>> Intro:
Welcome to the Wells Fargo, Ask Our Economists podcast series, where we explore what's on our clients minds, provide timely commentary on what's happening in the markets and discuss our outlook for the ever-changing investment landscape. Our economists provide their views on the latest domestic and global trends, insights on the demographics, social issues and challenges that impact our world, all which help you manage risk and capture opportunities. Join us as we take you down the road of navigating today's economic climate with confidence.
>> Jay Bryson:
Hello, I'm Jay Bryson, chief economist of the Corporate and Investment Bank at Wells Fargo. And you're listening to our Ask Our Economists podcast series. And today, I'm joined by senior economist Michael Pugliese to talk about some recent debt downgrades of US sovereign debt. So, Mike, as you well know, recently Fitch, which is one of the three major rating agencies, downgraded U.S. debt to sovereign debt from its highest rating, AAA to a AA+. And as some listeners may recall, this happened back in 2011 at the time of the debt ceiling debate. At that time, when Standard and Poor’s downgraded us. And so now it's been 12 years and just one more rating agency of the major ones. Moody's still has U.S. sovereign debt on AAA status, although it is on a negative watch. So, Mike, let's talk about that downgrade. Why did Fitch do it and was it expected or not?
>>Michael Pugliese:
Yeah, So I think in order to understand the downgrade, it's important to start a little bit with how we got here on the fiscal front over the course of the pandemic. So pre-pandemic at the end of 2019, the US debt to GDP ratio for the federal government was about 79%. So the national debt was about 79% of the US economy. And then when the pandemic struck, that skyrocketed. As a result of the economic damage from the pandemic and all of the fiscal aid that the federal government adopted to support the economy. So that same ratio went from 79% before the pandemic to a little over 100% in the second quarter of 2020 at the peak of the pandemic. But over the last few years, that's actually declined a little bit. So the federal government's debt to GDP ratio has fallen down to 93% around the start of this year. But more recently, that started to turn. It increased in the second quarter. And I think as we get data for the third quarter and the fourth quarter and into next year, you're going to start to see that increase again. And that was one of the two things that Fitch cited, was a deterioration in the medium-term fiscal outlook. Some of this for known reasons we've already been talking about for years, an aging population, rising health care costs, pressuring entitlement spending, but also some new things in terms of new spending initiatives, higher interest costs, normalizing revenues after they surged during the pandemic. And the second thing Fitch cited as a reason for its downgrade was sort of deteriorating governance as a result of the most recent debt ceiling fight and just the recurrence of these debt ceiling disputes, government shutdowns and some of the other sort of budget challenges the US government has had for really more than a decade now. To your point, Jay, the last downgrade happening in 2011 when that debt ceiling debate was going on. So I think the downgrade was unexpected. There have not been a lot of these over history. So certainly was not something that markets or analysts were looking for. But I think you can kind of see between the governance side and this shift on the fiscal front at least a little bit why it may have happened now and not say, you know, a year ago or three or four years ago.
>> Jay Bryson:
Okay. So you just said something kind of interesting there. You said that markets kind of, you know, were a little bit surprised and taken aback, you know, whatever. You know, I would think that, you know, if you downgrade someone's debt, that they're probably going to see higher interest cost on that. So, I mean, have we seen a major impact, particularly on the Treasury market? Are we looking at higher yields? Does the US government now have to pay more for its debt because of this downgrade?
>>Michael Pugliese:
So I think financial markets reacted a little bit to the downgrade, but certainly nothing major or material. So when you look at risk assets like equities, they were down a bit over the course of the following day or two after the downgrade, but certainly nothing calamitous. And same in the Treasury market where you saw yields in particularly longer-term yields rise a bit over the following couple of days. But one, it wasn't a whole lot. We're talking ten or 20 basis points over those next few days. And two, I'm not even entirely sure that was solely due to the downgrade. So I don't want to say there was no financial market reaction. But you know, we're not talking about a world where the credit downgrade happened on the federal government and yields doubled or something along those lines. It was a fairly small and muted reaction across really all markets, but also definitely the Treasury market as well.
