US Fiscal Profligacy and the Impending Crisis
Editor’s Note: This essay is part of Debt, Inflation, and the Future: A Symposium.
Massive demand-side incentives combined with supply-side restrictions in the form of higher taxes are a sure recipe for inflation and eventual recession. The U.S. budget deficit for FY2021 will be 15% of U.S. GDP after an additional $ 1.9 trillion in demand stimulus passes, according to the Federal Responsible Budget Committee, a proportion the United States has since Didn’t see World War II again.
It is difficult to avoid the Biden government’s fiscal irresponsibility being based on a cynical political calculation. Obviously, it is proposed to use the federal budget as a slush fund to distribute the benefits to different political constituencies, and to bet that the avalanche of new indebtedness before the congressional elections in 2022 will not cause a financial crisis. The government’s proposed additional infrastructure spending of $ 2.3 trillion consists mainly of handouts to Democratic constituencies.
Where does foreign money go?
In the twelve months to March the deficit was 19% of GDP. Worse, the Federal Reserve has absorbed virtually all of the rise in outstanding debt on its balance sheet. After the 2009 recession, when the deficit briefly rose to 10% of GDP, foreigners bought about half of all new government bond issues. For the past 12 months, foreigners have been net sellers of US national debt. (See Figure 1.) The US dollar’s role as the world’s most important reserve currency is rapidly disappearing, and the fiscal irresponsibility of this order threatens to accelerate the dollar’s decline.
The Federal Reserve has kept short-term rates low by monetizing debt, but long-term government bond yields have risen more than a percentage point since July. The markets know that what cannot go on forever cannot work. At some point private holders of government bonds will liquidate their holdings – as foreigners have started – and interest rates will rise sharply. (See Figure 2.) For every percentage increase in the cost of federal debt financing, the Treasury Department pays an additional quarter of a million dollars in interest. The United States could find itself in Italy’s position in 2018, but without the rich members of the European Union to save it.
The spate of federal spending has already had a number of dangerous effects:
- The U.S. trade deficit in goods reached an annual rate of more than $ 1 trillion a year in February 2021, an all-time record. China’s exports to the US also hit record levels in the twelve months to February. The federal incentive created demand that US manufacturing facilities could not meet and sparked a massive import boom.
- In February, according to the Philadelphia Federal Reserve survey, input prices for US manufacturers rose at the highest rate since 1973. And the gap between input and finished goods prices rose the fastest since 2009. (See Figure 3.)
- The producer price index for final demand rose 11% on an annual basis in the first quarter. The consumer price index only shows 1.7% year-over-year growth, but this reflects dubious measurements (for example, price protection, which makes up a third of the index, is said to have only increased 1.5% over the year, despite real estate prices increasing are by 10%).
If foreigners are net sellers of US Treasuries, how does the United States finance an external deficit on the order of $ 1 trillion a year? The US has two deficits to finance, the internal budget deficit and the balance of payments deficit, and here we are referring to the second. The answer is: by selling shares to foreigners, according to the Treasury Department. (See Figure 4.) Foreign investors dumped low-yield US Treasuries and corporate bonds under the Treasury International Capital (TIC) system last year. Foreign investors bought $ 400 billion worth of U.S. stocks and nearly $ 500 billion worth of U.S. agency securities (backed by domestic mortgages) in the twelve months through January, but sold $ 600 billion worth of government bonds $ 100 billion worth of corporate bonds.
This is a bubble on a bubble. The Federal Reserve is buying $ 4 trillion in Treasury stocks, pushing post-inflationary yields below zero. That pushes investors into stocks. Foreigners don’t want US Treasuries with negative real returns, but they do buy into the stock market, which continues to rise because the Fed is pushing bond yields and so on.
At some point, foreigners will run into overpriced US stocks and stop buying them. In this case, the Treasury Department will have to sell more bonds to foreigners. However, this means that interest rates will have to rise as foreigners will not buy US bonds with extremely low yields. Rising bond yields will continue to push stock prices down, which means foreigners will have to sell more stocks and the Treasury will have to sell more bonds to foreigners and so on.
The 2009 crisis came from the demand side. When the housing bubble collapsed, trillions of dollars in derivative securities backed by home loans collapsed, wiping out homeowners’ equity and the banking system’s capital base. The 2021 stagflation – the unfortunate combination of rising prices and falling production – is a supply-side phenomenon. This is what happens when governments toss trillions of dollars of money out of a helicopter while infrastructure and facility capacity deteriorate.
