On August 1, Fitch downgraded America’s debt rating, by just one notch from AAA to AA+. This was only the second time that US Treasury debt has been downgraded; the first being in 2011, when Standard & Poor’s lowered its AAA rating to AA+.

The announcement came a day after the US Treasury announced its quarterly borrowing estimated in excess of $1 trillion, well above the $733 million estimate in May. Although Fitch did not point specifically to these numbers, it stated that its decision “reflects the expected fiscal deterioration over the next three years, a high and general growing general government debt burden and the erosion of governance”.

In a follow-up interview, a senior official stated…. “you have the debt ceiling, you have Jan 6th” referring to the assault on the Capitol in 2021 by Trump’s supporters challenging the election results.

In May, Fitch had warned about a possible downgrade, as the perennial squabbling about the extension of the US debt ceiling was under way. US Treasury Secretary Janet Yellen warned a few times this year about potential default on Social Security and other payments if the Republicans did not agree to extend the debt ceiling. The ceiling, last raised in 2021, was suspended in early June until January 2025.

Debt ceiling

The ceiling, which was about $10 trillion in early 2008, before the Lehman Brothers financial crisis, has been raised about 13 times since then, and was $31.4 trillion before its latest suspension.

The downgrade attracted severe criticism from US officials, past and present.

But the decision was long overdue. There have been several past instances when it would have been appropriate to downgrade US debt.

Going back a few decades, the closing of the gold window by US President Nixon in August 1971 would have been a very apt time. After all, the rest of the world accepted the US dollar as the world’s reserve currency and thereby US Treasuries as the safest haven, under the explicit promise that the dollar was redeemable into gold at $35 an ounce. That had been the case from 1945 onwards.

Nixon, in August 1971, closed the gold window, going back on the promise on redeeming the dollar into gold at $35/ounce. Once that promise was broken, there was a compelling justification for a downgrade. Nevertheless, Standard & Poor’s, which had started rating US debt in 1944, did not do so.

This analysis is confined to the last 30 years, a convenient horizon since Fitch started rating US Treasury debt in 1994.

In 1995 the US government shut down in a stand off between Democrat President Clinton and the Republican House Speaker Gingrich, who was pushing for cuts in spending and a balanced budget act. Government workers were furloughed for a week before the debt limit was raised, but without concrete measures to reduce government spending.

Since the fiscal crisis did not trigger cuts in spending, it entailed just kicking the can down the road. Yet none of the three main agencies (S&P, Moody’s and Fitch) announced a downgrade.

The next occasion was when the Treasury suspended the sale of the 30-year Treasury bond in October 2001, in the aftermath of the 9/11 attacks. While the recession may have called for spending to stimulate the economy, reducing the maturity of debt to lower current borrowing costs tends to raise borrowing costs later on. The decision was hardly befitting the issuer of the world’s reserve currency.

The 20-year period from 2002 to 2022 provided several instances when there was justification for downgrading US debt. In November 2002, former Fed Chair Ben Bernanke in a speech in his capacity as a Governor stated that if cutting the short rate to zero does not provide enough stimulus, then the Fed should stand ready to buy long-term bonds to lower long rates. That speech justifiably earned him the sobriquet Helicopter Ben.

In late June 2003, the Federal Open Market Committee followed through on Bernanke’s proposed agenda by cutting the vital Fed funds rate to a 50-year low of 1 per cent to avert what it perceived as deflation risk. It is not possible to adumbrate how the Fed grossly overestimated the dangers of deflation, drawing on a misplaced 1930s comparison. That rate cut signalled its clear willingness to tamper with the Treasury market by buying long term bonds. Besides, the cut followed after several years of unwarranted laxity ( (Sir Alan’s Day of Judgement, Vivek Moorthy, businessline, January 17, 2003). A downgrade in 2003 itself may have restrained the Fed in its damaging war against deflation.

QE effect

The entire period from 2007 onwards through the September 2008 meltdown and the massive fiscal and monetary stimulus, culminating in rounds of Quantitative Easing that followed up to around 2015, warranted downgrades for various reasons.

However, there was just one downgrade by one notch by S&P in 2011 to AA+, but none by Moody’s or Fitch. Ironically S&P’s cited justification for its decision was flawed because of a $2-trillion error in projecting the deficit.

Before Covid hit, the repo rate spiked in the inter bank market to 9 per cent in mid-September 2019 when, in the process of ending Quantitative Easing, the Fed was trying to raise the funds rate above its then target range of 2- 2.25 per cent. It was clear that the Fed had lost control of the money market, to which Treasuries are closely linked, thus again providing grounds for a downgrade. But again there was none.

Going beyond economic numbers, the January 6 2021 insurrection by Trump supporters brought America’s robust political system close to collapse, indicating the erosion of governance, as stated by Fitch. That warranted a downgrade within a few weeks.

The Federal Reserve under Chairman Jerome Powell has belatedly raised rates by a massive 550 basis points between March 2022 and late July 2023. It has been lucky that inflation has been coming down and the rate hikes have not triggered a recession, a miraculous situation.

Against this backdrop, the White House economic adviser Jared Bernstein’s comment is noteworthy, “Fitch seems to be punishing the clean up crew when the guy who wrecked the room is long gone.” One could add to that: better late than never.

The writer is Distinguished Professor, St Joseph’s Institute of Management, Bengaluru