>> Jay Bryson:
Thanks for that. So I'm going to say something that may sound a little bit controversial at least to some of our listeners here, and it's not the level of debt per se that is potentially problematic. I mean, you think about it, right? You know, a very large corporation can sustain a large amount of debt relative to a smaller sort of one. So it's really, it’s not the level of debt per se, but it's the say, the inability to service that debt to make the interest and the amortization payments on that debt. That's what gets, you know, not only individuals and corporations into problems, but, you know, potentially, you know, a government as well. So, you know, with that in mind, can you talk a little bit on the ability of the US government to service its debt? How much is interest as we pay as a percent either of the federal budget or maybe as a percent of GDP? I mean can you put all that into context for us, what's the ability to service that debt?
>>Michael Pugliese:
Yeah, so what I would say on that front Jay is over the 2010s, what we saw was much higher debt burdens than had been the case in previous decades for the federal government, but actually lower interest spending. So even though the debt to GDP ratio more than doubled between 2007 and 2019, you saw interest spending that as a share of the economy really didn't do a whole lot of anything in terms of rising or falling as a result of much lower rates over the course of the 2010s. So to put it in perspective, interest spending as a share of GDP was about 1.7% at the end of 2019. Now, more recently, that started to shift. So right now, interest spending as a share of the economy for the federal government is about 2.5%. So it's clearly gone up. Now, is that a particularly worrisome level? I would say no right now. We've seen those interest spending as a share of GDP levels before. Throughout the 1980s and much of the 1990s, it was sort of around 3%, you know, 3.25% somewhere around then. So, you know, we're not even at the highs we've seen in relatively recent history. But I do think the trend is concerning because the longer-term fiscal outlook is very sensitive to interest rate assumptions. So if we're going to have a ten year yield that's 4% on a go forward basis like it is right now, over the next 5 to 10 years, that's double what it was roughly on, say in, 2019 or so. And so, you know, I don't think of it so much as what is the interest burden at the moment, but are we looking at a world where interest rates are going to be a lot higher over the next decade than they were in the previous decade? And is that going to have this compounding impact? When you look at the Congressional Budget Office's forecast, so CBO is kind of one of the top fiscal analyst groups in D.C. And when you look at their sort of longer term projections, they've got interest spending as a share of GDP at about 3.6%, 3.7% in a decade from now. And that's assuming a ten year yield of about 3.8% over the longer run, which isn't all that far from where we are today. And that would be a very high share of GDP in terms of interest spending if we actually realized those numbers higher than what we saw in the 1980s and 1990s and certainly higher than we're seeing today. So when I think about can the federal Government carry this interest burden for now, I think the answer is absolutely. It's really not something I'm all that concerned about at the moment. But I think it does certainly open the question of where will we be five, ten years down the road If you see yields at these levels that are sustained not just for the next 12 months, but say, for the next ten years or so, that puts a much bigger sort of fiscal squeeze on the federal government than was the case in much of the 2010s when rates were a lot lower.
>> Jay Bryson:
So to sum that up, Mike, it sounds like you're not overly concerned about the ability of the US government to service its debt right now, but isn't there you know, I'll call it an opportunity cost in some sense, right? If you're, if the government is paying more to service its debt, even though it can service it, if it's paying more to service its debt, isn't that going to potentially squeeze other parts of the budget? Right. Maybe you won't be able to spend as much on, I don't know, the military or you won't be able to spend as much on building roads or something like that. So, you know, can you talk a little bit about where interest as a percent of the budget is right now? And maybe put that into historical context as well?
