This article presents a hypothetical scenario of a fiscal crisis in the United States. The purpose is to explain how such a crisis would start, how it would unfold, and how Congress, the president, and the Federal Reserve can be expected to respond to it.
The scenario discussed here is meant for educational purposes only. It is not meant as investment advice of any kind. Its sole purpose is to explain that America is not at all immune to this type of crisis; that when it hits, the crisis could rapidly spin out of control and leave the American economy badly damaged.
As the European Conservative has documented in detail, a fiscal crisis is a dangerous event. Europe had an ugly encounter with it a decade ago, learning the hard way that when a fiscal crisis hits, it can destroy a nation’s economy with such ferocity that there is no path back to recovery.
There are ways to avoid a fiscal crisis, but the work to do so is arduous, complex, and taxing on the usually thin layer of patience that coats a politician’s mind. Hopefully, the following exercise can help boost the morale of elected officials in the United States who see the dangers of a fiscal crisis but who have yet to summon the political stamina to lead the nation in fiscally preventative reforms.
America’s fiscal crisis can begin either by Congressional action or by investors losing faith in the Treasury’s ability to honor its debt. The most likely starting point is an intertwining of these two causes, with Congress leading the way. When the cost of the debt becomes so burdensome that members of Congress are forced to make cuts in popular entitlement programs in order to pay interest to its creditors, then the United States has reached the point at which a fiscal crisis is most likely to begin.
Once there, Congress is likely to move forward along the path of least resistance: they will simply introduce a bill that says the United States Treasury can unilaterally write off some of the debt it owes its creditors. This will be the ‘least resistance’ alternative because Democrats will oppose spending cuts and Republicans will never agree to tax hikes.
We therefore start this fiscal-crisis scenario with the House of Representatives passing a bill that will write off part of the federal government’s own debt. The bill has bipartisan support from almost all members of the House.
The write-down bill will reduce the federal government’s debt by 25%—the same amount that the Greek government unilaterally wrote off in 2012. The American version begins with eliminating the debt that the federal government owes to the Federal Reserve, then it moves on to eliminate debt owned by financial corporations and very wealthy individuals. The process continues until 25% of the federal government’s debt is eliminated.
On the day that the bill is voted on in the House, the president announces his support for it. That same day, the U.S. Treasury holds three auctions to sell new debt. It needs to replace maturing debt and borrow a bit more on top of that toward the ongoing budget deficit.
Let us assume that the auctions are structured like some of the auctions held by the U.S. Treasury this week. They offer for sale $70 billion worth of three-month debt, $62.5 billion of six-month debt, and $42 billion of 2-year debt.
Let us also assume that these numbers are exactly the same as they sold a month earlier. At that point, the Treasury got $374 billion in tender offers from investors for its total $174.5 billion in sold debt. This means that investors offered $214 for every $100 of debt that the Treasury sold.
This ratio is important: it is a key indicator of a fiscal crisis in the making.
When the Treasury holds auctions right as Congress is trying to pass our hypothetical debt write-down bill, the response from investors is catastrophic. Initially, investors only tender $150 billion, which drops the ratio between investment offers and accepted debt purchases to 0.86, or $86 per $100 debt that the Treasury wants to sell.
This is a nightmarish scenario for the Treasury. When investors’ tender offers fall short of what debt a government is trying to sell, it is cause for panic in the Treasury. However, before they panic, they counter the poor investor interest by sharply raising the yield at the auctions.
Using the real numbers from the last real auctions for the three aforementioned maturities, we assume that the Treasury started its failed auctions by offering 5.25% for the 3-month bill, 5.24% for the 6-month bill, and 4.76% for the 2-year note. When the hypothetical auctions in our scenario fail to sell all the debt offered, the Treasury starts hiking the interest rate until it has sold all of the $174.5 billion it needed to sell.
Due to the mounting skepticism among investors in the wake of the debt write-down threat, the Treasury has to offer yields of around 7.5% in order to sell out the auctions. These very high yields are sure to put the nation on notice; just the day before, the yields were in the 4-5.5% range. Investors in the secondary market, i.e., the market where those who currently own U.S. debt can sell it, immediately start asking for significantly higher interest rates across the board.
Suddenly, the 7.5% from the three debt auctions begin spreading to other bills, notes, and bonds as well. Within two days of bond trading, rates on all maturities, from one month to 30 years, have reached 7.5-8.5%.
Now, the media picks up on what is happening. Many economists and pundits predict very expensive consumer credit, from credit cards to mortgages. Others try to play down the rate hike, explaining that it will subside once owners of the U.S. debt realize that the write-down is limited to the Federal Reserve and what some refer to as “the banks” and “the rich”.
