stock of debt, we're now seeing the interest burden price pretty fast actually in the case of the United States."

So, the underlying numbers are especially in the fiscal and debt side are quite negative. They too note they're seeing the annual deficit expand, which means more and more spending versus what the U.S. is earning. Richard notes that because interest rates are now a lot higher, the interest that the U.S. government will need to pay on this debt into the future is going to become a much bigger issue. Just like what we've been seeing with companies, the government's interest expense will start to really eat into their earnings, which means funding has to be cut in other areas, or taxes need to be raised.

This point is exactly why Ray Dalio went on the record after the U.S. debt ceiling was passed, saying that no matter the outcome, the U.S. is no better off because the underlying problem hadn't been fixed. While the debt limit was raised and it stopped the country from defaulting, the politicians didn't at all focus on returning the U.S. budget to surplus. "The debt ceiling negotiations is ridiculous because it is not dealing with the problem. The problem is that we're spending more than we're earning, and it doesn't have to be that way. That we can do the restructuring. If we don't fix that, we are going to have a debt crisis problem and a social problem that's going to cost us daily. It'll cost us our system as we know it."

So, make no mistake, there are issues that definitely do need to be addressed in the United States, and I think it's fair reasoning from Fitch as to why they've downgraded their credit rating. But with that said, what does it actually mean for America to have your credit rating downgraded from AAA to double A plus? Well, the answer is not a lot. Firstly, a ratings start from AAA to double A plus is such a small change that it doesn't really make a significant impact on investors' behavior. And the other thing is, it's just the opinion of one independent ratings agency. It's a company running their algorithms and putting out a press release saying that we used to think the U.S. debt was bulletproof, and now we think that it's almost completely bulletproof.

It's not as though the International Monetary Fund is stepping in and doing something, or the United Nations is taking action or anything like that. It's just a rating agency's opinion. And this is exactly what JP Morgan CEO Jamie Dimon had to say when he was asked about this last week: "Fitch, you know, big news today, obviously, is the downgrade of U.S. debt down to double A plus. What's your take on that decision?"

"Yeah, I'll give you a couple of quick things: it doesn't really matter that much. You know, the markets decide; it's not the ratings agencies that make these big decisions. Number two, they point out some issues, which we all knew about regarding our debt ceiling crisis and things like that. But number three, most importantly, the American public; this is the most prosperous nation on the planet. It's still the most prosperous nation on the planet; it's the most secure nation on the planet. I would point out to the rating agencies that there are a bunch of countries rated higher than us, like AAA, but they live under the American enterprise military system. For them to be AAA, not America, is kind of ridiculous. These are countries like Canada and others."

So, Jamie raises two key points in that clip as to why he doesn't think this credit downgrade matters all that much. His first is, what we're talking about before: that it's one ratings agency making the smallest possible adjustment, and ultimately they don't decide what happens with U.S. treasuries; the market does. But then beyond that, he also raises a very important point that America is the central pillar of the financial system of the world, as we know it. They are the top dogs, so much so that there are countries out there that are practically dependent on, as Jamie describes it, the U.S. enterprise military system.

The interviewer notes Canada, for example. "I'm Australian; we're exactly the same. Our closest ally is the United States, and we need to slot in under that U.S. military umbrella to ensure our country's prosperity." Yet, when you look at a ratings agency like Fitch, they now have Canada the same as the United States at double A plus, and Australia even sits higher at AAA. If China came knocking on our door, we'd be stuffed without the United States, so it's interesting that despite being under that U.S.-led economic military system, we've actually ended up with a higher safety rating on our government debt. Seems a little bit backwards, right?

But beyond that, Jamie also commented on the specific reasons for the downgrade that Fitch cited in their report, including what he thought about the game of political chicken regarding the debt ceiling: "You know, in terms of the actual decision-making behind the downgrade, it had a lot to do with political brinksmanship surrounding the debt ceiling debacle, the deficit itself. I mean, do you agree with any of those? Those are issues. This is the most prosperous nation on the planet. North America, we have the Atlantic and the Pacific, the best military, the best economy the world has ever seen, the most innovation; the credit is sound. It should be the highest-rated credit in the world, and yes, there are issues about you know they're being raised publicly. I agree with that. We should get rid of the debt ceiling. We should get rid of it; we should get rid of it. It's used by both parties, and it's always used in a way that makes it very difficult. We need certainty in the world, and we should have more of it."

So, Jamie really going out of his way to state that U.S. debt is sound, but interesting that he does actually agree with Fitch in a roundabout way that governance over in America does need to be improved. But, long story short, yes, the U.S. did just lose its AAA rating from Fitch, but remember that this is just one ratings agency, and they didn't really revise the rating by all that much.

Fitch definitely still believes U.S. debt is a very safe asset, and the United States is highly unlikely to default on any loans. We have to take this sort of stuff with a grain of salt, right? Ratings agencies are by no means the be-all and end-all. Remember, these are the same ratings agencies they talk about in The Big Short that gave the mortgage-backed securities, the CDOs, and the synthetic CDOs all AAA ratings back in 2007. Because if they didn't, the investment banks would simply take their securities and get them rated by the company meeting ratings agency just down the road.

But with that said, that's what's happening in the riveting world of credit ratings. Hope you're not asleep! But in all seriousness, I hope this video points out that yes, there are some issues with debts and deficits over in America. But despite the credit downgrade making news headlines all around the world last week, this really isn't a big economic catastrophe. Rather, a slight re-rating by one of the three big ratings agencies saying that instead of being bulletproof, U.S. debt is now basically bulletproof.

Anyway, please leave a like on the video if you did enjoy it, subscribe to see more from the channel, and I'll see you guys in the next video.