The outstanding financial obligations of the US federal government exceeded 34 trillion dollars, about 123% of the country’s gross domestic product (GDP), which is a historical record. So, investors around the world are rightly wondering if the scenario is gathering chances for a new financial crisis to break out.
In more detail, the federal government’s outstanding financial obligations now amount to about $34 trillion, about 123% of the nation’s gross domestic product (GDP).
Meanwhile, according to the Congressional Budget Office’s latest estimate, the deficit will exceed $1.5 trillion. USD annually in the coming years, between 6-7% of GDP. While this flow promises to add to the massive pile of outstanding debt, Washington appears to be constantly considering the potential damage this upward trend entails. The outlook is not encouraging at all.
The Wall Street View
There are some on Wall Street who dismiss such concerns. The buying public seems to be dealing well with the flow of new government obligations. Wall Street soaks up all that every US Treasury auction has to offer. Interest rates and yields on US Treasury debt do not show that investors are afraid.
The 10-year bond, for example, is currently selling at a yield of just over 4% – only slightly higher than inflation. If there were reason to fear, these optimists argue, buyers would demand much higher interest rates, perhaps closer to the 8% yield required on junk bonds, where fear is indeed warranted.
Those who do not have this perspective could point to Japan, where public debt is 263% of GDP and there has been no turmoil – at least not yet. However, they hide the fact that the overwhelming percentage of Japan’s public debt belongs to Japanese citizens and businesses, and not to foreigners. The US debt is overwhelmingly held by foreign investors and mainly by China.
It makes sense, Wall Street analysts say, only if you assume that bond buyers will remain as they are today indefinitely. However, investors’ willingness to buy US debt at manageable interest rates is neither stable nor reliable, as it will depend on the real economy being able to expand enough to support the outstanding obligations.
In other words, it will depend on whether the national income and wealth produced by the American economy can keep pace with the debt burden. The issue of debt then boils down to a matter of relative growth prospects. In any case, there are no guarantees.
What would happen in such a case as the US in a reliably fast growing economy?
Unlike the United States today, a reliably fast-growing economy, say a well-managed growing economy, could easily carry a relatively heavy debt load. Rapid real growth, perhaps in the double digits annually, would promise to push incomes and government revenues upward quickly so that such obligations could be met quickly.
Since the debt reflects spending and tax policies designed to promote growth, investors—both domestic and foreign—would buy domestic bonds, knowing they would be repaid.
This happened in the United States in the 1790s, when Treasury Secretary Alexander Hamilton could promise a rapidly growing economy and quickly sell American debt to Europe. However, today’s American economy is neither in the early stages of rapid growth nor particularly well managed. Deficits and debt outpace the economy.
The budget is burdened primarily by spending on Social Security, Medicare, Medicaid, with little to promote growth. At best, the real economy will only grow at about 3% per year. If not tomorrow or the next day, these dismal trends will undermine investors’ willingness to hold US Treasuries in their portfolios.
The first signs and the options available to correct the current situation
The first signs that such a doomsday is coming will come when its bond yields rise relative to other types of debt. If investors begin to suspect that there is insufficient real substance behind the bonds, they will demand higher yields, as is the case with junk bonds today. This event will further burden the US budget by increasing debt service costs. As this pressure mounts, the Washington administration will have the following options, and none of them will be pleasant.
1. The first and least palatable is bankruptcy. The US would proceed with a violent balanced federal budget, equalizing in one day the income with the expenditure. In this case they would declare bankruptcy, with the non-payment of their debt. Such an event would destroy financial markets and plunge the economy into recession. At the same time, it would trigger a war on the part of countries like China who would lose their money in American bonds once and for all. This is why Russia and China have been engaged in a race of speed to de-dollarize their foreign exchange reserves, constantly buying gold, and replacing the dollars they hold, either in the form of paper money or US bonds.
2. Second, Washington could cut spending to stem the tide of debt growth in order to convince everyone that it has gotten its finances on track. Such an answer, however, carries complications. Because the budget is dominated by defense and entitlement spending, most of what the government can cut without political and social risk will come from this small part of today’s growth-promoting spending. Such action may backfire and convince bond buyers that the situation will deteriorate further.
3. Washington’s third option would be to raise taxes. This could stem the rise in debt. On the other hand, any expanded tax burden will make investors believe that growth will suffer. As a result, Washington will shoulder a greater burden and the debt will risk becoming burdensome.
4. Washington’s fourth and final option is inflation. By reducing the actual purchasing power of existing debt, it will make it seem more manageable. Such a policy, however, would greatly burden citizens and significantly erode investor confidence. At the same time, the political cost would be great for each President and his administration.
The only hope
The only hope to counter the above-mentioned bleak outlook is for Washington to act now, before confidence erodes and pressure builds. Spending cuts and prudent tax adjustments would help.
But since debt fundamentals depend on growth and its prospects, a better policy would reallocate spending and fiscal priorities more towards promoting growth than they currently do.
Continued steps to control inflation will reassure those funding US debt that their assets will provide safe real purchasing power. By making such arrangements now, before the pressure becomes intense, the necessary shifts could be made gradually and thus cause less upheaval.
