IWM - Debt Downgrade: Ho-Hum

2023-08-03 13:49:54 ET

Summary

• Fitch Ratings has downgraded the credit rating of the United States from AAA to AA+ due to a deterioration in governance and mounting debt.
• Some experts believe the downgrade is irrelevant and that the probability of a U.S. default hasn't changed.
• The growing government debt problem has been around for sixty years and will continue to grow as both political parties follow their own paths to re-election.
• Both parties will continue to "kick the can" down the road as long as potential problems seem further away than is near-term political gain.
• Dealing with debt is an issue that can be postponed indefinitely, so politicians can ignore early warnings for quite some time.

The credit rating of the United States given by Fitch Ratings has been lowered "one notch" to AA+ from AAA.

The reason..."a steady deterioration in standards of governance over the last 20 years" along with the country's mounting debt load.

"I think it is completely and totally irrelevant," said Eric Winograd , director of developed market economic research at AllianceBerstein, an asset manager.

"I have been trying to come up with a reason why investors would care about this and I have not been able to. The probability of the US defaulting is exactly the same today as it was yesterday."

The general feeling is that nothing will change because of the change in the rating.

The last downgrade of the credit rating of the U.S. came in 2011, when Standard & Poor's reduced the rating. And, the rating has remained at this lower level since.

This is a long-term issue and attitudes change only very slowly on issues like this.

The basic problem is that the issue has grown over the years due to the polarization of politicians, a split that was evident in the battle over the debt ceiling in the U.S., a battle that was put to rest for the time being only a couple of months ago.

Joe Rennison and Alan Rappeport write in the New York Times that "There is no willingness on any side to really tackle the underlying challenges."

And, why should there be?

The basic battle over the federal budget and the growing debt levels do not seem to play any role in the re-election of politicians.

The economic results of the programs put in place by the politicians do have an effect on getting re-elected, but not in the way the topic of this post might lead you to think.

I would like to make three points here.

First, the quotes above imply that the issue is one of a long-term nature.

Fitch Ratings states that they have concerns about the "steady deterioration in standards of governance over the last 20 years."

That only takes us back to the start of this century.

To me, the era we are in began in the mid-sixties of the last century when President Lyndon Johnson moved the government into a steady policy stance that I have labeled "credit inflation."

The idea of this policy stance was for the government to stimulate increases in asset prices by directing flows of funds toward asset markets while minimizing the amount of money going into "real" markets.

The effort to stimulate rising housing prices is one direction this approach took in the 1960s.

The rising government debt problem, therefore, had its start a long time ago.

Second, the effort to stimulate the economy by means of credit inflation quickly attracted both parties.

President Nixon bought onto the "credit inflation" game when he came to office and claimed, at the time, "We are all Keynesians now!"

The point should be made right here that "credit inflation" became, right from the start, an effort of both the Democratic party and the Republican party. So, these were policies streaming out of the effort to create credit inflation

There were still problems to be worked out, the major one being consumer price inflation, but Fed Chairman Paul Volcker and the Federal Reserve System brought consumer price inflation under control in the early 1970s, and whereas "credit inflation" became a major part of the country's effort to stimulate the economy up through the 2010s, consumer price inflation, until 2021 and 2022, ceased to be a real issue.

However, the policy effort I have labeled as "credit inflation" was followed by both Republicans and Democrats, in their own way, throughout the remainder of the period. Even though "polarized," the two parties could continue "credit inflation" by supporting it in their own way.

Third, the reason why "credit inflation" was supported by both parties is that their own efforts to achieve credit inflation helped them to get re-elected.

Why did this happen?

Well, "credit inflation" helped to get the economy going and keep it going for long periods of time.

For example, when "credit inflation" was institutionalized in the 2010s by Federal Reserve chairman Ben Bernanke, the result was the longest post-World War II period of economic expansion in history.

What did Bernanke do?

Mr. Bernanke believed that if the Federal Reserve could stimulate the stock market that this would create a "wealth effect" that would lead to more consumer spending and, hence, economic growth.

Mr. Bernanke conducted three rounds of quantitative easing in order to provide the appropriate stimulus for the stock market.

He achieved his goal.

Two things I want to point out here.

The first has to do with the general economy. Credit inflation did produce economic growth, with minimal inflation. The economic expansion following the Great Recession recorded a compound annual inflation rate of about 2.3 percent. Very acceptable.

The compound rate of real economic growth only amounted to 2.2 percent for the period, a rate that was considered too modest.

But, and this is the second point, the policy of "credit inflation" has created greater growth in the "wealth" of the economy than ever before. Over the last thirty years of the 20th century, the income/wealth distribution in the United States rose toward the wealthier and set records for the time.

In the first two decades of the 21st century, the income/wealth distribution in the U.S. rose even further.

As credit inflation sought to generate rising asset prices, the wealthy in the United States learned what the government was doing and investment strategies changed.

The skewing of the income/wealth distribution was an integral part of the picture of the last sixty years or so.

But, very little attention was paid to this fact...except in political circles...and among the wealthier investors.

As I wrote above, there has been little or no willingness on any side of the political spectrum to really tackle the underlying challenges of the government's policy approach.

If the government, coming from either side of the political spectrum, can continue to keep on kicking the can down the road and keep on getting elected or re-elected, why should it stop?

The reason for Fitch to reduce the debt rating: "a steady deterioration in standards of governance over the last 20 years."

The response: the move is "completely and totally irrelevant,"

So, investors, what does this tell you about where government policy is going to go in the future?

Let's return to the policy of credit inflation, something I feel the government is already trying to do.

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