A U.S. fiscal crisis would likely not hit as one dramatic event but as a self-reinforcing spiral of rising Treasury yields, higher borrowing costs, slower growth and a growing debt burden, Capital Economics says. The firm argues the real risk is not America's ability to repay its debt, but whether investors keep believing Washington will rein in deficits.
A U.S. fiscal crisis would likely unfold as a vicious cycle of rising Treasury yields, higher borrowing costs, weaker growth, and an ever-growing debt burden, Capital Economics said in a new report. The firm says the risk hinges less on the country's ability to repay its debt than on investors' confidence in policymakers' willingness to rein in deficits.
Nominal GDP growth is likely to slow toward the pre-pandemic norm even as the average interest rate trends higher, the firm notes. Policy decisions have kept the federal government's primary deficits larger than before the pandemic, so the U.S. debt-to-GDP ratio remains on a steady upward trend.
What would trigger the spiral
Capital Economics says a fiscal crisis would most likely be triggered by factors that push up interest costs for reasons unrelated to GDP growth, causing r-g — the gap between the nominal effective interest rate and nominal GDP growth — to rise. Rising interest costs can turn unsustainable quickly, and a strong pace of nominal growth is unlikely to hold.
There is no fixed threshold, but the firm says interest costs rising above 30% of federal revenue would be concerning. If investors doubt the political will to get the fiscal situation under control, economists at the firm said, "they will likely demand a higher risk premium to hold Treasuries." That premium would compensate investors for the larger supply of Treasuries, for the risk of deficit-driven rate increases, and for any attempt to inflate the debt away. The result, the firm warns, can become self-feeding: investors sell Treasuries to protect against losses, yields rise further, the fiscal picture worsens, and more selling follows.
Households and markets feel it first
Because 30-year mortgages are priced off 10-year Treasuries, higher long-end yields would raise borrowing costs for U.S. households and firms first. Higher term premia also tend to accompany slower or negative equity growth, since higher yields reduce the present value of future income streams. As consumption and investment fall, GDP growth slows, pushing the debt ratio higher still and deepening the fiscal adjustment eventually required.
If Congress fails to act and the Federal Reserve is pushed toward what Capital Economics calls fiscal dominance, the central bank could be forced to purchase Treasury bills on a large scale, with the adjustment then coming mainly through a sustained period of above-target inflation meant to erode the debt's real value.
Why the fix is politically hard
Capital Economics says a long-term commitment to reining in the deficit, paired with looser monetary policy, could push the r-g dynamic in the right direction. But the firm calls the difficulty primarily political: defense spending is hard to cut, and discretionary spending makes up only a quarter of total federal spending. What is needed instead is revenue-raising, measures the firm expects to be unpopular.
Source: Investing.com
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