When the Party’s Over

Unless we start getting our fiscal house in order now, we will soon be at the mercy of our creditors.

S omebody needs to remind President Biden about the Golden Rule — the real Golden Rule: He who has the gold makes the rules, and we are clean out of ducats.

Jim Rogers, the famous investor, offered a version of that golden rule when explaining why he decamped to the Far East and has raised his daughters speaking Mandarin: “You know where the assets are, and you know where the debts are.” President Bill Clinton, enraged at the way the financial markets constrained his grandiose ambitions, observed ruefully that in his next life he wanted to be reincarnated as the bond market so that he would finally know what it’s like to have some real power. Mann Tracht, Un Gott Lacht, goes the Yiddish proverb: Man plans, and God laughs.

The bond market isn’t God, but, if you are a politician living on credit, it’s close enough.

The U.S. government currently is flooding the markets with newly issued U.S. debt, and President Joe Biden (three words still incredible to write) and his Democratic allies in Congress intend to keep the tap wide open as long as they can. But there are real limits on what they can do — and we already may be starting to feel the pinch.

The U.S. government borrows money mostly by selling bonds at auction. Demand for those bonds has been very strong for a very long time, for reasons that should be obvious: The United States has the largest economy of any nation in the world, is a financial and military superpower, and enjoys stable government (miraculously stable, considering the character of the jackasses we routinely put in charge of it). Though the dollar may not be quite as good as gold, it’s still the best option on offer. (There aren’t enough Swiss francs to go around.) But even if you are the world’s premier Triple-A platinum-level borrower, nobody (normally) lends for free. The interest the U.S. government pays on its debt is the price we pay to borrow money.

And, for a long time, that interest rate has been approximately squat.

So, from one point of view, Washington’s recent borrowing spree has been rational: When you can borrow for next to nothing, why not max out? Governments are not like families, political rhetoric notwithstanding, but think of it in the household context: If you’re making 5 percent on your invested savings, then borrowing money at 2 percent to pay for your kids’ college is a perfectly sensible thing to do, even if you have the money to simply write the check. Borrowing at 2 percent and investing at 5 percent is a great deal — for as long as it lasts.

But it won’t last forever. It never does. And the debt piles up in a sneaky fashion: Even at the low interest rates we’ve seen in recent years, paying interest on our national debt adds up to a heavy expense, amounting to more than a tenth of all federal tax collections in 2019.

The U.S. government has recently held a few auctions for some billions of dollars’ worth of new debt, and those auctions have ranged from “tepid” and “weak” to “not a good sign” to “a disaster” in the estimates of market-watchers quoted in the Financial Times, which has reported a great deal of not-as-bad-as-it-could-have-been, whistling-past-the-graveyard talk, e.g.:

Blake Gwinn, head of US rates strategy at NatWest Markets, said the auction was “not a good sign for demand”, but compared with the “disaster” of the previous seven-year auction in February, which rekindled fears about the health of the $21tn US government bond market, it was something of a “relief” for investors.

If anything short of “disaster” is a “relief,” it is time to start paying attention — especially if you happen to be a representative of the most indebted organization in human history.

One of the things that spooks bond investors is the fear of inflation. Another way of saying “fear of inflation” is “fear that the dollar will lose value,” meaning that when you lend the U.S. government money, the dollars you eventually get paid back with are going to be a hell of a lot less valuable than the dollars you lent. If you lend somebody money at 2 percent when there’s no inflation, you’re making a profit; if you lend somebody money at 2 percent when inflation is 5 percent, then you’re losing money. The guys on Wall Street and in the central banks may not be as smart as they think they are, but they are smart enough to know when they are losing money. They have people who keep up with that sort of thing.

The U.S. government props up demand for its own debt in part by having the Federal Reserve buy its bonds when nobody else wants them. That ends up being what is known as “monetizing the debt,” or creating new money ex nihilo in order to finance borrowing when the normal lenders are no longer entirely buying your story. That puts our government — and our entire economy — on a tightrope. Creating new money invites general price inflation, and the threat of such inflation makes investors less likely to buy our bonds at the low rates Washington has come to take for granted, which puts more pressure on the Fed to create even more money to take up the slack — your classic vicious circle. It’s the kind of trick that is hard to get right and easy to get very, very wrong.

