The Crisis in Financial Governance

And now there are two.

“In Fitch’s view, there has been a steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters, notwithstanding the June bipartisan agreement to suspend the debt limit until January 2025. The repeated debt- limit political standoffs and last-minute resolutions have eroded confidence in fiscal management. In addition, the government lacks a medium-term fiscal framework, unlike most peers, and has a complex budgeting process. These factors, along with several economic shocks as well as tax cuts and new spending initiatives, have contributed to successive debt increases over the last decade.

Additionally, there has been only limited progress in tackling medium-term challenges related to rising social security and Medicare costs due to an aging population.”

Fitch Ratings, partial explanation for the downgrade in U.S. Treasuries, August 1, 2023¹

Erosion of our Fiscal Foundations

Last month, the worldwide credit rating company Fitch Ratings joined an earlier action by Standard and Poor’s in downgrading U.S. debt.²
Out of the big three rating companies, only Moody’s Investors Service will continue to give the long-term debt of the United States a AAA rating.

Curiously, this momentous event, which marks a stunning turning point in U.S. financial history, was widely discounted by official Washington. The downgrade shocked the White House, which quickly was dismissive of its consequences.³ Leadership in Congress and in much of the financial sector discounted Fitch’s action by pointing to its use of “outdated data” and the rating company’s errors during the housing collapse of 2006 and 2007.[4 Wall Street Journal, “Fitch Downgrades U.S. Credit Rating,” August 1, 2023, at https://www.wsj.com/articles/fitch-downgrades-u-s-credit-rating-56c73b89. Accessed on July 7, 2023.]

The news coverage and, indeed, much of the commentary on the downgrade, followed the recent Washington script: finger pointing on who failed to slow spending or settle the most recent dispute over the debt limit. The big story, the one Fitch hoped we would see, has been largely missed. The downgrade stems from a massive erosion of governance standards, including fiscal governance, and, thus, the triumph of fiscal dominance over the Hamilton norm. This great 230-year policy norm—that Congress would always act in a way that supports the credit of the United States and the stability and convertibility of our debt—has crashed into a wall of dominating fiscal objectives which threatens long-term harm to America’s economy and her citizens.

This essay briefly describes the dramatic decay in Congressional support for this incredibly important policy norm. It starts with the policy foundation which has nurtured for centuries the soundness of our currency and debt. We call that foundation the Hamiltonian Norm.

The Hamiltonian Norm

The Founders had a long list of action items in 1789, including initiatives to boost the revenues of the new federal government, secure the defense of our western frontier against British incursions, and set the multitude of precedents that filled out the details on the powers of the legislative and executive branches under the brand new Constitution.

Perhaps highest on their priority list was the creation of a stable banking and monetary system.⁴ The new Republic needed to swiftly assure its major creditors, primarily Dutch and French banks, that we would repay our debts and be a good credit risk. A substantial amount of credit for establishing our financial system must be given to Alexander Hamilton. In particular, his 1790 essay on national banking (Second Report on the Further Provision Necessary for Establishing Public Credit (Report on a National Bank) urged the full funding of our national debt and the creation of a national bank.⁵ Hamilton intended both these steps to be the foundation of a high degree of trust in the new country’s credit system, which would encourage other countries to fold us into the international financial system of the time. It worked exceptionally well.

Over the course of the next 200 years, the “Hamiltonian norm” meant that the U.S. always worked to repay its debts, our monetary system was one of low inflation (thus, supporting the value of our bonds instead of letting inflation devalue them), and our fiscal programs would not endanger this norm. In other words, Congress would not spend in such excess that our credit might be in danger or force the monetary authorities to accommodate the fiscal authorities.

