U.S. government debt received a downgrading

Late on Tuesday, Fitch Ratings became the second of the three major credit-rating firms to drop its coveted triple-A rating of the United States government's creditworthiness. This caused a fight in Washington about spending and tax policies.

Fitch said that the main reasons it went from AAA to AA+ were because the federal government's debt was getting worse, and it was hard for the U.S. government to make decisions about spending and taxes because of politics.

Fitch said that its decision "reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance" compared to other countries with similar debt ratings.

The reduction might not have much of an effect on the financial markets or the interest rates that the U.S. government will pay in the long run. What you need to know is this:

The move by Fitch comes just a few weeks after the White House and Congress made up their minds about whether or not to raise the government's borrowing ceiling. A deal made at the end of May raised the debt limit for two years and cut spending by about $1.5 trillion over the next ten years. Janet Yellen, the Secretary of the Treasury, had warned that if talks didn't end by a specific date, the government would stop paying its debts.

The move made the Biden government very angry. Yellen said on Wednesday that Fitch's flawed rating is based on old data and doesn't take into account the improvements we've seen in a number of areas, including governance, over the last two and a half years.

"Despite the deadlock, both parties have worked together to pass a bill to solve the debt limit problem," Yellen said.

But Douglas Holtz-Eakin, president of the American Action Forum and former head of the Congressional Budget Office, said that Fitch made the right choice because Washington isn't doing much to fix the government's long-term budget deficit.

"This is about a fundamental mismatch between our spending growth and our ability to bring in money over the long term," he said.

After a similar standoff over the borrowing cap in 2011, Standard & Poor's took away the coveted triple-A rating from U.S. debt.

Fitch said that the ratio of U.S. government debt to the size of its economy will likely rise from almost 113% this year to more than 118% in 2025. This is more than two-and-a-half times higher than is usually the case for governments with triple-A or even double-A grades.

WHAT USUALLY HAPPENS WHEN DEBT RATINGS ARE LOWERED?

Rating agencies like Fitch and its competitors Standard & Poor's and Moody's Investors Service rate all kinds of corporate and government debt, from local government bonds to debt released by big banks.

When a debt issuer's credit rating goes down, it usually means that it has to pay a higher interest rate to make up for the fact that it may be more likely to fail on its debt.

WHAT COULD THIS MEAN FOR TAXPAYERS IN THE U.S.?

Many pension funds and other types of investment vehicles are required only to hold investments with good credit ratings. If, say, a city or state's credit rating drops too low, these investment funds would have to sell any shares they own from that city or state. That would mean that the government that issued the bonds would have to pay a higher interest rate on future bonds in order to attract more buyers.

If that happened to U.S. Treasury securities, the federal government might have to pay higher interest rates, which would raise interest costs for the government and people.

WILL THE COST OF LOANS IN THE U.S. GO UP?

Few analysts believe that this will actually happen. Instead, they think the rating by Fitch will make little difference. Goldman Sachs says that only some pension funds can hold debt with a triple-A rating. This means that the current AA+ rating from Fitch and Standard & Poor's will be enough to keep demand for Treasurys high.

Alec Phillips, the chief political economist at Goldman Sachs, said in a research note, "We don't think any large holders of Treasury securities will be forced to sell because of a downgrade."

In an interview, Phillips said that regulators wouldn't change the rules that force big U.S. banks to hold Treasurys because of the downgrade. This is because regulators will still see Treasurys as safe investments.

Most buyers think that U.S. Treasury securities are in a class all by themselves. The U.S. government bond market is the biggest in the world, which makes it easy for investors to buy and sell Treasurys as required. Because the United States has a big economy and has been politically stable in the past, many buyers see Treasurys as almost as good as cash.

Most of the time, smaller, less well-known debt issuers, like local governments, feel the effects of downgrades from rating agencies more. Phillips said that in these situations, even big buyers might need to learn more about the bond's creditworthiness, so they depend more on the rating agencies.

But, that's not true for Treasury bills and notes. He said that significant investment funds and banks don't use rating companies to decide what they think about Treasury securities. Instead, they make their own decisions. He also said that Fitch's research only told us a little new. Other groups, like the independent Congressional Budget Office, have made similar predictions about where the U.S. government's debt is going.

Phillips added, "No one holds Treasuries because of the ratings."

WHAT DOES "GOVERNANCE" MEAN TO FITCH?

Fitch said that a drop in "governance" was a big reason for its downgrade. This was a reference to the many fights in Washington over the past 20 years that have led to government shutdowns or even brought the government close to defaulting on its debt.

"The repeated political standoffs over the debt limit and last-minute fixes have hurt trust in fiscal management," Fitch said.

At the same time, Fitch is talking about how even compromise legislation can't deal with the long-term causes of the federal government's debt, like entitlement programmes for the old like Social Security and Medicaid.

Fitch said that there hadn't been much done to solve the medium-term problems of rising costs for Social Security and Medicare because of an ageing population.