A Government Debt Crisis?
It can happen here
The U.S. government has $30 trillion in outstanding debt. If the average interest rate on this debt were to reach 3.3 percent, then interest payments on the debt would be $1 trillion. That means issuing $1 trillion more in bonds. What if the market will not absorb that much? In that case, we will face a debt crisis.
Before I spell out that scenario, let me make a few remarks.
First, a debt crisis is always an improbable scenario. If we could be sure that a debt crisis will occur, then we would already be in one. If investors thought that the U.S. would have difficulty rolling over its debt next week, then they would stop buying bonds today, and the U.S. would have trouble rolling over its debt today, so that the crisis would take place today.
Second, many deficit hawks have been warning about potential debt crises that have not occurred. This is true for the United States, and it is more famously true for Japan, where the ratio of government debt to GDP has exceeded that in the United States for many years. But John Cochrane points out that the U.S. fiscal position is worse than Japan’s because we have unfunded liabilities in our entitlement programs. That is, in the future, we will have obligations under Social Security and Medicare for which we have not collected sufficient taxes.
My take on Japan is that in the late 1980s they experienced a remarkable bubble in stock prices and real estate, and the subsequent crash has depressed inflation and interest rates, offsetting the rise in government debt. A collapse of stock prices and real estate prices is one way to keep interest rates low, but it is not a scenario that we should hope takes place in the United States.
We Need Low Inflation and Low Interest Rates
Recall the four possible scenarios I laid out for interest rates and inflation.
Low interest rates and low inflation.
Low interest rates and rising inflation.
High interest rates and high inflation.
High interest rates and falling inflation.
Under the first scenario, we avoid a debt crisis. This is the scenario that most experts expect we will see, once the “transitory” inflation of recent months subsides.
Under the second scenario the ratio of debt to GDP actually declines. But I believe that a scenario of low interest rates and rising inflation cannot be sustained for very long. As long as interest rates are low relative to inflation, households and businesses have an incentive to spend. They can borrow today and pay back in depreciated dollars tomorrow. This incentive to spend only exacerbates inflation. Inflation starts to accelerate, until eventually interest rates have to rise.
That leads us to the third and fourth scenarios, under which we face a potential debt crisis. In a crisis, there is no interest rate at which the market will buy all of the securities that the government is issuing. Higher interest rates force the government to issue more debt to pay the interest expense, and there is not enough saving to absorb the additional debt. It is like a situation where the interest on your credit card debt is so high that you can never get out from under your credit card debt.
One response to a debt crisis would be for the Federal Reserve to step in and buy the extra trillion or so of government debt. But Fed purchases of debt amount to printing money. This will increase inflation, and that in turn will lead to higher interest rates. Ultimately, the money-printing solution would lead to hyperinflation.
When a government faces a debt crisis and wants to avoid hyperinflation, it has to make drastic reductions in spending and/or sharp increases in taxes. If the United States has to go that route, the “easy” adjustments will not be sufficient, and the additional political choices will be unpopular. How much will Social Security benefits be cut? How much will middle class taxes be raised? Or will the government default on its debt in some way, perhaps by postponing interest payments to bondholders?
One way for the government to avoid drastic spending cuts or tax increases would be to sell off assets. For example, the government owns about one-quarter of all land in the United States. Although some of this land is of little value, there is enough land that would attract bids from the private sector that the government probably could end a debt crisis by undertaking land sales.
The United States enjoys a reputation as being the least risky debtor in the entire world. The interest rate and U.S. government debt is known as the “risk-free” rate. But if we were to suffer a debt crisis, that status would be lost. From then on, probably for decades, the interest rate on our debt would include a risk premium. The cost of our debt would be higher. We would no longer have the flexibility to increase government spending any time we choose to do so.
In recent years, I have described myself as the last fiscal hawk in America. There are other fiscal hawks, to be sure, but not many in Congress. There, neither Republicans nor Democrats have shown any desire to rein in government spending. Instead, a decision to spend $1 trillion more of other people’s money on “infrastructure” is hailed for its bipartisanship.