>>Michael Pugliese:
Yeah. So, you know, pre-pandemic again, just kind of using this pre and post pandemic baseline, interest spending as a share of the federal budget was 8%, maybe a little bit over 8%. And now it's up to 10%, a little over 10% and rising. Right. That's headed higher again, as I already noted, in the coming quarters. And so you're up to about $0.10 on the dollar of federal government spending is going towards just servicing the debt. And exactly to your point Jay, you know, that can crowd out other forms of spending depending on the fiscal policies that Congress and the White House adopt on a go forward basis, whether that's defense spending, as you mentioned, or other investment initiatives or money transfer payment programs that the federal government runs because the deficit is pretty big right now. It's now trending towards somewhere between 6% and 7% as a share of GDP, which is unusually large for an economy that's pretty good. With unemployment at about 3.5%, growth is hanging in okay. And I think this is really where the concern came from for Fitch in terms of if you're running deficits this big in good times, what will that look like a few years down the road? If rates are still pretty high, there's potentially a recession on the horizon in 2024. You know, all these different factors kind of layered on the governance issues. And I think you can see why at least from Fitch's view, the downgrade was warranted. So maybe kicking it over to you then, Jay, we've talked a little bit about the short-term outlook for interest spending and the fiscal outlook more broadly.
We’ve talked about the market reaction. What about longer run, right? I mean, do you have any concerns about sort of a longer run, maybe this downgrade or the fiscal deterioration more broadly plays into the U.S. losing its role as the world's reserve currency?
>> Jay Bryson:
Yeah. So I guess, like you, Mike, you know, I'm not overly concerned about things here in the short term, you know, maybe in the long run. But, you know, here in the short term, I don't think it really has any major impact. I mean, at the end of the day, the market for U.S. Treasury securities is the deepest, most liquid, most transparent financial market in the world. Treasury securities serves as collateral for trillions and trillions and trillions of dollars of other financial sort of transactions. And the long and the short of it is there's just no substitute for U.S. Treasury securities. You know, people talk about Europe or the Eurozone. Well, if you think about it, the Eurozone is a collection of, you know, 19 or so, you know, sovereign countries. Spanish or Portuguese government bonds are just not the same as German government bonds. And the German government bond market, although it's one of the best in the world in terms of ratings it's just nowhere close in terms of size to the U.S. Treasury market. You know, Japan has its own set of long-term fiscal challenges. And then there's also China. But I’d mention the word transparency in terms of the U.S. That's certainly not really the case when it comes to Chinese financial markets. So, you know, in the near term, I don't worry about a downgrade like this affecting the status of the U.S. dollar in terms of its reserve currency status. You know, maybe if you and I are having this conversation ten, 15, 20 years from now and things have gotten even worse and worse then maybe. But, you know, again, right now, again, there's just no substitute for U.S. Treasury securities. So I'm just not overly concerned about that. Mike, let me let me ask you a follow up question. You know, what's to be done here? Are we just going to have to wallow in continuous downgrades going forward? I mean, is there a way out of all of this?
>>Michael Pugliese:
You know, what I would say is that if there's good news here, it's that it's not just that the U.S. Treasury market is the world's deepest and most liquid and backing that world’s reserve currency. The United States also has the world's largest and most diversified economy. It produces $27 trillion of annual GDP per year and growing. Household net worth in the United States is more than $140 trillion at present. And Fitch actually noted in its in its credit downgrade that a possible catalyst for an upgrade in the future could be either bringing mandatory spending in line with current revenues as a share of GDP or alternatively bringing revenues in line and up to fund these sort of commitments on the spending front on a go forward basis. So whether policy makers will adopt one of those paths or a mix of the two or neither remains to be seen. But a medium-term fiscal adjustment to kind of meet those fiscal realities would certainly be something that I think could be a positive catalyst on the fiscal front for a future upgrade and to alleviate some of these challenges and concerns we've talked about over the course of our discussion here today.
>> Jay Bryson:
Well, thanks, Mike, and thanks for the discussion today. Obviously, these issues won't get solved here in the near term, but maybe as you mentioned in the medium term, maybe there's a solution there. But thanks, Mike, for joining us today. And thank you all for listening and thank you for the questions that you continue to submit to us for this series. Thank you very much for joining us today.
>>Outro:
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