The current situation is unprecedented in other ways: not in the past century has the United States faced a competitor with an economy as large as ours, growing much faster than ours, with the aim of ousting us as the world’s leading power.
The cause of the 2008 crisis was excessive leverage on homeowners and businesses. I was among a small minority of economists who predicted this crisis.
Federal debt was 60% of GDP in 2008, excluding Medicare and Social Security unfunded liabilities. By the end of 2020, federal debt as a percentage of GDP had more than doubled to 130%. The Federal Reserve owned only $ 1 trillion in securities in 2008. The US government debt remained a safe haven. Following the bankruptcy of Lehman Brothers in September 2008, the yield on 30-year US Treasuries fell from 4.7% to 2.64% as private investors bought Treasuries as a haven.
The treasury: not a refuge, but a cause of the crisis
Today, the US financial market is the weak link in the financial system, supported only by the monetization of debt by the central bank. If the extreme fiscal waste of the Biden administration causes private investors to exit the treasury market, there will be no safe assets in the dollar financial markets. The effects would be extremely difficult to control
The vast majority of over-the-counter (privately traded) derivative contracts serve as interest rate hedges. Market participants typically pledge Treasury bills as collateral for these contracts. According to the Bank for International Settlements, the face value of such contracts now exceeds $ 600 trillion. Derivative contracts carry some market risk, and banks only enter into them with customers who want to hedge interest rate positions if the customers provide collateral (such as the cash margin on a stock bought on credit) (see Figure 5). The market value (after offsetting against matching contracts that cancel each other out) is approximately $ 15 trillion. If Treasury note prices drop sharply, it will result in a global margin call on the derivatives market, forcing large amounts of positions to be liquidated.
Something like this happened between March 6 and March 18, 2020, when the yield on US Treasury Inflation-linked Securities (TIPS) rose from around 0.6% to 0.6% in two weeks. The COVID-19 crash triggered a cash jam at American banks as U.S. corporate borrowers used their credit lines. US banks, in turn, have cut lines of credit for European and Japanese banks, which have been forced to withdraw funds from their customers for currency hedging for holdings of US Treasuries. Customers in turn liquidated US Treasury securities and the treasury market crashed. This was the first time a financial market crash coincided with a stock market crash: instead of acting as a haven for crises, the US financial market became the epicenter of the crisis.
The Federal Reserve quickly stabilized the market through massive treasury purchases and by extending dollar swap lines to European central banks, restoring dollar liquidity for its customers. These emergency measures were justified by the extraordinary circumstances of March 2020: an external shock, namely the COVID-19 pandemic, the financial markets, and the central bank were responsible for expanding liquidity into the market. The Federal Reserve and the Biden Administration are now proposing to extend these emergency measures to a sustained surge in demand. The consequences will be dire.
The current situation is unprecedented in other respects: not in the past century has the United States faced a competitor with an economy as large as ours, growing much faster than ours, with the aim of ousting us as the world’s leading power. China believes America’s fiscal irresponsibility will undermine the dollar’s status as a world reserve currency.
Here’s what Professor Bai Gang of Fudan University told the Observer, a news site close to the Chinese State Council:
Put simply, the United States has issued a massive amount of currency this year, which has given the US economy, which has been severely or partially stalled due to the COVID-19 epidemic, a certain kind of survivability. On the one hand it must be recognized that this method. . . is very effective. . . . The US stock market reached another record high.
I would like to stress, however, that this approach is at the expense of the future effectiveness of the dollar lending system. You don’t get the benefit without paying the necessary costs.
A hegemonic country can maintain its currency hegemony for a certain period of time even after the loss of national hegemony. After Britain lost its global hegemony in at least the 1920s and 1930s, the pound sterling continued to function as the world’s most important payment method for currencies. To some extent, the hegemony of the US dollar is stronger than any currency before it. . . .
We can see that the US dollar will remain the most important national currency in the international payment system for a long time after the end of US hegemony. Since this year, the US has been issuing more and more currencies to improve the internal situation. The pressure will ultimately seriously damage the status of the US dollar as a core currency in the international payments system.
America has tremendous power, but the Biden administration and the Federal Reserve are abusing it. And China is waiting for the next crisis to assert its primacy in the world economy.