Confidence in Institutions Matters More Than Sovereign Credit Ratings. . .

At first glance, the indifference (and derision) with which markets met the downgrade seems justified. Moody’s hasn’t told investors anything they didn’t already know. While countries with lower credit ratings do face overall higher borrowing costs, the spread between yields on US bonds and those of other advanced economies already reflect the higher risk premia (additional borrowing costs) of the current fiscal outlook. That is, bond markets had already “priced-in” the slightly higher default risk supposedly conveyed by the new credit rating.

More importantly the one-notch downgrade doesn’t matter from a financial risk perspective. The debt-to-asset ratio that regulators require from banks aren’t calculated by considering the decision of ratings agencies like Moody’s. US bonds will also remain high-quality collateral for funding. Despite the downgrade, Moody’s is still of the opinion that US debt is “investment grade,” which applies to any debt rated above “BBB-.”

Consequently, yields on US Treasuries ticked up (reflecting higher borrowing costs) but did not exceed the levels they had risen to in previous weeks.

In the larger scheme of things, downgrading the credit of a country that issues debt in its own currency does seem odd. After all, barring any drastic changes in the world economy, demand for US debt securities will remain high. Put simply, if you both print and issue dollars, your outstanding debt in dollars doesn’t pose a problem.

And even if what economists call the “exorbitant privilege” of the dollar were to evaporate one day, the experience of advanced economies such as Japan suggests that government deficits can be financed by central banks for lengthy periods. Despite its national debt totaling 263 percent of GDP, more than twice the size of the US debt stock, and budget deficits often in excess of 5 percent, Japan’s debt remains investment-grade. It also faces significantly lower borrowing costs than the United States. Ten-year Japanese government bonds currently yield investors around 1.5 percent compared to the 4.5 percent for Treasuries of the same maturity.

It is certainly true that this arrangement required inflation to be muted over much of the last decades, the Bank of Japan to keep interest rates and thus government borrowing costs low across the maturity spectrum. This is because bond yields strongly correlate with interbank lending rates set by the central bank; higher rates imply higher returns on cash and other assets, which causes investors to “optimize” their portfolios by shedding bonds. That is to say, had inflation been higher, as it was in the United States, this would have put pressure on the central bank to raise rates to shore up the value of the yen. This, in turn, would have increased the borrowing and debt-servicing costs of the Japanese government.

What it reflects above all, however, is widespread market confidence, not just in long-term prospects of the Japanese economy, but in the character and stability of the country’s institutions and macroeconomic policymaking. Firms are likely to keep workers in employment, borrowers are likely to pay back their debts, and the rule of law is likely to be respected. This is the sufficient condition for an economy to conduct an expansive and deficit-financed fiscal policy without incurring serious consequences.

. . .but for the US, That Confidence Is Slowly Fading

The events of recent weeks provide evidence that confidence in America is eroding. Moody’s announcement follows an unprecedented capital flight from the US financial system, reminiscent of the dynamics faced by “emerging markets,” whose main predicament is that they cannot issue large amounts of debt in their own currency.

Some expected the initial sell-off in the stock market, precipitated by Trump’s erratic trade war, to be followed by a rush of investors into Treasuries. Though the returns they promise are lower than those of equities (stocks) they are “safe-haven” assets and preferable to holding cash whose value is depreciated by inflation. What happened instead was a flight from the US bond market. This raised yields and strained financial markets globally. The third layer, after stocks and bonds, preventing investor flight is the dollar system itself. But investors deemed that dollar-denominated assets, too, were not safe enough, a fact that became evident by the greenback’s depreciation relative to virtually every other major currency.

While the stock market at least seems to have reversed its losses for now, the repeated breach of this triple integument of American financial power signals a larger shift in sentiment. The economic exceptionalism that had up to now allowed investors to turn a blind eye to persistent “twin deficits” (in trade and fiscal policy) seems to be fading.

In this context, the credit rating suddenly seems oddly relevant. While perhaps irrelevant from a financial risk perspective, it is a litmus test for markets concerned with the overall trajectory of US fiscal policy in an unfavorable geoeconomic context.

These cracks in the dollar system are emerging just as major European economies (France and Germany in particular) are finally committing to large debt-financed spending programs. This is in stark contrast to 2011: when S&P initially stripped the United States of its “AAA” rating and Treasury yields didn’t budge. This was at least in part due to the EU’s austerity measures, which limited the availability of other investment-grade government debt. Now investors have other options.

While the repercussions of his tariff policies have prompted Trump to temporarily suspend many of these measures, it is hard to see confidence in American policymaking drastically improving. To wit: just over the weekend, following Moody’s downgrade, the president openly threatened the credit ratings agency, further lambasted the Federal Reserve for not lowering interest rates, and raged at retail giant Walmart for (predictably) passing on the burden of higher import costs to consumers.

And on Sunday, Republicans announced a reconciliation budget that through a combination of highly regressive tax cuts for the wealthy and drastic curbs on welfare spending would constitute the single largest upward redistribution of wealth ever enacted by legislation.

In addition to weakening the fiscal outlook by further decreasing future tax revenue, this bill is set to deepen the social crisis that endangers American economic prospects in the long run. As geopolitical tensions and the effects of the trade war start to bite, it is easy to imagine a scenario in which America’s economic exceptionalism erodes to the extent to which it can no longer compensate for the increasing dysfunction of its institutions and politics.

While further adverse reactions to government budget announcements and downgrades in credit worthiness are likely, nothing currently suggests that the United States is close to defaulting on its debt anytime soon. Rather, as is common with such crises, the transition to “emerging market” status will likely proceed gradually — then all at once.