The following is a scenario for a U.S. fiscal crisis. It is based on my two articles on the history of the Treasury debt and on who owns the debt. It also draws on my own research on the fiscal crises in Europe a decade ago.
Friends: this is no longer a hypothetical issue. It is no longer something we can ignore and leave for another day. This is a real problem, and unless Congress acts very soon, the inflation and economic disruptions we have seen so far this year will be a walk in the park by comparison.
Let me stress this again: my scenario is a realistic one. As you read through it, please keep in mind what the consequences will be for each and everyone of us. Then please consider what you can do to convince your U.S. Senators and Representatives to do everything in their power to bring our budget deficit under control.
A Crisis Like No Other
The crisis is preceded by another spending bill being passed by Congress – it doesn’t really matter what the spending bill is, except that it is large and adds permanently increases the budget deficit. When it is clear that the bill will be signed by the president, sovereign-debt investors react to it at the next Treasury auction by not buying all the debt the Treasury is trying to sell.
As my good friend and fellow expert with Compact for America, Baker Spring, has explained, this is the “trigger point” for a fiscal crisis. The news that the Treasury could not unload all its debt at the latest auction rapidly spreads through the financial markets and hits the top of the news cycle. The Treasury Secretary tries hard to play down the negative message, but investors and analysts do not believe her.
News leaks about a panic meeting between the Treasury Secretary and the Chairman of the Federal Reserve. The Secretary demands that the Chairman abandon the central bank’s newly adopted monetary conservatism and again commit to accommodating the budget deficits. The Chairman points to the high inflation rates and steadfastly refuses to relent.
The majority of the Federal Open Market Committee stands behind the Chairman, but two of its members – proponents of MMT appointed by President Biden – openly voice their dissent. Radical members of Congress echo their views, demanding that the president fire the Chairman and replace him with a monetary expansionist. The president does not comment on the matter, but the Treasury Secretary hints of some support for the radicals.
Media speculation about the future of the Chairman of the Federal Reserve exacerbates the turmoil caused by the radical rhetoric. The silence from the president on the independence of the central bank adds insult to injury. Meanwhile, the Treasury, eager to restore investor confidence, announces an extra ordinary debt auction and unofficially promising to offer higher yields. This is in effect a promise to raise interest rates to attract more buyers, and to further increase the chances of selling the debt, they increase the supply of long-term debt and offer generous rates in return.
This is a break with Treasury tradition: normally it manages its rising borrowing needs by expanding the supply of short-term debt, i.e., bills. The Treasury Secretary refers to the stagflation episode in the early 1980s, pointing out that back then, investors absorbed high-yielding long-term debt because they were confident that inflation would subside and the high yield would be profitable. This, however, is not how the market responds this time: during the stagflation era the president and Congress recognized the independence of the Federal Reserve. Since that does not seem to be the case this time, investors point out, they refuse to buy enough of the long-term debt to sell out the auction.
Having been left with unsold securities at two auctions in a row, the Treasury is now in full-fledged panic. They turn to states, begging them to open their purses and buy non-marketable securities. However, due to inflation and a stalled economy, states are almost universally wrestling with fiscal problems of their own. The amount they are willing to buy is nowhere near what the Treasury needs to sell immediately, let alone enough to help restore market confidence in the debt.
One of the major international credit rating agencies announces that it will now downgrade U.S. debt. Another agency announces a “review”. This immediately causes foreign investors, who own about one quarter of U.S. debt, to raise concerns about what this will do to the value of the dollar. Even if their investments remain unchanged in U.S. currency, a dollar depreciation would inflict losses on them anyway.
As a result, term trade in the dollar rises rapidly, but the trend that emerges is one of expectations of a weaker dollar. Foreign investors start selling U.S. debt; normally, the money would go into the stock market, but due to the stalled economy and high inflation the outlook for stock portfolios is weak. The dollar declines.
When the U.S. currency declines, forecasts emerge that suggest yet more inflation to come. Since inflation was one of the factors triggering the crisis in the first place, this only adds to the negative outlook that got the snowball moving. The radicals in Congress double down on their demands that the Fed print all the money needed to bankroll the Treasury, but at this point conservatives and moderates counter with their own plan: suspend the latest spending bills.