I hope that I turn out to be wrong. I hope that interest rates never rise to the point where we face a debt crisis. But the less that politicians seem to worry about a debt crisis, the more concerned I become.
Note: Those of you interested in more warnings about a debt crisis might wish to watch a presentation John Cochrane made several weeks ago. Note that starting at about minute 12 of the presentation, he spends about ten minutes discussing the 1970s, a history which also concerns me.
The incredibly low rates on long dated debt allows the US Treasury to fineness some of these problems by affordably issuing long term bonds. If debt is long dated this reduces the rollover risk (US Govt wanting funding in excess of capital markets willingness to supply that funding) and makes it possible to inflate away some of that debt if inflation rises. With short term debt almost all the inflation risk is held by the issuer (the Treasury).
As we can see in the Treasury's most recent Treasury Presentation to TBAC, (https://home.treasury.gov/system/files/221/TreasuryPresentationToTBACQ22021.pdf),
the Treasury has lengthen the Weighted Average Maturity of Marketable Debt Outstanding from about 55 months pre-financial crisis to 67 (5.5 years) months today. Lengthening that to 30 years would cost about 1.9% instead of 0.7% per year. Of course, we don't have to go all the way to 30 years to get significant and inexpensive insurance here.
I have pre-ordered the book “The Debt Trap” by Josh Mitchell that will be circulated tomorrow. I read a review praising the book for the description of how this huge debt has been accumulated by many thousand students in your country. I believe it’s important to understand how politicians are planning to deal with this private debt because as of today the barbarians intend to bail the debtors out with the expectation that most will vote for them in future elections and the opposition to the barbarians look weaker each day. It doesn’t matter if the bailout is over $1.0 trillion, or just under it. It’s large enough to signal what may happen with other huge debts and entitlements. Sooner or later the federal government will have to deal with total debt much larger than the $30 trillion you mention in your column because nobody should expect an “automatic” increase in tax revenue from investments financed with that huge borrowing. You can bet that most “additional” spending financed by that borrowing was on consumption of all sorts of goods and services, mainly by the constituencies that benefited from income redistribution. Don’t trust people that entertain the idea that at least a significant part of that spending was on productive investments. Please, make clear this point any time you write about the debt: it implies that Federal Government is running the largest Ponzi game in history, meaning that “new” and “old” savers/lenders expect that the FG will continue to find other “new” savers/lenders to pay for both the increasing redistribution and the increasing interest burden (even assuming that the rates remain at the current level).
At this time, the bailout of the students’ debt may trigger the crisis. It’s not the only trigger, however. One may argue that all nominal interest rates may suddenly increase as they did in response to Paul Volcker’s policies in 1980, but today the world’s financial markets are quite different, and I suspect that any disruption will be on the savers/lenders’ side as a result of a sharp change in their expectations about the U.S. government’s ability to refinance the huge debt without accepting some serious conditionality. Although lenders may not be prepared to negotiate and impose conditionality, the main problem is that American politicians will be quite reluctant to accept any conditionality because “the U.S. is not Argentina”. As Sebastián Edwards shown in his American Default, it’d not be the first default, but this time the defaulting debtor is the FG. Since 1933, lenders have been able to learn to negotiate with small governments but not with large ones. The FG may have the power to impose its solution as in 1933, but the proposed solution would have to be negotiated within the FG (meaning both the President and the Congress and therefore both parties) and then accepted by the lenders without challenge it before courts. Any serious solution will involve some conditionality, meaning a serious fiscal adjustment (it will affect future flows of tax revenues and their spending and therefore the careers of all the politicians involved), something that American politicians have evaded for a long time. To make matters worse, now the barbarians are part of FG and fighting for consolidating and expanding their power.
Good luck. Please don’t focus on prices and interest rates (they are endogenous). Focus on politics and government and try to explain the behavior of all factions involved and the bureaucrats.