A quick perusal of social media (which I don’t recommend for anyone’s mental health) reveals lots of posts warning of an impending US bond market implosion. Exponential growth rates of government deficits and debt, central banks shrinking their bond holdings—that’s the stuff of a never-ending internet horror show.
But is a US debt crisis likely? Is ‘Bond-Armageddon’ inevitable?
Clearly, some stoke fear for personal gain (e.g., those who pimp cryptocurrencies). That aside, might there be legitimate reason to fear US public debt dynamics?
In what follows, we explore the issue with the dispassion it deserves, focusing on the source of most concerns, the US Treasury bond market.
It’s all relative
To begin, it is advisable to look at debt relative to income. That’s true for the individual borrower, as well as the government. The average mortgage today is many times larger than that of our grandparent’s generation. Dollar values are inflated and generally misleading. What really matters is borrowing relative to debt servicing capacity.
Today, US gross federal government debt amounts to about 121% of US GDP. That’s below its pandemic and postwar peak of 126%, but more than twice its 55% level at the turn of this century.
Contrary to popular belief, the stock of US federal government debt relative to GDP does not always go up. In 1946, in the immediate aftermath of World War II, US federal government debt peaked at 119% of GDP (i.e., roughly where it is today), and then proceeded to decline steadily and almost without interruption until 1981, when it reached its postwar nadir of 31%. It then climbed to nearly 65% of GDP in 1995, before declining in the ensuing half decade by roughly 10 percentage points. (Note: These figures do not include estimates of unfunded future liabilities of the US government, which are omitted for simplicity, even if they represent large potential claims for future generations.)
US fiscal history is important for several reasons.
- First, despair is not warranted. Levels of government indebtedness relative to income can and do fall.
- Second, periods of falling debt relative to income occur in part because of fiscal discipline, but mostly because of strong growth (i.e., the denominator grows faster than the numerator).
- Third, falling debt/GDP ratios do not require high inflation. Neither falling debt-to-GDP in the second half of the 1990s, nor during the three decades following World War II, was accompanied by persistently high inflation.
- Lastly, of the increase in the US federal government debt/GDP ratio this century, most of it (a net increase of 65 percentage points) came because of two historically improbable events—the global financial crisis (GFC) and the Covid-19 pandemic. Specifically, 80% of the increase in US federal government debt this century occurred between 2007-2012 and 2020-2022. In other words, if, by some miracle, neither the GFC nor Covid-19 had occurred, US federal government debt today would be around 70% of GDP. Debt pessimists, who extrapolate growing liabilities into the future, would have us believe that the improbable (massive dislocations) has become the normal.
Maybe voters are to blame?
One other lesson emerges from history. Since 1981, US Democratic presidents (Clinton, Obama) have generally presided over declining federal government deficits (as a percentage of GDP), while Republican presidents have governed when deficits (and debt levels) have surged. Importantly, as well, much of the deficit reduction under Democrats took place under divided government (i.e., when Republicans controlled one or both chambers of Congress).
That is too small a sample from which to draw statistical inference. But we can, perhaps, question whether deficit reduction has been rewarded by voters. In the 2000 and 2016 presidential elections, voters (or at least the electoral college) rewarded Republican challengers advocating tax cuts, rather than Democratic candidates offering continuity of fiscal discipline. Also, in the late 1990s and again during the early ‘teens’, voters rejected Republican Congressional deficit ‘hawks’ (Gingrich, Boehner, et al).
That’s worth noting. If Democrats and Republicans today are reticent to push legislation to raise taxes or cut spending, perhaps that is because voters have not rewarded the politics of fiscal discipline over the past quarter century. Can we place all the blame on Washington, or might voters be (ir)responsible?
Are bond investors complacent?
But if US voters are ultimately to blame for lax fiscal policy, why then are bond investors blasé? That question is even more interesting given that a major buyer and holder of bonds (Treasuries and mortgage-backed securities), namely the Federal Reserve, is now shedding its holdings to the tune of a $1.5 trillion reduction in just over two years. Why hasn’t the combination of fiscal indifference and ‘quantitative tightening’ sent the bond market reeling?
It turns out there is good reason for the bond market to shrug its shoulders—at least for now. But to see why, we need to review some national income accounting.
It is an accounting truism (not economic theory) that the size of the general government budget balance must equal the size of the trade balance plus the gap between all business investment spending and total household savings. Put differently, the budget deficit must be financed by borrowing from abroad and/or by excess private sector savings beyond what is required to finance business investment.
This century, and especially in recent years, the foreign sector has played a big role in financing US government borrowing. For example, when the US budget deficit mushroomed during the pandemic, so did the US current account deficit (which widened from -1.9% to -4.5% of GDP between 2019 and 2022).
