With its public deficits climbing dizzyingly into the trillions of dollars and a government debt-to-GDP ratio ominously approaching the 100% level, the US is in a fiscal tailspin. But despite all the red ink, its debt is still finding buyers, allowing US interest rates to remain very low, at least for now.
Who is buying America’s debt? This is a vitally important question because where the US is headed, the world will follow, and much will depend on who proves to be the “buyer of last resort.” There are only four possibilities here: US households, foreigners, the Fed, and financial intermediaries. Let’s look at the implications for each.
If US households buy their government’s debt, they are, in effect, saving more. While this is virtuous behavior and would help to ease global imbalances, it would also stifle consumption, which would cripple the US business cycle and, by extension, global growth. In fact, if only US households were buying US government debt, America would slip into a Japanese-style deflationary spiral, as subdued domestic private demand hobbled growth and fueled an explosive debt-to-GDP ratio, which in Japan is now set to pass the mindboggling 200% level.
If foreigners buy US government debt, they merely reinforce the abysmal imbalances between the US and the rest of the world. Indeed, they would hinder a much-needed dollar depreciation as they stockpile more US dollar reserves. How high is up? China’s reserves just passed the two trillion US dollar mark. Another mindboggling sum. These massive reserves create a global liquidity (money) overhang that could easily feed into the next financial bubble, whatever form it might take, and the next financial crisis.
If the Fed continues to do “whatever it takes” to avoid a Japanese-style slump, as Chairman Bernanke has vowed, and it buys up a mountain of US Treasuries, thus keeping interest rates low, let’s be frank here: it is just running its printing presses, with the ugly consequence of rising inflation.
And if financial intermediaries jump into the breach? Then we merely have a somewhat more sophisticated version of plain-vanilla Fed monetization of debt, where banks score a nice, riskless profit by borrowing short at the Fed (a US government entity) at near 0%, and lending long to the Treasury (another US government entity) at around 3.5%. Moreover, as long as the difference between long interest rates on government bonds and short rates on the Fed’s liquidity lending remains this high, there is no incentive for financial intermediaries to lend to businesses and individuals. So this scenario could even lead to stagflation.
In sum, there is no painless cure for our debt problem. Each remedy has unpleasant side-effects. The not-merely-inconvenient truth of the matter is that the bill for “fixing” last year’s financial crisis is about land on the table with a very loud thud.
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