This Hamiltonian regime means that deference is given to the value of our money or credit. Another way of naming this regime is monetary dominance. That means the inflation rate stays on target thanks to the actions of the central bank, and Congress restrains spending whenever publicly held debt gets too high.⁶

When Congress continues to spend above its revenues and adds more red ink to an already high level of debt, this behavior could lead to fiscal dominance. This is a state of financial affairs that prevails when our central bank, the Federal Reserve, is primarily reacting to the financing needs of Congress. In this scenario, the bank supports excessive debt increases by tolerating inflation above its target level while facilitating the purchase of new government bonds by the banking system.

We all know that the U.S. hasn’t always abided by the Hamiltonian norm, sometimes because emergencies forced higher spending and large debt increases. That said, into the 20th century Congress and the president generally worked to restore balance and resume Hamiltonian adherence as quickly as possible. Perhaps the most heroic and overlooked effort to restore the norm occurred during the administrations of Warren Harding and Calvin Coolidge. These presidents, but particularly Coolidge, worked diligently to reduce massive spending and debt increases stemming from World War I. President Coolidge reported in 1925 that outlays had fallen 41 percent from peaks set by wartime spending and the nation’s debt had declined by 14 percent. This progress in “constructive economy”⁷ permitted Congress to develop historic tax reduction legislation, which it passed the following year as the Revenue Act of 1926.⁸

Erosion of our Fiscal Foundations

We find ourselves in 2023 very far, indeed, from these happy budget outcomes of 1925. Here are some indicators: Publicly held debt increased by 53.1 percent in the four years between fiscal years (FY) 2019 and 2023 and now stands at about $24.7 trillion, which is nearly equal to the nominal size of the U.S. economy ($26.5 trillion). If the borrowing from the social insurance trust funds (for example, Social Security and Medicare) for general government purposes is added to this sum, gross federal debt stands at $32.4 trillion.10 Federal outlays for all purposes grew by 42.7 percent over this same time.⁹

These stunning fiscal increases stem in part from the pandemic and from profoundly dysfunctional budget processes, but the end of the pandemic failed to prompt the Federal government to address its woeful record of budget management. For example, Congress has enacted all its appropriation bills only 3 times since FY 1977. Rather than pass budgets, Congress has passed 200 continuing resolutions (CRs) since the Budget and Impoundment Control Act of 1974, legislation written to improve the budget processes of the executive and legislative branches.¹⁰ Indeed, CRs funded government activities for every calendar day of three entire fiscal years and over 150 days or more of six more additional fiscal years from FY 1998 through 2023. The average duration of CRs over this 25-year period is a staggering 137.15 days.¹¹ More telling for this essay, Congress again failed to manage its budgetary challenges in 2023, and took the U.S. financial system to the brink of a serious crisis.

As President Coolidge knew, headlines about Washington’s budget woes are not by any means the whole story, and they often obscure the real effects of budget dysfunction. Public finance crises are rarely predictable, but, when at last they become visible, damage already has been done to economic activity, national defense, financial markets, and an untold number of life’s other departments where one rarely expects to find the effects of severe public finance problems. Indeed, substantial public finance imbalances, like those we are experiencing currently, trigger strategic actions by individuals and organizations exposed to significant losses from dislocations in government and economic activity. From Main Street to Wall Street, the breakdown of federal budgeting and the explosion of federal debt have effects far beyond talking heads in the national media and high-stakes budget negotiations in the White House.

Even our vital defense capacities are affected by our seemingly perpetual public finance crisis. For example, we now know that the well-meaning Budget Control Act of 2011, which was intended to slow the growth of spending and debt through statutory restrictions on increases of discretionary and non-discretionary outlays actually convinced major firms in the nation’s defense industrial base either to cease working with the Defense Department altogether or to consolidate their operations with other defense contractors in an effort to survive budget uncertainties.¹² Indeed, over the longer period since the passage of the Congressional Budget Act of 1974, major defense contractors have become more concentrated, with the number decreasing from 51 to 5.¹³

