As the economic recovery from last year’s shutdown turns into a standstill, it is a safe bet that government will have to borrow more money. The welfare state, which consumes 70 percent of all federal spending and two thirds of total government spending in the United States, is designed to keep spending regardless of whether taxpayers can afford it or not. In fact, many of its entitlement programs are constructed in such a way that their outlays increase when economic growth slows down.
The elephantine question in the room is: when will America reach the point where a full-scale fiscal crisis erupts? Since there is no history of such events in economies as large and complex as ours, we cannot draw on history for any convenient, statistically significant answer. We do, however, have some qualitative historic precedent to rely on, and we can definitely say a thing or two about what a fiscal crisis would look like.
To get a better understanding of what we can expect when the sovereign-debt market finally loses confidence in our Treasury – and by consequence in the ability of Congress to show even a modicum of fiscal responsibility – we need to take a closer look at what the U.S. debt actually looks like. We need to look at its composition, its trends and how the debt and its yields have varied depending on economic conditions.
Most of this historic information is not relevant for our effort to understand what a fiscal crisis will do to us, but there are a couple of episodes that are helpful. The Great Recession is a good example, and the stagflation era is an even better one. In coming blog articles I will put our current debt situation in the context of, primarily, those two episodes; for now, let us take a look at the most important trends in the federal government’s debt over the past few decades.
The U.S. Treasury publishes a wealth of data on the debt, with exquisite detail and frequency. Going back to 1869, the curious taxpayer can get some very valuable – and scary – insight into government borrowing. For the purposes of the current review, I will limit myself to the debt trends since the mid-1970s: that was the point in time when stagflation was setting in and when President Lyndon Johnson’s War on Poverty had finished its redesign of the American welfare state. Government suddenly spent more money on redistributing income, consumption and wealth than on national security and the rule of law. As a result, government spending had been decoupled from what taxpayers could afford – and, logically, budget deficits became the norm rather than the exception.
Let us start with the composition of the debt. The most commonly known component is the three-category Treasury securities we know as bills, notes and bonds. These are the fixed-maturity, nominal-yield securities within the category of so-called “marketable” debt. This category also includes TIPS, or Treasury Inflation Protected Securities, and a couple of other kinds, all of whom together account for only a small share of the total debt.
In addition to “marketable” debt, the Treasury also issues “non-marketable” debt. This category consists of securities that are offered on a restricted, tax-exempt basis. Due to the restrictions, this category is not directly comparable to marketable debt, which as the term suggests can be traded openly; any analysis of how the U.S. debt interacts with the rest of the economy is best concentrated on the debt that is subject to market signals – and, by logical consequence, changes in its debt-risk evaluations.
For the purposes of reference, I will include non-marketable debt from time to time, but the main story about the U.S. debt will be focused on the marketable side. There, in turn, I will put the spotlight on the nominal-yield securities, in other words the traditional bill-note-bond triad. Not only does it astutely convey signals of market confidence, but it also serves as the main exhibit of how monetary policy interacts with fiscal policy: whenever the Federal Reserve monetizes – or chooses not to monetize – the debt, its actions are reflected crisply in the bill-note-bond securities triad.
Figure 1 reports the change in size of these three kinds of debt; data points are from the end of each fiscal year. The shortest-maturity category, namely bills with a maturity span from one month to one year, has declined in relevance over time. (There is one notable exception that we will return to in a moment.) Notes, spanning 2-10 year maturities, have grown in relevance, to the point where they carry the heaviest weight of marketable debt. Bonds, i.e., the 20- and 30-year maturities, have been of minor importance.
The fact that the medium-term category with maturities from two to ten years has grown, is not very surprising per se. It offers investors a great deal of portfolio flexibility while avoiding the potential volatility that comes with the shortest-maturity securities.
