Here’s a view of America’s economic future that may amaze you; it certainly floored me. Over the next decade, America’s credit standing is likely to remain top-of-the-line—despite a wave of debt and deficits dwarfing almost anything experienced by a major industrialized nation.
The reason: The U.S. boasts two unique advantages so potent that they’re likely to blunt the looming, severe deterioration in our fiscal outlook. Those advantages are tremendous economic strength, and the dollar’s power as magnet for global capital.
That’s the thesis of a new report from Moody’s Investors Service, entitled “Preeminent Financial, Economic Position Offsets Weakening Government Finances.” “The U.S. stands out in the global context [for] an unusually high ability to carry a large government debt burden,” the study states. It outlines an extraordinary scenario in which America will depend more than ever before on its matchless muscle to counteract the pressures from a severely deteriorating balance sheet.
Moody’s issued the report to update its forecasts in light of the recently enacted Tax Cuts and Jobs Act, a measure that will severely curtail revenues, and swell deficits, in the years to come. The study appeared just before a recent deal in which Congress passed a $150 billion increase in discretionary spending for 2018, so it didn’t incorporate all of the appropriation’s impact in its projections.
“We had already adjusted defense spending as a share of GDP upwards to historic levels,” says lead author Sarah Carlson, a Moody’s SVP, who adds that Moody’s hasn’t yet run the numbers on the non-defense cuts. “Clearly, these new appropriations will put upward pressure on the expenditure line.”
Today, Moody’s awards the U.S. its highest rating for sovereign bonds, Aaa. Were the U.S. to suffer a downgrade, all borrowers, foreign nations, banks and individuals, would demand much higher rates. That menace is a favorite bogeyman for deficit hawks in Congress. And a spike in rates caused by worries over U.S. credit, on top of the rise in yields already in the cards, could ignite a crisis.
But that’s not an outcome Moody’s foresees as most likely. “We expect the U.S.’s broad economic strength to support its credit profile for the foreseeable future,” states the study.
The big threat, says Carlson, is a major, structural downshift that hobbles future growth. And that could happen if President Trump actually delivers on the protectionist agenda he championed as a candidate. But barring an historic reversal in U.S. economic policy, the credit outlook is surprisingly positive. “In the report, we wanted to express a balanced view. We don’t want readers to forget the significant strengths that the U.S. has, and that other highly-rated countries don’t have,” says Carlson.
Still, America’s indebtedness is growing at a rapid pace, making the outlook unusually fragile. Remaining an economic juggernaut is now essential to averting a credit crunch, a situation we’ve never faced before. Here are the prime drivers of our fiscal decline, and the countervailing strengths.
The big problem: Diminishing growth
Following the Great Recession of 2007 and 2008, the outlook for U.S growth declined substantially. In the post-war decades, the GDP typically advanced at around 3% annually. Today, the CBO, OECD, World Bank and IMF all forecast expansion about one-third lower, at 2%. Most of the other big industrialized nations have experienced a similar decline in both performance and expectations. Moody’s also expects the U.S. long-term growth to decelerate to around 2% in the next 10 to 15 years. That’s still a “healthy level,” says the report, but it signals that the U.S. will lose ground to developing nations, which are suffering far smaller declines in growth than the industrialized world.
The even bigger problem: “Debt affordability”
As the report notes, America’s debt and deficits were on a steep upward trajectory before passage of the tax cuts. Since 2008, total federal debt has doubled, and the ratio of federal borrowings to GDP has jumped by 40 points, to 77% in 2017.
As Moody’s points out, last year’s deficit of 3.4% of GDP was the highest of any industrialized nation except Japan, and the shortfall is headed skyward. Moody’s forecasts that debt to national income will jump to just over 100% by 2027, and that the new tax cuts will have added 5 points to the previous forecasts of around 95%.
Here’s the rub: Although debt will surge, interest payments will rise a lot faster–for two reasons. First, Moody’s reckons that rates will not only increase substantially, but wax a lot more quickly than the CBO projects, going from the current 2.9% to 4.3% by 2024. Second, the average time to maturity on U.S. debt is six years, meaning that most of the low-yielding bonds now on the books will be exchanged for more expensive debt over the next decade. further raising future interest costs. “In the U.K., the average time to maturity is around 15 years, and it’s 7 to 8 years in most other major European countries,” says Carlson.
The acceleration in interest expense, exceeding the rapid trajectory of borrowing, will make America’s debt far less affordable, and at worst, unaffordable. Today, the U.S devotes 8.1% of federal revenues to debt service, a level exceeded only by Italy among major OECD nations. By 2027, the share going to interest will catapult to 21.4%, according to Moody’s forecast, or more than one dollar for every five tax dollars collected.
“For assessing the interest burden, the most important measure is the share of revenues,” says Carlson. “Revenues pay for government programs. If interest takes a larger share of the pie, that puts constraints on other choices.” Interest’s fast-growing slice, Carlson continues, makes it much more difficult to fund infrastructure, education or community health care.
America’s unique strengths
Moody’s stresses that the dollar’s central, essential role in the global economy will help the U.S. address some of these problems. Because foreign nations park their export earnings in dollars, the U.S. can always tap a deep pool of savings to sell its bonds and finance its deficits. The greenback cushions the U.S. against shocks that can ravage competing nations. In a global crisis, investors and governments seek in Treasuries and other dollar assets as a safe haven. Put simply, the U.S. benefits from a big edge because it can always borrow, and usually at excellent rates.
The report also evokes America’s unmatched scale and economic diversity. The U.S. boasts one of the world’s most flexible labor markets. We supply most of the energy and food consumed at home, providing a cushion against swings in global commodity prices. The U.S. benefits from a great entrepreneurial spirit, and harbors the world’s largest service sector, encompassing five of the world’s biggest tech companies.
Thanks to the potent dollar and its economic might, the U.S. is a special case, says Carlson. Its ability to shoulder mountainous debt is far greater than that of competing nations.
Here’s what could cause a fiscal
As Moody’s warns, “Declining growth potential, coupled with an emerging aversion to open trade and foreign labor and rising global competition may cause this key source of relative strength to erode over the long term.” Of course, the “relative strength” refers to the America’s twin champions, the transcendent dollar and the traditionally superb performance of its economy.
Moody’s doesn’t make any predictions about missteps that could lead to a fiscal crisis. But here’s my take on what could go wrong. If the the Administration shuts down NAFTA and substantially curbs the influx of foreign workers growth could fall below 2%, and federal tax collections would drop. Our interest burden would soar beyond the 21.4% of revenues now forecast. America’s Aaa rating would very likely be downgraded. Borrowers would get spooked, and demand higher rates on what were once perceived as the world’s safest bonds. That would further inflate interest costs, likely triggering a full-blown fiscal crisis.
The Moody’s report is an important primer in how America’s economic dominance provides a shield for fiscal policies that would ruin our global competitors. If we retain our traditional power, our stellar credit rating will remain in place, defying the decline in our balance sheet. But that’s the ten-year view. As Carlson says, both major cuts and spending and major increases in revenue are essential. If they don’t happen, the U.S. risks a debt “affordability” crisis in the 10 years after that. The reckoning may be a long way off. But our current course promises a rendezvous with disaster.