Moreover, the budget pains in the U.S. affect financial and trading relations with other countries, who, in turn, affect domestic economic activity through their own budget and debt problems. The crisis in public finance is truly international, and it is becoming more international as growing value chains advance the internationalization of finance. General government debt as a percent of gross domestic product (GDP) among the 27 Organization of Economic Cooperation and Development Countries (OECD) stood at 90 percent in 2022.¹⁴ By comparison to each country’s GDP that year, the United Kingdom’s general government debt stood at 104 percent, France at 138 percent, the U.S. at 144 percent, and Japan at 256 percent. And growth in debt and spending has unintended consequences: economists at the International Monetary Fund argued in April that inflation has its roots in spending, which disproportionately harms low-income families and countries.17

Some Economic Effects from the Erosion of Fiscal Principles

Most policymakers continue to treat the perpetual public finance crisis as an accounting problem that will be corrected by slower spending growth. Unfortunately, the U.S. has long passed the time when slowing spending fixes our fiscal problems. In fact, we are at the point where fiscal activity is now a key factor in monetary policy.
The interaction of fiscal policy with monetary policy is a constant dynamic that assures greater risk to our financial future.

Some very important economics hides behind the debt and deficit numbers that festoon our fiscal fiasco. For example, high and sustained inflation frequently results from periods of rapid outlay growth. Substantial increases in outlays frequently alters the after-tax budgets of private individuals and companies who directly receive subsidies or contracts from government programs. In economics jargon, their budget constraint shifts to the right. That most likely leads to higher consumption, or higher demand for goods and services. However, as we will discuss shortly, this rightward shift in the budget constraints of households and businesses often leads to price increases and sustained and high inflation.

Likewise, if these outlays exceed revenues, then the bonds needed to finance deficit spending work their way into the banking system where they become bank assets that support credit expansion. Economists sometimes refer to this dynamic as the creation of money, since banks loan out multiples of their cash assets to credit worthy bank customers: for example, one dollar of bank cash becomes seven dollars in bank credit to customers. These two effects—increased consumption from subsidies or contracts and increased credit, which also leads to increased consumption—have been associated with sudden and sustained inflation.

Inflation, of course, is primarily experienced through increases in prices, or decreases in purchasing power. It is, thus, a monetary phenomenon. There is strong evidence that rapidly growing federal debt fuels inflation, both through the support it gives for additional public and private spending and through the expectation that because debt will continue to rise and the future will be inflationary.¹⁵ Thus, the Federal Reserve is compelled to react to deficit spending and inflation with macroeconomic tightening. The economy currently is slowing from higher interest rates, which also will cause deficits to rise by $1 trillion over the next ten years as buyers of Treasuries demand higher interest payment. The inflation of 2021 through 2023 illustrate how serious the consequences of fiscal dominance can be.

Our current inflation, however, could have been much worse. There are many historical examples of inflation following ill-advised fiscal policies. The most famous example is Germany in the early 1920s. The Treaty of Versailles that ended World War I saddled Germany with heavy reparation payments to victorious European countries. Germany already had its own massive war debt. It simply could not keep up with all its fiscal requirements, and Germany turned to massive expansion of its money supply, which led to inflation rates that topped over 500 percent per month in 1923.¹⁶

A more recent example is Turkey. President Recep Tayyip Erdogan called high interest rates “the mother and father of all evil” and fired three central bank heads until he found a fourth one who would fully embrace his political goals and lower interest rates. Unfortunately for Turkey, inflation reached 19 percent per year in 2021, 70 percent in 2022, and skyrocketed to 150 percent in 2023. ¹⁷

The United States, however, has reflected the Hamiltonian norm with an enviable and long record of commitment to stable money and impeccable credit, which has been tested from time to time by episodes of seemingly risky fiscal policy. For instance, the 1981 Economic Recovery Tax Act, which certainly spurred economic growth, also created significant revenue shortfalls early in its implementation. Congress retreated from tax cutting, and, over the next 10 years passed four tax bills that completely offset the revenue losses of the 1981 act.
Indeed, Congress maintained a remarkable level of fiscal discipline throughout the period leading up to the 2008 financial crisis. The “great moderation”, as this long period of economic growth preceding the Great Recession is sometimes called, could as easily be labeled the period of the great monetary dominance. The Fed maintained low and stable inflation target and Congress hit spending targets that supported the bond market.

