Back in March, I warned that the American economy “is on the threshold of a fiscal meltdown the size of which the world has never seen.” I pointed to the rapid rise in government debt during the pandemic and explained that even if the budget deficit returns to ‘normal’ levels, it would still increase the debt by at least $1 trillion per year.
That debt, which is currently 26% bigger than the entire American economy, has not yet become an unbearable burden to taxpayers. The only reason for this is that the Federal Reserve has bought trillions of dollars of U.S. government debt, pushing interest rates to virtually zero.
This is about to change, and change drastically. Already in early 2023, the U.S. government is likely going to find itself facing runaway debt costs—and be on the verge of a Greek-style fiscal crisis.
In this article, which admittedly is a bit technical, I am going to explain how we can all watch, almost in real-time, how the U.S. government drifts closer and closer to the crisis point.
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To understand how the American economy is drifting toward a fiscal crisis, we first need to understand how rapidly, and significantly, rising interest rates hit the federal budget. This impact originates in the relationship between the amount that the U.S. Treasury borrows on a regular basis—in other words, its debt auctions—and the interest rate it has to pay in order to sell the debt.
As an example of how that rate has risen, consider the change in interest on the so-called two-year Treasury note, i.e., the security that matures in two years. From October 2020 to September 2021, the U.S. Treasury borrowed $814 billion by selling two-year notes. On average, it had to offer an interest rate of 0.15% to sell them.
In September this year, the Treasury sold $43 billion of the same two-year note, but now the interest rate was 4.2%.
Investors who bought this security in 2020 and 2021 earned a total of $1.2 billion in interest. If they had gotten 4.2% instead, they would have earned more than $34 billion.
The rise in interest rates is good for investors, but as it spreads and applies to more and more of the U.S. debt, it gradually expands into a disaster for American taxpayers.
And expand it will. The Treasury holds weekly auctions to renew portions of all of its outstanding debt. Currently, about one quarter of the total debt matures in three years or less. This means that the higher interest rates relatively quickly eat their way into the federal budget.
That ‘eating’ is about to get a lot worse. The reason is found in the pandemic-related borrowing: in 2020 alone, the U.S. Treasury borrowed more than $4.5 trillion. Half of it consisted of Treasury bills maturing in one year or less. Since then, they have tried to replace some of that short-term debt with longer maturities, but the short-term bias remains.
In the last quarter of this year, the Treasury will have to refinance at least $2.4 trillion in short-term debt. They will have to pay interest rates that are up to 27 times higher than on the debt that is being refinanced.
As these higher rates affect a growing segment of U.S. debt, Congress is going to enter 2023 facing an alarming rise in debt costs. To illustrate this point: when interest on the debt reaches 3%—which is a certainty by now—the debt cost will be the second-largest spending item in the federal budget.
At 4%, the debt cost equals the largest item in the budget, namely Social Security retirement benefits. And that is if the debt does not rise; at 4% interest and annual deficits of $1 trillion, the debt cost will become the biggest item in the budget no later than 2024.
The words ‘fiscal crisis’ will be on every American’s lips.
It is also going to be on every European’s lips, in no small part thanks to the continent facing its own, new debt crisis—and doing so in a liquidity-trap situation. The combination of the two means that central banks, including the ECB, have exhausted their abilities to mitigate a debt crisis.
Before we get to the numbers that can help us track the U.S. economy’s descent into a fiscal crisis, let us nail down a good definition of the term. It is widely used in the political arena, in public policy research, and in the academic literature, yet few writers ever bother to define it.
There are some exceptions, among them a group of Irish scholars from the Economic and Social Research Institute in Ireland. In 2011 they co-authored “The Irish Fiscal Crisis” with the National Institute Economic Review. They refer to a fiscal crisis as, simply, a rapid rise in the budget deficit. Many others make use of the same definition.
Unfortunately, this definition is inadequate. A government can experience a rise in its budget deficit, even a fast one, without being even close to a fiscal crisis.
A better approach comes from an unexpected place, namely two Marxist sociologists. One of them, Fred Block with the University of Pennsylvania, wrote an article in 1981 for the Annual Review of Sociology (“The Fiscal Crisis of the Capitalist State”), where he relies on a fiscal-crisis definition from James O’Connor and his widely recognized book The Fiscal Crisis of the State.
Block elegantly summarizes O’Connor’s contribution in two steps:
1. A “disproportion between government expenditures and revenues,” and
2. This “disproportion” becoming permanent.
If we peel away Block’s and O’Connor’s Marxist deadweight, there actually is a grain of truth in this ‘fiscal crisis’ definition. Its key ingredient is the so-called structural deficit, i.e., a permanent imbalance between tax revenue and government spending. This deficit exists no matter how poorly, or how well the economy is doing.
