The Threat of U.S. Public Debt to Global Financial Stability

The Economic Crisis Facing the United States

The United States is grappling with a potentially catastrophic economic crisis, compounded by a combined budget deficit at the federal, state, and local levels nearing 8% of GDP.
This marks a historical first, as the nation has never entered a recession with such a high budget deficit.
The prospect of a recession under these circumstances could have severe repercussions, not only for the American economy but also for the entire global financial system.

The Unprecedented Budgetary Situation

Typically, during a mature economic cycle, public accounts should trend towards a near-balanced budget.
However, the United States finds itself in a strikingly opposite position.
If the country were to descend into a serious recession from this already fragile base, the budget deficit could soar past 15% of GDP, irrespective of the outcomes of the upcoming presidential elections in November.
Such chronic expansion of public debt would severely test the U.S.’s ability to issue government bonds, crucial for financing economic stimulus in prolonged downturns.

This scenario would have immediate and devastating implications for the global financial system, tightly interlinked with U.S.
debt yields.
Torsten Slok, chief economist at Apollo Global Management, emphasized: “The U.S.
has always been a special case, but it’s now testing the limits.
So far, everything has remained under control, yet the last two Treasury auctions have been quite weak, and we are observing the situation closely.”

Roots of the Imbalance

The causes of this imbalance are multiple.
On one hand, there are irresponsible fiscal policies, such as the unfunded tax cuts from the Trump administration.
On the other, massive public spending promoted by the Biden administration has contributed to an explosion of public debt.
Coupled with an aging population and the expansion of social benefits for the middle class, the debt has surged alarmingly.
Currently, gross federal debt in the U.S.
has reached 122% of GDP, a staggering increase from the 50% left behind by Reagan’s administration in the late ’80s.

Signals of Recession

The fiscal situation is so precarious that financial markets may soon question the sustainability of public debt.
Claudio Borio, an economist at the Bank for International Settlements, cautioned: “Experience teaches us that things seem sustainable until suddenly they are not.” While he did not explicitly mention the U.S., the implication was clear.
Recently, signals of an impending recession have proliferated.

For instance, retail sales have risen in July, but this increase was only possible due to a drastic drop in the personal savings rate, which fell to 3.4%, similar to levels observed in late 2007, just before the onset of the Great Recession.
Such a low savings rate is a sign of economic weakness, foreshadowing a potential collapse in domestic demand that could trigger a recession.

The Federal Reserve’s Challenge

The Federal Reserve (Fed) finds itself in a delicate position.
Its current “data dependency” policy makes it susceptible to delayed economic indicators, such as inflation in services, which could lead to a belated and inadequate reaction to economic slowdown.
While U.S.
Treasury securities remain the premier safe asset in global crises, the ongoing expansion of public debt could significantly elevate financing costs, accelerating a vicious cycle undermining debt sustainability.

Fitch Ratings estimated that the combined U.S.
deficit (federal, state, and local) reached 8.8% of GDP last year and is projected to be 8.2% this year.
Moreover, interest costs on the debt are expected to hit 10.3% of revenues by 2025, three times the average among rated AA countries.
Any figure exceeding 10% is considered a “red alert” by financial markets.

The Congressional Budget Office (CBO) forecasts that the federal deficit will reach $1.6 trillion this fiscal year, climbing to $1.8 trillion next year and hitting $2.6 trillion by 2034 unless Congress takes decisive action.
These projections assume a stable economic growth rate, but in a recession scenario, the figures could escalate dramatically.

International Implications

The net interest costs on debt are already greater than America’s defense budget and stand at 3.4% of GDP this year, up from 1.2% a decade ago.
This trend indicates a rising financing cost trajectory in the coming years, worsening the public debt dynamics.

On the international front, various central banks have begun reducing their exposure to U.S.
Treasury securities.
For example, China has lowered its Treasury holdings from $939 billion to $767 billion over the past two years.
Additionally, the share of Treasury bonds held by foreign central banks has declined from 25% in 2019 to 14% this year.
While private buyers currently compensate for foreign central banks’ reduced purchases, this situation may not last long.

The Fed’s Potential Response

In light of these developments, the Fed may be forced to intervene again to purchase U.S.
debt, similar to its actions between 1942 and 1951 to control Treasury yields.
However, a return to quantitative easing (QE) may be hard to justify, especially after contributing to inflation in recent years.
The Fed might consider a new strategy, such as yield curve control, to legitimize Treasury purchases without labeling it as QE.
Nevertheless, this would essentially constitute explicit monetary financing of Treasury debt, a practice that could be necessary under a hypothetical Trump 2.0 or Harris administration.

Conclusion

What begins as a permanent fiscal disorder is at risk of evolving into a similarly lasting monetary disorder.
The U.S.
seems to be barreling down this path quickly, with few prospects to return to sustainable financial management.
Despite all, no other nation or economic bloc is currently capable of anchoring the global monetary and credit system.
The dollar remains the dominant currency, but the entire world may soon need to reckon with an increasingly unstable and unpredictable hegemon.

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