Growing Tolerance for Unsustainable Fiscal Paths

Then a constellation of factors conspired to move the U.S. and many of the North Atlantic democracies away from this commitment. Some did so inadvertently. For example, in its well-meaning desire to require stable spending, the EU required member countries to maintain a slow growth in debt and a 3 percent target for deficits.
This policy, however, had the effect of slowing consumer demand, which produced a long period of exceptionally low price and economic growth. Eric Leeper calls this “unwitting fiscal dominance.”¹⁸

More challenging are policy decisions made decades ago that now are running afoul of unrelenting demographic trends, in particular the social insurance programs found throughout the western democracies. Policy makers created these programs to transfer income from working citizens to retirees, and they built these programs on the assumption that these transfers would never become the dominant form of retirement income and that five or six taxpaying workers always would be around to support each retiree. However, social insurance now dominates private savings and too few workers support retirees. Again, fiscal dominance results, simply from the inescapable fact that public spending will be required to make up the shortfalls in working age transfers.¹⁹

If it were always inadvertence and poorly calculated policy moves or faulty programs on unsustainable fiscal paths that raised the interests of fiscal policy over monetary, we might breathe easier. History indicates that our government will at some point work to restore a closer adherence to the Hamiltonian norm. However, something new is challenging the Hamiltonian norm: fiscal brinkmanship. Increasingly, Congress is playing fiscal chicken with the public debt.

This is critical because the Hamiltonian norm of our public debt being convertible, liquid, and default free meant that it became the premier standard of credit. Indeed, our dollar’s status as the world’s reserve currency owes much to the respect our debt commands.

Congress, however, is jeopardizing that status with its increasing willingness to threaten default on debt payments, no matter how well- meaning those efforts may be. In 2011, 2013, and 2023, Congress took the U.S. government and much of the financial world to the brink of financial crisis when borrowing limits were hit. The crisis of 2011 resulted in our first credit downgrade by Standard and Poor’s. The second debt confrontation in 2013 resulted in new laws that inadvertently weakened our national defense by deepening the worries among defense contractors about the government’s ability to support planned production and R&D. It also delayed, again, the work Congress must undertake to reform and defend the country’s major social assistance programs. These broken programs now drive a larger percentage of our annual deficits. The most recent 2023 brinkmanship failed to resolve any element of our fiscal problems and simply instituted a truce between parties until after the 2024 election, thus guaranteeing another crisis over debt payments as early as 2025.

And, what is particularly worrisome is that over the past decade, the political support for triggering a debt limit crisis has grown. If it becomes normalized, the consequences could be significant. Already, each of these episodes of debt limit brinkmanship have directly affected short and long-term interest rates and the marketability of new debt. Indeed, these showdowns have led some central banks to move from long maturing US bonds to shorter term bonds, which could be taken as a signal that these central banks worry that holding long term US debt could lead to financial losses. For instance, these fights have also caused China, the country that
owns more U.S. debt than any other, to accelerate its swapping of long-term for short- term U.S. debt, as well as quicken the pace at which it encourages its trading partners to leave the dollar and use the yuan instead when settling international contracts.²⁰

Which brings us back to Fitch Ratings and their credit downgrade. The question before the U.S. Congress today is financial governance: which path will it take in the future? One that restores the Hamiltonian norm? One the persists in fiscal policy prominence? Or something new, something new that places other priorities above the stability, convertibility, and quality of our sovereign debt?

One course leads to fiscal restraint and policy reforms, some of which may be politically hard to make. The other leads to more expansive assistance for key segments of the population but at the cost of monetary instability and inflation. The third leads to unpredictable consequences. All affect the individuals and organizations and governments who purchase our debt and trust in our dollar.

At least one aspect of this uncertain future is certain: all will be watching which path our government chooses to follow.