The federal government’s expensive response to the coronavirus pandemic makes an already-bleak long-term fiscal outlook even bleaker.
After five years in which federal budget deficits gradually climbed toward $1 trillion, the coronavirus pandemic forced Washington to borrow $1 trillion per month between April and June. And this is just the beginning. The unlikelihood of a quick economic recovery and the additional relief legislation sure to come out of Congress should together push the deficit to roughly $4 trillion in 2020 and ensure that it averages $2 trillion annually over the rest of the decade.
As a result, the national debt held by the public — $17 trillion earlier this year — is projected to reach a staggering $41 trillion by 2030, even before accounting for any additional pandemic-relief measures or the expensive proposals that Democrats are salivating to enact if they sweep the White House and Congress this November.
Who is going to lend the federal government all this money? Politicians promising trillions in new spending seem unconcerned with the question. Financial markets, which are trading ten-year Treasuries at interest rates of 0.7 percent and 30-year Treasuries at interest rates of 1.3 percent, don’t seem worried, either. Many analysts see a world awash in excess savings and a Federal Reserve dedicated to pouring liquidity into the market. Yet borrowing $24 trillion (or more) over the decade would create a nearly unprecedented burden: The debt held by the public would rise from 79 percent to 128 percent of GDP, in the largest debt surge since World War II. But when World War II ended in 1945, the debt burden quickly declined; our present national debt is set to continue rising steeply for decades, because Social Security and Medicare face a 30-year cash shortfall of more than $100 trillion.
Washington has easily financed this year’s exorbitant borrowing. Since March 11, the national debt has jumped by $3.1 trillion. Treasury data through May suggest that foreign borrowing has financed virtually none of this new debt. Instead, the Federal Reserve has increased its Treasury holdings by $1.7 trillion (from $2.5 trillion to $4.2 trillion), and the remaining $1.4 trillion has come from domestic savings such as banks, mutual funds, and state and local governments.
But this model may not be sustainable. Economists have long argued that rising debt is affordable because the large global economy will continue to eagerly lend America — creator of the world’s reserve currency — dollars at low interest rates. Yet international borrowing has not kept up with America’s rising debt. While foreigners held nearly half of America’s $10.5 trillion debt at the end of 2011, they have funded less than one-fifth of the extra $9 trillion in borrowing America has undertaken since. Over these past nine years, while America’s debt soared from $10.5 trillion to $20 trillion, the total American debt held by Japan and China barely increased, from $2.2 trillion to $2.3 trillion. The American debt held by the rest of the world grew from $2.8 trillion to $4.5 trillion in the same time frame, with the U.K. and Ireland driving one-quarter of the increase.
Moving forward, China — whose decisions to buy and sell Treasuries are often driven by whether it wishes to appreciate or depreciate its own currency — is not expected to embark on a Treasury-buying spree large enough to cover much of America’s exorbitant new borrowing; White House talk of defaulting on America’s Chinese debt as payback for China’s coronavirus-related behavior will only limit Beijing’s appetite for Treasuries. Japanese investors and pension funds should retain some enthusiasm for Treasuries as long as U.S. interest rates exceed Japan’s own zero (or negative) rates. But America’s interest-rate advantage in that case has fallen by 80 percent since 2018, and even a Japanese borrowing surge would cover only a small portion of Washington’s heavy borrowing needs. It is highly unlikely that other countries with much smaller economies and debt holdings can finance much of the $24 trillion in new borrowing, especially when many of their own national debts are rising.
Consequently, American lenders will have to bear the brunt of all this new federal spending. During the pandemic, the Federal Reserve has added $1.7 trillion in new Treasury holdings out of $3.1 trillion in new federal borrowing. The Federal Reserve is not permitted to buy securities directly from the Treasury Department, so it has bought existing T-bills from secondary markets at the same time that the Treasury has issued new debt.
Thus, the Federal Reserve has indirectly monetized more than half of the new pandemic-related debt. And despite what Modern Monetary Theory enthusiasts may tell you, monetization is not a viable long-term strategy. The Federal Reserve has already begun slowing its purchase of Treasuries since Mid-May and may well seek to pare back its Treasury holdings after the economy recovers, the budget deficit stabilizes, and financial markets need less emergency liquidity.
The final $1.4 trillion in borrowing since March has come largely from domestic savings, as the personal-savings rate surged from 8 percent to 32 percent, and corporate investment opportunities dried up. These savings have to land somewhere, and Treasuries have recently proven safer than the volatile stock market.
The $24 trillion question is who will feed Washington’s insatiable borrowing appetite moving forward. The days of borrowing $1 trillion per month are hopefully over, yet the remaining $21 trillion in projected borrowing over the next decade (plus any new spending approved by Congress) would still represent a doubling of the national debt.
China, Japan, and other countries are highly unlikely to finance a large portion of this debt. As a result, the Federal Reserve will face increased pressure to continue buying government debt in the future. The Fed previously increased its Treasury holdings by $2 trillion between 2008 and 2014 without inflationary consequences, so the most recent $1.7 trillion addition may be sustainable. But that doesn’t mean the Fed should — or desires to — take on a large portion of the remaining $21 trillion borrowing binge.
That leaves domestic savings to fund much of the new debt, which is a problem, because at some point the economy will recover, personal-savings rates will descend to their pre-pandemic level, corporate-investment opportunities will reappear, and the stock market will start to attract more savings. When that happens, even a return of Treasury bonds to their pre-pandemic 2 percent rate might not be enough to attract $2 trillion in additional borrowing each year. If it isn’t, interest rates will rise. And once Washington is $41 trillion in debt, each one-point increase in the average interest rate paid by the federal government will cost taxpayers an extra $410 billion per year in interest payments on the national debt.
Furthermore, an overreliance on domestic savings for most of Washington’s exorbitant new borrowing is likely to eventually begin crowding out business investment and blunting economic growth. This would represent a reversal of the past few years, in which large savings and cheap borrowing often exceeded the amount of sound business-investment opportunities. At some point, tapping domestic-savings markets for an ever-soaring national debt may begin to squeeze investment.
Over the past 20 years, the national debt gradually rose by $14 trillion (from 32 percent to 79 percent of the economy) without major economic consequences. But the U.S. is now embarking on a debt binge the likes of which it hasn’t risked since the height of World War II. If foreign borrowing remains relatively flat, there may be intense pressure for the Federal Reserve to essentially monetize more of the debt in order to keep rates from rising and protect business investment. America’s borrowing capacity is large, but we may discover that it is not unlimited.
This piece originally appeared at National Review Online (paywall)
Brian M. Riedl is a senior fellow at the Manhattan Institute and author of the recent issue brief, Coronavirus Budget Projections: Escalating Deficits and Debt. Follow him on Twitter here.
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