The United States is approaching an unprecedented level of debt, exceeding historical highs experienced post-World War II. This situation indicates that fiscal adjustment is unavoidable, as the country cannot simply outgrow its debt dilemma. Despite high domestic and external demand for US debt, relying on this demand amid such significant debt increases is risky.
The trajectory of US federal government debt is escalating, with debt held by the public potentially rising from just under 100% today to more than 170% of GDP in 30 years. This raises concerns about the feasibility of financing and the associated costs. The end of low interest rates could lead to a higher portion of tax revenue dedicated to debt service, higher inflation, and possibly stifling economic growth.
Historical data suggests a weak relationship between the supply of federal debt and the interest rates charged. However, this relationship may not hold with the current rise in debt levels. The lack of strong growth prospects to reduce the debt-to-GDP ratio and the absence of political willingness for fiscal adjustment present significant risks. As a result, investors should anticipate higher term premiums in US debt markets.
Two scenarios of fiscal adjustment are explored: gradual fiscal consolidation and forced abrupt adjustment. The former would involve a slow increase in yields, leading to political consensus for spending cuts and tax increases. The latter, driven by a more sudden loss of investor confidence and market disruptions, could result in significant global repercussions. In either case, the Federal Reserve may be required to support US bond markets, although its actions could be less effective in a high-inflation environment with diminished confidence in US debt.
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