For weeks, American media outlets have been full of dramatic forecasts that the U.S. government will default on its debt obligations in June. In response to those hyperbolic predictions, on May 10th I explained:
I hate to disappoint the drama merchants, but there will be no such default now—as boring as it sounds, the U.S. government is going to be able to pay its bills in June. Congress and President Biden will reach an agreement.
Last Saturday, on May 27th, Republican Speaker of the House of Representatives Kevin McCarthy and Democrat President Joe Biden reached a debt-ceiling deal “in principle.” Two days later, the bill that will turn the deal into law was made available for the public to read.
There will be a default, and it will be one ugly experience, but it will not be as a result of failed negotiations over the statutory limit on government borrowing. American politics works in such a way that neither Democrats nor Republicans will want a default to happen. Therefore, when it does happen, it will originate in the international sovereign-debt market.
If the concerted efforts by China, Russia, and others are successful in de-dollarizing the global economy, the U.S. debt crisis will take on catastrophic proportions.
How likely is that to happen? Not very likely, at least not now. But there is one event that could turn all de-dollarization forecasts on their heads.
Let us get back to that event later. First, we need to understand the new debt-ceiling deal, its context, and what its merits are.
The current deal must inevitably be viewed in the context of global anti-dollar sentiments. The very credit rating of the U.S. government hinges on the dollar as the world’s reserve currency. The new debt deal was reached without a mention of these global perspectives, which likely means that neither the president nor the leaders in Congress take the global threat against the dollar very seriously.
In addition to ignoring the global scene, the debt deal leaves so-called mandatory spending, i.e., programs where Congress simply allows outlays to grow on autopilot. These programs include Social Security and Medicare—retirement and health benefits for retirees—and account for approximately 70% of total federal spending.
Things look better under the spending category referred to as ‘discretionary.’ This is the kind of spending that Congress budgets for on a regular basis. About 10% of federal health care spending is included here, as are outlays on education, transportation, social welfare, and ‘international affairs’ or aid to developing countries.
Under the debt-ceiling deal, discretionary spending will be subject to restrictions for the next two years. The one exception is the defense budget, which for reasons nobody outside Congress can understand, counts as ‘discretionary,’ not mandatory.
The non-military portion of discretionary spending will be funded for the 2024 fiscal year (which begins October 1st). Interestingly, the re-appropriation is set at 99% of current levels, which means that for the first time in recent history, Congress will actually cut some of its programmatic spending. The cut is minimal and, as Republican Senator Rand Paul has pointed out, allows those programs to continue to spend more than they did before the recent pandemic:
The programs that receive a cut will see a 1% increase in the 2025 fiscal year. What happens beyond that will be up to the next Congress and the president elected in 2024.
Looking at just the numbers, it is easy to be disappointed, especially since the temporary 1% cut applies to less than 17% of the total federal budget. As Senator Paul notes, military and mandatory spending will continue to grow; a rough estimate says that this deal allows total federal spending to increase by approximately 3.74% in the coming year.
Again, for fiscal conservatives, these numbers are no reason for a big celebration. However, their big achievement is the fact that there are cuts in the first place. When House Republicans first started asking for negotiations over the debt ceiling, the Democrats explained that the only conceivable agreement was a clean debt ceiling increase, nothing else. Spending cuts were simply unthinkable.
In other words, Speaker McCarthy has set an important precedent; in two years, when the debt ceiling is up for negotiations again, it will be much easier to include spending cuts right from the start.
The big problem here is, of course, the agreement to raise the debt ceiling by $4 trillion. The federal government can now increase its debt from just below $31.5 trillion to $35.5 trillion. This is a big rise in the debt, especially since it means adding $2 trillion per year for two years in a row. This is twice the deficit in the federal budget under normal circumstances; if we disregard the pandemic years 2020 and 2021 and look at the four latest normal years, i.e., 2017, 2018, 2019, and 2022, the average annual budget deficit is $946 billion. In 2019 and 2022 the deficit exceeded $1 trillion by, respectively, $52 billion and $90 billion.
I have no direct information on why the debt-deal negotiators chose to allow twice as much borrowing as the recent deficits, but there are likely two reasons for it. First,83.5% of total federal spending is not subject to cuts under this deal. Mandatory programs and national defense can sprawl freely until the new debt ceiling is reached.
Notably, the $4 trillion in new borrowing would allow for a two-thirds expansion of mandatory spending over the next two years. This is an enormous amount of money, with only one reasonable explanation: the new debt permitted under this agreement will at least partly be used for a structural expansion of mandatory spending programs.
Democrats have for a long time pushed for tax-paid benefits to parents who stay at home with newborn babies or sick kids. Some Republicans have proposed that this new entitlement be rolled in under Social Security.