A structural deficit becomes a problem, and eventually a fiscal crisis, when it has led to the accumulation of so much government debt that investors have lost so much confidence in the indebted government that they consider it too risky to buy its debt. When this happens, the indebted government can no longer find investors for all the debt it needs to finance.
The U.S. government gets weekly assessments of its credit worthiness at the auctions where it sells Treasury securities (known as bonds, notes, and bills). So far, no U.S. debt auction has been close to the point where there aren’t buyers for all the debt on sale. However, there is a disturbing trend in demand for U.S. Treasury securities that suggests that this point is not too far off.
To track how close the auctions are to the fiscal-crisis trigger point, we need the ratio between two variables known as ‘tender’ and ‘accept’:
- Tender is the total amount of money that buyers are willing to spend at the auction in order to buy the debt being sold;
- Accept is the total value of the debt securities that are sold at the auction.
For example, if investors come to the auction willing to buy $25 billion worth of Treasury securities, and the Treasury has brought $10 billion worth of securities to sell, the Tender-to-Accept ratio, or T/A, will be 2.5:1.
The T/A ratio is important because it indicates how high demand is for the Treasury securities; it also determines the interest rate that the Treasury has to set in order to attract buyers. The higher the T/A, the lower the interest rate that the Treasury will have to pay investors, and vice versa.
It is right here, in the thick of the technical soup that is the market for U.S. government debt, that we find all the information we need to determine how far away the United States is from a fiscal crisis.
In 2019, the year before the pandemic, the U.S. government was selling its debt at interest rates that almost never exceeded 3%. In fact, demand for Treasury securities was rising, which means that the market price was going up; when the price goes up, the interest rate falls.
For the securities with one- and two-year maturities, the Treasury paid about 2.5% at the beginning of the year and roughly 1.5% toward its end.
In other words, the return on owning U.S. government debt was not exactly spectacular. Yet we can see the high demand in high T/A ratios. In Figure 1 below, the T/A ratio for one-year bills in 2019 is illustrated by the blue line. It shows how the T/A was never lower than 2.66.
January of 2022 saw the interest on a one-year bill fall far below even the modest rates at the end of 2019. The Treasury was paying a microscopic 0.4% to anyone willing to own a one-year bill. The reason for this extremely low rate was, of course, the Federal Reserve’s intervention in the market: they drove up demand to the point where the yield was almost wiped out.
As Figure 1 shows, the T/A ratio was lower in early 2022 than in the same months of 2019. At this time, the Federal Reserve had announced its exit from the Treasury security market. Since the yield was almost non-existent, the Fed pull-out caused a risk for a critical drop in the T/A ratio.
To counter this, the U.S. Treasury gradually offered higher rates: it passed 1% in February, 2% in April, and its 2.5% peak point (from 2019) in June.
These yield hikes were partly motivated by the Federal Reserve’s gradually raising its key federal-funds rate. This rate went up from 0.08% early in the year to 0.33% in March, 0.83% in May, 1.58% in June, 2.33% in July, and 3.08% in September. The yield on the 1-year Treasury bill followed suit, reaching 4% on September 15th.
This long trend of rising yields should attract massive amounts of investors to the Treasury auctions, should they not?
Yes, they should, but they haven’t—and this is what is so alarming about the data in Figure 1:
Since May, the T/A for the one-year bill in 2022 has been close to where it was in 2019—with yields rising in 2022 while declining in 2021. At the September auction, the T/A ended up below where it was in the same month in 2019, even though the yield was 2.5 percentage points higher than it was three years ago.
If this trend persists, and if the same pattern appears in the auctions for other Treasury securities, then we know that we are rapidly approaching a U.S. fiscal crisis.
The well-informed reader will point out that inflation is higher in 2022, and therefore buyers want a higher return on their investments. This is true, but it does not explain why demand is weakening for U.S. debt. If inflation was the reason, investors would be scrambling for the kind of Treasury security known as ‘TIPS,’ i.e., the notes and bonds that guarantee the investor a return protected against inflation. Per available Treasury data, there is no meaningful change in demand for TIPS.
The cold, hard truth embedded in all these numbers is this: going forward, the U.S. Treasury will have to continue to raise interest rates just to keep the T/A from falling. This applies not only to the 1-year Treasury bill but to all Treasury debt instruments.
There is a cap above which they cannot raise interest rates without virtually destroying the U.S. economy. Both the Federal Reserve and the U.S. Treasury are in mortal fear of hitting this point, at which they will helplessly watch the T/A ratio fall below 1.
If it does, markets have lost confidence in U.S. government debt. By definition, that is the beginning of a fiscal crisis.
When will we get there? That is very hard to determine, but it could happen in the first half of next year.