A debt crisis does not come slowly and predictably, like the tide. It comes unexpectedly, like an earthquake. This year’s short-term bondholders are mostly interested in whether new bondholders will show up next year, to lend the government money that the government can use to pay this year’s bondholders back. Bondholders can run, refusing to invest this year at the usual rates, if they have even small jitters about that question.
When bondholders get nervous, they demand higher interest rates. They may also diversify their portfolios, or just refuse to purchase more bonds. Debt gets hard to sell at any price. A different class of bondholders, willing to take risks in return for better rates, must come in to replace the safety-oriented clientele that currently holds short-term government debt.
As interest rates rise, interest costs on the debt rise. The US national debt is roughly $20 trillion. If interest rates on that debt rise to 5 percent, interest costs rise to $1 trillion, essentially doubling the already huge deficit. That’s 5 percent of GDP, and a quarter of federal revenues. That deficit would make bond markets even more nervous. They would demand still-higher interest rates. When that spiral continues, you have a full-blown debt crisis on your hands.
Short-term debt compounds the problem. Since the US has issued much of its debt using short-term bonds, interest-rate increases make their way to the budget more quickly. If the US had borrowed everything in 30-year bonds, higher rates would only slowly translate to larger deficits, giving us time to fix the underlying fiscal problem.
Debt crises typically come in bad times: when in a war, recession, or financial crisis, the government suddenly needs to borrow a lot more, and markets doubt its ability to repay.
But crises can happen in good times as well. We have known for decades that the US has promised entitlement spending far beyond what our current tax system can fund. Markets have—sensibly, I think—presumed that the US would fix this problem sooner or later.
“Well,” said markets in 2005, “OK for now—you have a war on terror and a war in Iraq on your hands. We’ll trust you to fix entitlements later.”
“Well,” said markets in 2012, “OK for now—you’re recovering from a massive financial panic and the Great Recession. We’ll trust you to fix entitlements later, and we’ll even lend you another $10 trillion.”
Markets have a right to think that perhaps America won’t fix our fiscal mess in time.
But what’s our excuse now? At 4 percent unemployment, after eight years of uninterrupted growth, if we can’t sit down now and solve the problem, when will we? Yet there is no sign in Congress of either long-term entitlement reform or the massive—5 percent to 10 percent of GDP—tax increases needed to fund current entitlements. Markets have a right to think that perhaps America won’t fix our fiscal mess in time. Or, more accurately, markets have a right to worry that next year’s markets will have this worry, and get out now.
For some historical context on America’s recent fiscal health, take a look at the chart below.
The graph is federal surplus (above the 0 line on the graph) or deficit (below it), not counting interest costs, divided by potential GDP. Taking interest costs out allows us to see the underlying tax and spending decisions more clearly.
US fiscal policy actually has been quite sober over the years. In economic good times, we run primary surpluses. The impression that the US is always running deficits is mostly because of interest costs. Even the notorious Reagan deficits were, for the most part, payments on outstanding debt occasioned by the huge spike in interest rates. Only in the extremes of 1976, 1982, and 2002, in which we were mired in steep recessions and, in the latter case, war, did we touch any primary deficits, and then we pretty swiftly returned to surpluses.
Until 2008. The last 10 years really have been an anomaly in US fiscal policy. One may say that the huge recession demanded huge fiscal stimulus, or one may think $10 trillion in debt was wasted. In either case, what we just went through was huge. And now primary deficits are set to dramatically increase again, via about 1 percentage point of GDP extra tax cut, 4 percentage points of GDP extra spending. And then the social security and health care deficits really kick in.
So perhaps today’s bondholders have good reason to fear that tomorrow will be the day that markets finally lose patience with US fiscal policy. Most commenters, including me, think this day is still far in the future. But the future comes unexpectedly.
Torsten Sløk of Deutsche Bank noted this year in an email to clients and other market watchers that in Treasury auctions, the ratio of dollars being bid to the total value of the bills being offered—the bid-to-cover ratio, an important measure of demand—is lower than it has been since the 2007–10 financial crisis. “The bid-to-cover ratio at four-week T-bill auctions is currently at the lowest level in almost 10 years,” he wrote. “Demand is also structurally weaker when you look at 10-year auctions.”
“Things are so far looking OK,” Sløk continued,
but the risks are rising that the US could have a full-blown [emerging markets]-style fiscal crisis with insufficient demand for US government debt, and such a loss of confidence in US Treasury markets would obviously be very negative for the US dollar and US stocks and US credit. The fact that this is happening with a backdrop of rising inflation is not helpful.
We’re not there yet, and I think we have a long way to go. But the low bid-to-cover spreads could be a tremor. Another could be flagging international interest in owning US debt, as observed by the Wall Street Journal in February, when US 10-year yields were at 2.9 percent and German yields were at 0.68 percent, and Europeans were still shying away from US bonds, in part because of worries about a further slide in the dollar (which comes when next year’s international bondholders really don’t want to hold US debt).
Again, these are little rumbles. I still think that a full-blown crisis will come only amid a large international crisis. Perhaps the debt mess in China explodes, along with a few big country defaults, or state and local pension failures. (A crisis always starts with a mountain of debt and shady accounting.) Perhaps an expensive war increases our borrowing demand while freezing markets. The US then comes to markets with unresolved entitlements and asks for another $10 trillion just as everyone else is selling their Treasury reserves too.
But I could be wrong. We live on an earthquake fault of debt, and the one thing I know from my own past forecasting ability—I lived through 1987, the dot-com boom and bust, 2008, the recent bond boom, and more, and saw none of them coming in real time—is that I will not see it coming either. The one thing I know from studying finance and its history is that most other people won’t see it coming either.
John H. Cochrane is a senior fellow of the Hoover Institution at Stanford University and distinguished senior fellow at Chicago Booth. This essay is adapted from two posts on his blog, The Grumpy Economist.