We Americans sometimes arrogantly think of debt crises or problematic inflation as problems experienced only in the poor and sweaty and exotic corners of the world — I am pretty sure the editors over at the Wall Street Journal must have a keyboard shortcut for “Argentina defaults” — but the United States was a perfectly normal and reasonably well-governed country when it was ravaged by inflation from the 1960s until the 1980s, and Canada was not a banana republic when it was wracked by a debt crisis in the 1990s.

These problems aren’t the result of divine judgment — they are the result of math.

During the Trump years, the U.S. government blew through money like MC Hammer at a Lamborghini dealership in 1991, and, with Democrats controlling all the levers in Congress, the Biden administration is freight-training U.S. dollars out the door as fast as it can. That $1.9 trillion stimulus bill comes on top of a $900 billion package passed in December, $953 billion allocated to extend the Paycheck Protection Program in July, the $2.2 trillion CARES Act before that, etc. Biden is about to propose another $3 trillion in infrastructure spending. For many people, those numbers are pure gobbledygook. But look at them context: The U.S. government expects to collect only about $3.8 trillion in taxes this year. A third of that will be consumed by Social Security alone, while Medicare will eat up almost another $1 trillion by itself. That doesn’t leave much left over, and we’ve been running big deficits even in years when we don’t have an epidemic to deal with or multi-trillion-dollar infrastructure schemes.

So where will the money come from?

Some will answer, tremulously: China!

Japan is actually the largest foreign holder of U.S. debt, with China in second place, followed by the United Kingdom in third. But overseas central banks have not shown an enormous appetite for U.S. debt recently: China spent much of 2020 reducing its holdings of such debt, and so did Japan. (It should be noted that these things do not move in a linear fashion — they’ll go up and down. But the recent trend is down.) For a long time, China bought up U.S. bonds for many of the same reasons as any other institutional investor, and also because Beijing has a preference for a relatively strong dollar, which makes Chinese exports more attractive to U.S. buyers. But that math is changing a little bit, because China also is a big importer of U.S. goods, from farm produce to aircraft. (Before President Trump launched his trade war, China accounted for 20 percent of U.S. motor-vehicle exports, up from less than 1 percent in 2001.) You wouldn’t know it from our political conversation, but it’s actually been quite some time since Beijing was making serious efforts to drive down the value of its currency in pursuit of an export edge. Even a brutal and nonconsensual government will do that only for so long, because it is in reality a policy of artificially lowering your own people’s standard of living and devaluing your own assets. Back in the queasy days of 2009, China’s top banking regulator gave a blunt assessment of Beijing’s relationship with U.S. debt as it appears in trillion-dollar installments: “We know the dollar is going to depreciate. So, we hate you guys, but there is nothing much we can do.” That was then; figuring out what might be done about the same relationship now is one of the aims of Beijing’s “dual circulation” strategy.

We spend a lot of money on Social Security, Medicare, Medicaid, and the military — sobering, incomprehensible, vertigo-inducing amounts of money. If interest rates on our debt go back to something closer to their historical averages, then that would add about a Pentagon’s worth or a Social Security’s worth of new spending obligations onto the federal budget. For context, interest payments could easily jump from around 11 percent of all federal tax revenue to half of all tax revenue — and they conceivably could jump to more than 100 percent of tax revenue, which would be catastrophic. Unlike farm subsidies or cowboy-poetry festivals, paying the interest on the national debt is not really optional. Defaulting would crater the U.S. economy and set off an economic crisis unlike anything the world has ever seen.

There’s an old joke that if you owe the bank $1 million and can’t pay, then you have a problem — but if you owe the bank $1 billion and can’t pay, then the bank has a problem. There is some truth to that, but only a little. It isn’t the case that debtors are always defenseless hostages to creditors, but when it is time to go and ask for yet more money, every debtor is a dancing monkey to precisely the extent that the guys with the gold demand. That’s the real inflection point: the point at which creditors start to say, “No,” or, more likely, “Okay, but it’s going to cost you a lot more than what you used to pay.” And so we have two options. The first is that we can start taking the necessary measures to put our fiscal affairs in order and reduce the deficit and debt to a manageable size relative to that of our economy.

And the second option?

Dance, monkey.