Members of Congress in both parties could also be expected to want a continued expansion of the federal government’s outlays for health insurance.
With discretion to borrow $4 trillion over the next two years, Congress is now free to consider paid leave, more health care benefits, and other entitlements that require a major expansion of federal spending. By borrowing the money to pay for those new entitlements, our federal lawmakers can once again try to give us something for nothing.
I doubt that Speaker McCarthy would get much support from the fiscal conservatives in the House of Representatives for any new entitlement benefits. However, nothing can be ruled out, especially since this debt ceiling deal stretches beyond the 2024 election.
The other reason why Congress is now going to expand its own borrowing authority by $4 trillion is the rapidly rising cost of the U.S. government’s debt. As of May 25th, the estimated average interest rate on the U.S. debt—calculated with a debt analysis model developed by yours truly—was 2.52%. On a debt of $31.47 trillion, that comes out to an estimated annual cost of $793.8 billion.
On October 1st, 2022, at the start of the 2023 fiscal year, the U.S. government owed $30.93 trillion. With an estimated average interest rate of 1.87%, the estimated annual cost for that debt was $579.4 billion. In other words, the cost has risen by 37% so far this year.
With the new borrowing—which will kick into high gear as soon as the new debt ceiling has the president’s signature on it—this interest cost will rise rapidly, and will likely exceed $1 trillion for the current fiscal year. If Congress borrows another $500 billion between June 1st and September 30th, and if on that day the average interest rate on the debt is 3.13%, then the total annual cost will be $1 trillion.
Technically, since the year started out with a lower interest rate, Congress will actually not have paid $1 trillion in interest over the 2023 fiscal year. However, the number is an excellent debt-cost prognosticator: so long as the debt continues to grow, and so long as interest rates keep going up, we can extrapolate the recent trend and pinpoint with good accuracy how big of a bite debt-cost interest rates will take out of the coming year’s federal budget.
If the cost estimate reaches $1 trillion before the end of this fiscal year, we can safely forecast that it will be a bit higher than $1 trillion for the 2024 fiscal year. If we then add the new borrowing, we get a trajectory of accelerating debt cost.
This frightening scenario is reason alone for Democrats and Republicans to ask themselves how they are going to pay for the interest on the debt. As absurd as it seems from the outside, their go-to solution can very well be to borrow more money. They raise the debt ceiling because it may help them pay for already existing debt.
Logic is a scarce commodity on Capitol Hill.
Time now for the frightening part of the looming $4 trillion debt increase. As I explained last year, as well as recently, there is a growing effort to de-dollarize the global economy. China is leading the effort, using a new central bank reserve system based on their renminbi. This system is meant to motivate central banks to replace their dollars with Chinese currency. As a consequence, these countries will shift the denomination of their foreign trade from dollars to Chinese currency.
Many people shake their heads at the mere possibility that China would be able to replace the dollar as a central bank reserve currency. I agree that the global prospect is unlikely, but as I explained in an article last year, if this was done by as few as ten countries, including China, Russia, India, and Brazil, the dollar sell-off would equal an 8.8% increase in the U.S. money supply (in 2022 numbers).
This is more than the monetary expansion during the financial crisis in 2009-2011. In 2020, the money supply grew by almost 25%, which—transmitted through reckless fiscal expansion—caused the high inflation we have just experienced. If de-dollarization becomes widespread enough, we could see a monetary expansion of the same proportions.
But wait: is that even realistic? Beyond the small group of BRICS nations accounted for here, who else would join?
The simple answer is that the number is open. To get an idea of the interest in the subject, we could take a look at how many countries will participate in the international economic conference in St Petersburg, Russia, in mid-June. Last year the conference attracted representatives from 131 countries. Roscongress, the foundation behind the conference, has a track record of putting de-dollarization on the agenda. At its 2021 Eastern Economic Forum, one of the sessions discussed a “dollar-free model” for global economic integration.
At this year’s St Petersburg conference, one of the sessions focuses on “BRICS business partnerships in the new economic reality.” Judging from the session abstract, there is no doubt that this will be about how to advance de-dollarization.
If this effort gains momentum, central banks around the world will dispose of enough dollars to cause a major expansion of the dollars in circulation. This would, in turn, generate a money supply shock in the U.S. economy that could rival the one we saw in 2020. This opens for the possibility of another double-digit inflation episode in the near future.
I should point out that this scenario is not probable, but possible. A de-dollarization below 10% of the world’s central-bank reserves would be difficult but manageable for the Federal Reserve. However, there is one event that could completely upset this outlook—one event, that with the metaphorical stroke of a pen could catapult de-dollarization to such proportions that it poses an existential threat to the U.S. currency.
What if Russia wins in Ukraine?