It is quite interesting to look at these three categories from the yield side. Take a close look at the stagflation era of the 1970s:
A “normal” debt market asks a higher yield on longer-maturity debt. The reason is obvious: the longer you own someone’s debt, the higher the risk that they at some point default and won’t pay you back. This has been a purely theoretical concern regarding U.S. debt, but the rule of the-longer-the-higher when combining maturity and yield is also motivated by risks regarding the investor’s portfolio return. On a fixed-yield security, such concerns as inflation and alternative costs and returns become exponentially more prominent the longer he owns the debt.
As Figure 2 shows, for the most part this longer-higher combination applies to the yield structure of Treasury securities. However, it did break down and was in fact reversed at the height of the stagflation era. The longest maturities suddenly came with the lowest yields, while the shortest maturities paid the best.
There are two reasons why this happens, both of which will be relevant when we start applying our historic review to our present time and the risk for a fiscal default. The first reason has to do with expectations: the high interest rates of the late 1970s and early 1980s were caused in good part by high inflation; when investors accepted lower interest rates on long-term debt than on short-term debt, they exhibited expectations that the inflation problem was transitory and would go away over time.
The second reason has to do with the inverse interaction between the price and the yield: when the price of the bond increases, the yield drops, and vice versa. For example, if a security pays $1 per year and is sold at a price of $50, the yield is two percent. If the price doubles to $100, the yield is unchanged at $1, which means that the yield viewed as an interest rate has now dropped from two percent to one percent.
These two mechanisms are perfectly compatible with one another. When investors have confidence in the long-term performance of the U.S. economy and the U.S. government, they are perfectly willing to buy bonds instead of bills, for the purposes of portfolio stability. If you can get 20- and 30-year bonds that pay in excess of ten percent per year, you have made quite a deal for yourself – especially if you believe that inflation rates of 10-15 percent are only a short-term phenomenon. This is apparently how investors reasoned back in the stagflation era: demand rose faster for bonds than for notes and bills, pushing the market price up and yields down, relatively speaking.
We will return to this analysis of the stagflation era at a later point, when we discuss the actual nature of a U.S. fiscal crisis and what market signals that precede it. That will have to wait until a later article; for now, let us add one more piece of information regarding U.S. debt and its change over time. Figure 3 reports changes in the three Treasury categories; four points in time are important:
The four episodes highlighted in Figure 3 have one thing in common: in response to rising government deficits, the Treasury has rapidly increased the supply of its shortest-maturity debt instruments. The supply of bills shoots up rapidly at the onset of the recession in the early 1990s and it is the leading debt category when the Treasury needs to fund the Millennium recession (and respond to the uncertainty after the 9/11 attacks). The Treasury also used this category to rapidly increase borrowing during the Great Recession and during last year’s artificial economic shutdown.
Short-term debt can function as “supplemental” investments for portfolio managers. A one-month Treasury bill is essentially a way to park money while considering longer-term use for it. This makes it easy for the Treasury to expand its borrowing when the budget deficit widens. However, for this to work properly, the market has to respond by buying up that debt as it is being issued; if a sharp rise in the supply of bills is met with lukewarm interest from the market, yields will rise rapidly as supply exceeds demand (causing the price of the bill to fall). This interaction between supply and yield will be another key variable as we look more closely at what a fiscal crisis in America could look like.
Overall, then, we have learned three valuable things about our beloved government’s debt:
- Most of it is of medium-length maturity, allowing sovereign-debt investors a great deal of flexibility in their portfolio management;
- During the stagflation era, the last time we had high inflation and therefore a great deal of uncertainty in our economy, investors exhibited confidence in the future in how they prioritized their U.S. debt investments; and
- The Treasury prefers to respond to a sudden, adverse fiscal event by rapidly increasing the supply of bills on the sovereign-debt market.
In a coming article I will explore what these findings can tell us about the unfolding of a fiscal crisis in America. There are a lot of unknowns associate with it; one thing, though, is beyond doubt: unless Congress immediately reverses course and starts cutting spending, a fiscal crisis is coming. And when it does, it will be the hardest socio-economic experience that the United States has gone through in at least half a century.