That borrowing continues today (albeit at a lower clip, near -3% of GDP). Critically, foreigners have been enticed by higher US yields, but not dramatically higher ones. That’s because the big-three—Europe, Japan, and China—are all experiencing economic stagnation or worse. Consequently, they have excess savings looking for a home, and that home has become the US Treasury market, with foreign buying manifested in a surging US dollar in the world’s foreign exchange markets.
Domestically, another dynamic has been a work. Since the GFC, US households have been saving a greater fraction of their income than they did between 1997-2007. (The savings rate has dipped at the beginning of 2024, and it bears watching whether this is a new trend or just noise.) So, greater US domestic savings has also financed higher government borrowing.
Also, households have been significantly reducing their borrowing, relative to income, over the past 15 years. According to the OECD, US household debt as a share of GDP has fallen by nearly a third since 2007. Meanwhile, corporate borrowing, also as a share of GDP, has remained relatively constant for more than a decade.
Accordingly, and consistent with national income accounting, large US federal government borrowing since 2007 has been financed out of higher household savings and muted private sector borrowing demand, alongside foreign lending.
One might counter, of course, that had the government not borrowed so much, private sector borrowing—perhaps especially corporate sector investment financing—might have surged. But that ignores that private sector borrowing has been sluggish for more than a decade even while real interest rates were historically low, even negative. It seems more plausible to argue that without fiscal stimulus, the US economy would have stagnated, and many Americans would have struggled to find work.
What about the Fed?
But wait, isn’t the Federal Reserve the ‘straw that stirs the bond market’? Isn’t the Fed the reason why bond yields have been so low over the past 15 years? Won’t its departure as ‘buyer of last resort’ inexorably raise bond yields?
Unquestionably, bond yields reflect, in part, the expected future path of short-term interest rates (which the Fed controls). They are also influenced by the central bank’s large-scale asset purchases. ‘Forward guidance’, namely the projection of future Fed policy intentions, also matters. Those are all tools the Fed has employed since the GFC and have helped produced low bond yields.
But in important ways the Fed might not be as influential as is widely believed. In recent years, as the Fed has reversed course, allowing its balance sheet to shrink (‘quantitative tightening’), hiking short-term interest rates, and allowing for more uncertainty about what it will do next, bond yields have risen. But not cataclysmically, as many feared.
As noted, that’s because US and foreign savers have readily welcomed a modest uptick in US yields, while private sector borrowers have demurred. Moderately higher yields have therefore both ‘crowded in’ savings and ‘crowded out’ borrowing, creating enough excess savings to finance even enormous US government indebtedness without requiring a huge jump in bond yields.
In short, the bond market has not collapsed under the weight or government deficits and debts, nor has it been undermined by ‘quantitative tightening’. The reason is because (global) savings and investment have responded ‘elastically’ to rising interest rates.
Can bonds remain boring?
The picture that emerges, therefore, is far more boring than suggested by the breathless internet commentary about a coming bond debacle.
But the question remains: Can bonds defy the Cassandras and remain boring for longer?
The answer, as so often is the case in economics: ‘It depends’.
Specifically, here is what would have to happen to genuinely undermine the bond market. Any of the following, or some combination thereof, would make for a more ‘exciting’ set of bond market ructions.
- First, growth in Europe, Japan, China, and perhaps the rest of the world, would have to accelerate, thereby reducing the supply of global savings and diverting a greater fraction of that savings to overseas investment, resulting in a higher global real rate of interest.
- Second, US business investment must boom.
- Third, US household savings must decline.
- Fourth, US inflation must re-accelerate.
- Fifth, the market must begin to question the US federal government’s ability and willingness to finance its debt, adding a credit risk premium to US Treasuries.
Any of the preceding five outcomes is possible, but are any of them probable?
Many seem unlikely. For example, foreign growth is anemic for well-known reasons due to demographics, geopolitics, or past gross misallocation of resources, depending on where one looks. A US investment boom is possible, but it hasn’t occurred despite more than a decade of soaring profitability, dazzling innovation, and super-low borrowing costs. So, why should it change now? US households may begin to save less, though why that should be the case is not obvious. Inflation could rise, though it seems more likely to fall.
Which leaves the final concern—a US default premium. That’s unlikely to emerge from today’s level of debt, as such. After all, other countries, including Japan, have higher levels of debt relative to GDP and are not seen as obvious default candidates.
But if US voters continue to reward politicians of both parties who offer tax cuts and spending increases, rather than plans for deficit reduction, then one day investors may question the US willingness to manage its fiscal affairs.
Still, it is important to note that US politicians and, by implication, US voters, have delivered on fiscal consolidation in the past, so downright pessimism is probably not yet warranted.
So, for now, the odds are stacked in favor of bonds remaining boring. That’s not what you’ll find on social media. But, then again, when was the last time you found anything useful on social media?
