Is the U.S. Downgrade Such AAA Big Issue?

In the near term, it doesn’t matter much that Fitch became the second key rating agency to downgrade the U.S. as an issuer of sovereign debt, reducing the country’s score from the highest AAA to AA+. Markets received the news with hardly a knee-jerk. Realistically, this is not going to force many bond investors to disinvest from any U.S. Treasury holdings.

Treasuries form the bedrock of the global financial system. They still represent the standard method for settling international transactions, and they constitute over half of all foreign reserves held by sovereigns globally. They’re so central that schema restricting large institutional holdings of acceptable investments in the “safest” end of the spectrum often refer to “U.S. Treasuries” directly rather than “debt with a AAA designation.”

But what does it mean for a financial system that is predicated on investments with “risk-free” rates to rely on an institution that two key rating agencies now say is not quite risk-free? What does it mean that the occasion for Fitch’s downgrade was broadly the same as the one S&P had for its first downgrade of the U.S. in 2011?

It’s Political, of Course

The cause is not really economic, instead stemming from dysfunctional hyper-partisan U.S. politics. The downgrades have been brought about by impasses and brinkmanship around the U.S. debt ceiling (an odd and completely arbitrary self-imposed limit on the country’s debt issuance that seems to pay little heed to the U.S.’s unique global position). For a system developed around stable U.S. leadership, this inscrutability and uncertainty both corrode the confidence and dominance of the financial world order.

This perhaps hastens the day when we will see an end to the “exorbitant privilege” of the U.S. (As French minister of finance Valery Giscard d’Estaing called it in the 1960s, concerning the country’s ownership of the world’s reserve currency.)

For now, Moody’s and Morningstar DBRS both maintain a AAA rating for the U.S. Realistically, it doesn’t seem feasible that the U.S. will be allowed to default. But amid a maelstrom of turbulent politics, mistakes (even impossible ones) threaten that possibility. The Biden administration is incensed by the political implications here and how it’s provided Republicans with an avenue to attack their fiscal responsibility (instead of any reward for their notable success in hashing out a solution to the latest debt crisis with House leader Kevin McCarthy).

This situation showcases the reflexive nature of markets and politics, whereby the impression of risk is broadcast, which then conditions the assessment of that risk and perversely increases the chance of the feared outcome happening.

The jury is out even among rating agencies. But typically, a system crumbles slowly before collapsing very quickly. Throughout history, dominant regimes have had only finite lives. Highly respected thinkers are actively considering the U.S. potentially relinquishing its dominance, changing the financial order we have become accustomed to.