Fiscal Health: Moody’s downgrade a warning sign

It may be a cliché, but Ernest Hemingway’s quip about going bankrupt “gradually and then suddenly” feels very much on point if you look at America’s spending and debt situation — deteriorating, with momentum building toward a crisis.

The latest step along that path came Friday, when Moody’s Ratings removed the final major Triple-A credit rating for the federal government. That means America’s debt is officially no longer considered pristine by any of the main companies that rate it. Moody’s cited successive bipartisan failures to reverse the growing US budget deficit, which it estimated could increase to 9% of the gross domestic product within the coming decade, from the 6.4% it hit last year. It has previously reached those levels only during times of global crisis: World War II, the 2008 financial crisis and the COVID pandemic.

It’s easy to downplay these fears after decades of hand-wringing that have come to nought. In 1988 — 37 years ago — when US federal debt was less than half what it is today, measured as a percentage of GDP, the Federal Reserve chairman, Alan Greenspan, warned of the country’s fiscal situation. He said that “the long run is rapidly turning into the short run.” He added that “the effects of the deficit will be increasingly felt and with some immediacy.”

It turned out that domestic and foreign investors were willing to buy ever-larger amounts of government debt to finance America’s overspending. Investors even continued to buy debt after America’s first credit downgrade, by what’s now known as S&P Global Ratings, in 2011. The coming week seems unlikely to repeat such a rosy scenario.

Dynamics today are changing in ways that finally make Greenspan’s warnings urgent. Some investors are questioning how much exposure they want in US financial assets. Politicians clinging to increasingly thin majorities in Congress are more willing to encourage voters with spending or tax cuts than they are to tackle the problem. The combination will lead to investors demanding higher interest rates to buy US debt, which slows economic growth by raising borrowing costs for households and businesses. It also eats into the cash available for the government itself, worsening the underlying budget math. Wash, rinse, repeat.

By making tax cuts temporary, the overall cost of the 10-year plan is reduced, which makes it easier to pass. It also puts the burden on the next administration and Congress to choose between extending the cuts, which would add further to the deficit, or letting them expire, which to most voters would feel like a tax increase — something most lawmakers would want to avoid.

As long as politicians and voters aren’t on the same page about how to get the federal debt on a sustainable path, which increasingly points to Social Security reform and selective tax increases, both parties are likely to indulge in more and more fiscal accounting tricks. Anything described in Washington as temporary rarely turns out that way.

So what would this do to America’s fiscal outlook? The Yale Budget Lab, as a thought experiment, assumed that the temporary tax provisions under consideration would become permanent. Even including some potential tariff revenue to help offset the lost tax revenue, the cost would be $2.5 trillion over the coming decade. At the end of 30 years, the size of America’s debt would represent 180% of its GDP. The only countries with higher debt ratios today are Japan and Sudan.

Moody’s decision tells us that this fiscal path has costs. One is the willingness of investors to buy Treasury debt without getting a higher interest rate to reflect the growing fiscal risks. A report by the Peter G. Peterson Foundation, a think tank that favours deficit reduction, showed that foreign ownership of publicly held US debt had risen to about 30% of the total by the end of last year, from about 5% of the total in 1970.

A jump in interest rates for the US 10-year treasury was one reason Trump paused his reciprocal tariff plan. And they continue to have the administration’s attention. Treasury Secretary Scott Bessent told lawmakers this month that “the debt numbers are indeed scary,” and a crisis would involve “a sudden stop in the economy as credit would disappear.”

The growing debt burden risks making bond buyers nervous and thus America’s debt more expensive to maintain. To put numbers to this spiralling scenario, the Committee for a Responsible Federal Budget, a nonpartisan nonprofit group focused on fiscal policy, estimates that a sustained 10-year Treasury interest rate of 4.4%, which is where it was Friday morning, would add an extra $1.8 trillion to the debt even beyond what’s currently forecast for the coming decade.

Sadly, it seems unlikely that Moody’s rating downgrade will be the catalyst for Congress to change its current policy path. But lawmakers should know that the potential for America to shift from a gradual, albeit unsustainable path to a sudden financial crisis is surely increasing.

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