A U.S. fiscal crisis would likely unfold as a cycle of rising Treasury yields, higher borrowing costs, weaker growth and an increasing debt burden, according to Capital Economics. The firm says the central risk is investors losing confidence in policymakers’ willingness to control deficits. Higher interest costs could then make the debt burden harder to stabilise. Capital Economics considers gradual fiscal adjustment the best response, but doubts Congress will commit to it.
Why the debt burden could keep rising
Capital Economics says U.S. “nominal GDP growth is likely to slow toward the pre -pandemic norm, even as the average interest rate trends higher.”
The federal government’s primary deficits have also remained larger than before the pandemic because of various policy decisions. Together, these factors put the U.S. debt-to-GDP ratio on a steady upward path.
Capital Economics says the best solution would be for Congress to commit to gradual fiscal adjustment. However, the firm considers this unlikely. The Fed could instead find itself in a state of fiscal dominance: term premia could rise sharply and financial conditions could tighten, forcing it to purchase Treasury bills on a large scale. In that scenario, “the necessary fiscal adjustment would mainly occur through a sustained period of above-target inflation to try to inflate away the debt.”
How a loss of confidence could raise Treasury yields
The firm notes that the U.S. issues the world’s reserve currency and has an exceptionally deep Treasury market. These advantages mean global investors do not generally fear a U.S. default. Their concern is whether policymakers have the political will to stabilise the debt burden.
“If investors doubt the political will to get the fiscal situation under control, they will likely demand a higher risk premium to hold Treasuries,” economists at the firm said.
Higher yields would compensate investors for the increased supply of Treasuries. Investors might also demand more compensation for the risk of higher interest rates driven by deficit spending, or for policymakers attempting to inflate away the debt.
Whatever drives the repricing, it could become self-reinforcing. Investors selling Treasuries to protect against future losses would push yields higher. That would worsen the fiscal outlook and could prompt further bond sales.
What could trigger a fiscal crisis
Capital Economics says a potential trigger would be a rise in interest costs for reasons unrelated to GDP growth. This would increase r-g: the difference between the nominal effective interest rate and nominal GDP growth.
The firm notes that rising interest costs can become unsustainable quickly, while strong nominal GDP growth is unlikely to last indefinitely. It identifies no specific crisis threshold for interest costs as a share of government revenue, but says a rise above 30% would be concerning.
Effects on households, companies and growth
High bond yields would increase borrowing costs for firms and households, particularly at the long end of the market. U.S. households would be especially exposed because 30-year fixed-rate mortgages are common and are priced in relation to 10-year Treasuries.
Higher bond yields would also likely tighten financial conditions as equity prices fall. Capital Economics notes that higher term premia tend to coincide with slower or negative equity growth because higher yields reduce the present value of future income streams. Households and firms could then cut consumption and investment, slowing GDP growth.
Slower GDP growth would push the debt ratio higher still, increasing the fiscal adjustment needed to stabilise it.
The policy response and its political difficulty
Capital Economics thinks a long-term commitment to reducing the deficit, combined with looser monetary policy, could improve the relationship between interest rates and growth.
The difficulty is primarily political, the firm observes. Defence spending is hard to reduce, while discretionary spending accounts for only a quarter of total federal spending. Raising revenue would therefore be necessary, but the measures required would likely be unpopular.