Not everyone is impressed with this rhetoric. Foreign investors have a particular problem to deal with: if they do not sell their U.S. debt quickly enough, someone else might do it before them. Since debt sales by foreigners usually includes selling dollars to buy one’s home currency, the debt sale is immediately followed by a depreciation of the dollar. Therefore, the prospect of a decline in the exchange rate is enough to set in motion a debt sell-off by foreigners who want to ‘beat the gun’ and cash out before the dollar depreciates too far.
Inevitably, the dollar plunges vs. all major global currencies.
The next day, the Treasury has plans to auction off debt under its shortest maturities: the 1- and 2-month bills. However, due to the terrible results from the auctions the day before, they decide to cancel those auctions. In Congress, the majority leader of the House points out that by doing so, the Treasury is jeopardizing the federal government’s ability to pay its bills.
Several influential media commentators, as well as leaders in Congress, call for the Federal Reserve to enter the market and start buying debt. The Fed chairman refuses to do so, explaining that a return to so-called quantitative easing would only reignite the inflation fire.
Witnessing the unfolding crisis, the president starts putting pressure on the Fed to respond. If the Fed does not reconsider its policy to not buy debt, the president hints that he might take the initiative to remove some of the members from the Fed’s board of governors. He may or may not have the legal right to do so; the murkiness of the president’s authority here is enough to put pressure on the Federal Reserve to intervene.
Meanwhile, the Senate is considering the debt write-down bill from the House. Political pressure is building from the far Left for them to pass the bill. The president and leaders of both parties in the House also urge the Senate to vote for the bill, and soon.
Large investors with major holdings of U.S. debt lobby against the bill. Their case is reinforced by another day of major debt sell-offs in the secondary market. Interest rates now reach 10%, and the pundits who said the interest-rate hikes would subside, are beginning to look nervous on TV and on social media.
Other, more realistic forecasters, point to 15-20% in coming days.
At this point, the Fed chairman announces that starting the next day, the central bank will resume its so-called quantitative easing program and start buying large quantities of government debt. This announcement is applauded widely in the media, and Senate leaders from both parties agree to pass the debt write-down bill the next day, so it can go to the president’s desk for a signature.
Since the Federal Reserve is legally banned from buying sovereign debt at the auctions, it enters the secondary market the next day. This has a clear, soothing effect on the market, enough so that the Treasury can reopen its auctions.
At this point, the fiscal crisis seems to have been properly managed. We should all expect it to end here, right?
Unfortunately, that is not the case. The crisis just shifts character. The first big question is what the banks are going to do when the write-down bill becomes law and they lose large amounts of assets in the form of eliminated sovereign debt.
There is an answer to this question: the loan program that the Federal Reserve created after the Silicon Valley Bank collapsed. This program was meant to keep banks afloat that were suffering from the drop in value of U.S. government securities as a result of the rapidly rising interest rates in late 2022 and early 2023. Its mechanics are simple: the banks buy government debt and get an “advance” from the Federal Reserve for the purchase. The bank holds the debt, cashes in on the interest, gets its money back when the securities mature, and then pays back the loan to the Federal Reserve.
In the context of a fiscal crisis, this program is a tempting solution to compensate the banks for the debt write-down. The only problem is that the program depends existentially on the Federal Reserve continuously supplying new credit to the banks; if they do not expand the program, the banks will not buy new debt. At best, they will roll over old debt upon maturity.
Regardless of how we fine-tune the intervention of the Federal Reserve in the unfolding fiscal crisis, we end up with a scenario where the Fed is on the hook for increasingly absurd amounts of deficit monetization. To get an idea of how big of a commitment the Fed would have to make, consider the fact that as of today, 19.2% of the total federal debt matures in one year or less. This means that over the next 12 months, the Treasury needs to sell $6.2 trillion just to pay back its short-term creditors. This number does not include the yearly budget deficit, nor does it include refinancing debt of longer maturities.
If the Federal Reserve were to monetize a third of the $6.2 trillion, it would have to expand its M2 money supply by 10%. Add $1.5 trillion for regular deficit spending, and the money supply expands by almost 17%. For comparison, in 2020, when the Fed bankrolled all the pandemic-related spending that Congress engaged in, they expanded the money supply by just below 25%. This monetary expansion is the culprit behind the inflation episode we have just been through.
The only difference is that in the scenario laid out here, the monetary expansion cannot end. It will continue, and grow continuously, for as long as Congress fails to make spending cuts. The longer Congress waits, the more drastic those cuts will have to be. This means, plainly, that America will be faced with a choice between austerity policies of the same potency that destroyed one-quarter of the Greek economy, or enduring inflation that could reach levels of 20-50%.
Either scenario would change America permanently, and not for the better. Hopefully, Congress will at least get started on preventative reforms before a fiscal crisis hits.
