Two weeks ago, on the evening of May 16th, Moody’s (one of the three credit rating agencies) downgraded the sovereign debt of the United States. The credit rating was trimmed back from the top Aaa to Aa1, one notch below.
Successive US administrations and Congress have failed to agree on measures to reverse the trend of large annual fiscal deficits and growing interest costs. We do not believe that material multi-year reductions in mandatory spending and deficits will result from current fiscal proposals under consideration. Over the next decade, we expect larger deficits as entitlement spending rises while government revenue remains broadly flat. In turn, persistent, large fiscal deficits will drive the government’s debt and interest burden higher. The US’ fiscal performance is likely to deteriorate relative to its own past and compared to other highly-rated sovereigns.
An especially striking comparison was drawn between American debt interest costs and those of other top-rated countries.
The US general government interest burden, which takes into account federal, state, and local debt, absorbed 12% of revenue in 2024, compared to 1.6% for Aaa-rated sovereigns.
In and of itself, the downgrade was not a huge surprise; if anything, the surprise was that it took Moody’s so long to get around to it. Fitch Ratings downgraded the United States from its own top rating in 2023, and S&P did the same way back in 2011.
On the one hand, the downgrade is unlikely to have any real material impact. Going from the top rating of 21 to the second top may be a psychological blow, but the chances of a default are still incredibly low. Whilst moving from being rated as investment grade to junk status is a big step down the credit ratings ladder, moving from Aaa to Aa1 is a much smaller step. Especially when the other two rating agencies have already moved.
What matters more is the underlying debt dynamics that led to the downgrade in the first place – especially now that Congress has passed the so-called Big Beautiful Bill, which will materially add to government borrowing in the coming years.
As the Economist argued last week:
Today’s official forecasts, which suggest that net debt interest could soon hit a record high as a share of GDP and then keep rising, are bleak—and they assume that the 2017 tax cuts expire and that deficits will narrow. The new law would ensure that deficits stay around 6-7% of GDP, raising forecast debt in 2034 by about $3trn. And if new temporary tax cuts become permanent, the cost could exceed $4trn. These measures include tax exemptions for tips and overtime pay that were promised by Mr Trump during his election campaign. Once enacted, they will be hard to get rid of, whatever the law says.
Nor are tariff revenues or faster economic growth likely to fill the ever-growing fiscal hole. Thirty-year government bonds yield are now around the 5% mark, and the ten-year around 4.5%, both at or near post-financial crisis highs. The difference, though, with 2006 is that nowadays Federal debt to GDP is around 125%, whilst it was closer to 45% back in 2006.
The panel was first asked whether ‘Long-run US fiscal sustainability will require some combination of slowing the growth of spending on Medicare, Medicaid and Social Security benefits and/or tax increases, including higher taxes on households with incomes below $400,000’?
Weighted by confidence, 47% of respondents strongly agreed and 47% agreed. That is pretty much a slam-dunk consensus as far as these polls go.
The panel then considered the (now passed) Big Beautiful Bill directly. They were asked whether ‘Issuing an additional $2.3 trillion of debt over the next 10 years, as is projected by the Congressional Budget Office if the House Reconciliation Bill is enacted, will substantially raise interest rates on government debt over that period’?
Again, weighted by confidence, 27% of respondents strongly agreed and 63% agreed. As Darrell Duffie of Stanford put it, ‘The logic seems pretty inescapable. Actually, recent upward shifts in long-term bond yields already seem to be a reflection of the increased likelihood that this bill will pass’.
The strong consensus then, amongst the Experts, is that US fiscal policy is likely to substantially add to US interest rates in the years ahead and, given the already large stock of debt, push up interest costs – as a share of revenues – ever higher. Without strong corrective action of the kind identified by the first question posed, an ever greater share of US revenues will be devoted to servicing debt.
Of course, policymakers may be inclined to shrug their shoulders and say that they’ve heard this all before. US fiscal policy, in the view of most economists, has been on an unsustainable path for many years. But if something is unsustainable, it will eventually stop. And the process of adjustment could well turn out to be painful.