Meanwhile, the Treasury, desperate to rake in cash from selling debt, goes back to the market with a big pile of bills. These securities, with a maturity of one year or less, are dominated by 1-3 month bills and come with interest rates in excess of six percent. The package is good enough to sell out the auction, but with the majority of the bills maturing very soon, everyone knows the Treasury will soon be back at square one again.
The rise in rates on Treasurys has direct consequences for banks. With U.S. debt accounting for one fifth of their assets, they now see an opportunity to restructure their portfolios. However, as they do, they also push interest rates up across the board: car loans, mortgages, personal lines of credit, etc., are suddenly slated to become a lot more expensive. The combination of rising inflation and the outlook of rising interest rates causes both families and business owners to call their representatives in Congress and voice loud complaints.
So far, the president has not made any major statements on the crisis. The Treasury Secretary has been forced to take the heat and deal with it on a day-to-day basis. Pushed to the brink by two failed auctions and one that barely sold out, the Secretary is now under enormous stress and asks the President for support. Motivated more by falling poll numbers than pleas from the Secretary, the President gives a speech promising to “work with Congress” to solve the problems plaguing the nation. It is unclear what faction of Congress the President will work with, but unofficially the White House expresses support for the suspension of the latest spending bills.
At this point, however, it is clear that the Treasury sell-off by foreign investors, followed by a complete halt in purchases by states and local governments, far outweighs any extra purchases by banks. The Fed’s steadfast refusal to re-enter the sovereign-debt market is seen as encouraging by some analysts and investors, but adds to the downward pressure on Treasury prices, and therefore to the upward pressure on interest rates. The highest yields are now touching ten percent.
Encouraged by at least implicit support from the President, but gravely worried about both inflation and interest rates parking themselves above ten percent, moderates in Congress go to work on a plan to not only suspend the latest spending bills but also to actually make cuts in current spending. Since entitlements account for 70 percent of the federal budget, everything is on the chopping block, from Medicaid reimbursement rates and benefits to a drastic reduction in child-care tax credits and the EITC. This enrages the radicals, who do everything they can to sabotage the process.
The gridlock on Capitol Hill is widely broadcast by media. Investors maintain that they are unimpressed and will continue to downsize their holdings of U.S. debt. The dollar falls yet again, and to avoid a run on the currency the Fed starts selling off part of its foreign-currency reserves to support the dollar. This unheard-of move by the U.S. central bank – never in history has the Fed had to buy its own currency for the explicit purpose of stabilizing its exchange rate – is viewed as reassuring over the short term, but also serves to underscore the gravity of the crisis. While foreign sell-off of U.S. debt wind down, investors see the Fed’s unique move as yet another sign that U.S. debt is not to be trusted.
Demands once again emerge for higher interest rates at the next Treasury auction. The Treasury has no other way to go but compliance: rates now exceed ten percent across the maturity spectrum, with the highest ones touching 15 percent.
At this point, the MMT proponents on the Federal Reserve’s Open Market Committee vocally renew their demands that the central bank intervene in the market. They are joined by Congressional radicals who promise to let the moderats raise taxes “on the rich” and cut some benefits for “higher income families” if the President fires the Chairman of the Federal Reserve and appoints an MMT supporter instead. If the President refuses, the radicals hint, there will be violence in the streets of America’s major cities.
Pushed into a corner by inaction and failure of leadership, the President is left with only two choices:
- Comply with the radicals and make the Fed go all out to monetize budget deficits. The reactions from sovereign-debt investors will be ferocious, with a massive foreign sell-off, a collapse of the dollar and the realistic outlook of inflation rates in excess of 50 percent per year.
- Stick by the Fed chairman, defy the radicals and work with the moderates to cut spending. The problem with this strategy is that the spending cuts have to be massive, and immediate: a temporary but full suspension of the EITC, cuts of 20-30 percent in Medicaid benefits, the grounding and “porting” of U.S. armed forces with military furloughs in the thousands, a federal sales tax of five percent, plus a five percentage-point increase in federal personal income taxes for everyone making $50,000 or more.
What will the president do?