Economist Brian Easton says the recent reduction in the US credit rating signals that market lenders are not happy with the US fiscal arrangements. New Zealand’s lower rating is a warning that we could do better too

This is a re-post of an article originally published on pundit.co.nz. It is here with permission.

Fitch recently lowered its long-term credit ratings rating of US government debt from the top grade of AAA to AA+. Financial markets hardly moved – they had already incorporated Fitch’s reservations in their thinking.

Borrowers, including the New Zealand government, pay credit raters (the other main ones are Moody’s and Standard and Poor) to assess their credit worthiness. The raters also give an indication of how they may change their rating next time. New Zealand’s Fitch long-term credit rating is AA and ‘stable’, just below the US one which is also stable. Countries above the US at AAA include Australia, Denmark, European Union, Germany, Luxembourg, Netherlands, Norway, Singapore, Sweden and Switzerland – all are stable too. (For a list of country ratings see here.)

Lenders require a rating to assess the risk of investing in sovereign bonds; some may not even be allowed to hold the bonds unless the rating is above a particular level. The higher the grade, the more willing they are to invest; usually the higher grade bonds pay lower interest rates. Credit ratings also reduce the costs of monitoring for lenders. I guess a country acquiring a credit rating is a kind of penance for borrowing; not having one reduces a country’s ability to borrow.

Ratings below AAA do not mean that the credit rating company or the lenders expect the country to go into meltdown soon. But there could be a hitch. I take it that Fitch’s US downgrade arises from an inconsistency in US laws. Congress approves the US government’s additional borrowing (spending more that its revenue) but it also sets a debt ceiling which total debt may not exceed. The two figures may not reconcile – inevitably so, if the government keeps borrowing in the long run.

As total US government debt nears the ceiling, the political parties in Congress play a kind of ‘chicken’ of who yields first. On the last occasion this year, the Republicans, who are not in the executive, refused to raise the ceiling, while the Democrats, led by President Biden, refused to restrain spending. After much political argy-bargy, which included the president cancelling an important overseas trip, the Republicans agreed to suspend the ceiling in exchange for the Democrats making some spending concessions. The next round of chicken is expected in 2025, when there will be a new Congress and possibly a new president. (The last round was in 2021.)

No one is sure what exactly would have happened if no agreement had been reached. The US government would not have melted down, but certainly there would have been turmoil in the US market for treasury bills, which underpins the entire international financial system. The Fitch downgrade was intended to signal that it was time that the US got its financial arrangements into order. Others in financial markets would say ‘hear, hear.’

More fundamentally, the crisis arises out of the structure of the US constitution – the oldest functioning one in the world. It was greatly influenced by the British arrangements of the time in which the king still had a lot of power. Instead of a king the US constitution provides for an elected president who still has a lot of the eighteenth-century royal powers. Meanwhile the British system, which we follow, evolved until most of those royal powers became held by a prime minister appointed by parliament and commanding its confidence.

The US has no such prime minister. It is quite possible for its president to not have the confidence of either its House of Representatives or its Senate. (The British parallel of the House of Lords has been largely neutered; New Zealand’s – the Legislative Council – was abolished in 1950.) This can happen – and has happened – when both arms of the US Congress are dominated by a party different from the President’s. In any case, US political parties are not as well-disciplined as the British and New Zealand ones – and you may think even those are a bit shambolic.

Why does New Zealand get an AA rating? Are not our public debt-to-GDP ratio low and our public accounts transparent by international standards? Yes, but Fitch does not look only at our public debt. It looks at private foreign debt and the indirect public exposure to it. After all, during the GFC bailout, the New Zealand government ended up, in effect, owning a large proportion of private housing mortgages, when they were used to underwrite the support commercial banks, heavily exposed to offshore debt, needed. The crisis was handled so smoothly that the public was largely unaware of the achievement. Had there been a hiccough, the economy’s financial markets would have been in deep trouble and so would have been the economy.

Our overseas debt, denominated in foreign currencies – most often subject to exchange rate risk – is almost all private, while New Zealand public debt is denominated in New Zealand dollars – it has overseas investors but they take the exchange rate risk. (Will they always?) But the private overseas debt is interlinked with the public debt as the GFC crisis demonstrated. The credit rating agencies (and our Reserve Bank and Treasury) understand that, even if not everyone does.

Very often the commentators’ monetary theories ignore the foreign sector of the economy. I read the books and other accounts which explain their theories, look up the index and too often there is not a single reference to the exchange rate, foreign capital flows, exports and imports. It is not sufficient to say that under a floating exchange rate attention to the external sector is unnecessary, because financial capital flows are very influential on exchange transactions, the exchange rate and the domestic monetary situation.

I can understand how the theories apply better to the US economy, because it issues the international currency. (Even so, most American economists are wary of the theories for technical reasons.) But, for heaven’s sake, the New Zealand dollar is not the US dollar. Haven’t those commentators noticed?

So the credit rating agencies look at New Zealand’s substantial private foreign debt and downgrade our standing accordingly. It’s a warning to us, and to anyone lending to us, just as Fitch was warning the US about its financial arrangements.

*Brian Easton, an independent scholar, is an economist, social statistician, public policy analyst and historian. He was the Listener economic columnist from 1978 to 2014. This is a re-post of an article originally published on pundit.co.nz. It is here with permission.