In recent weeks, the US has experienced unprecedented economic turbulence, raising concerns about the sustainability of its fiscal policies and the potential repercussions for the global economy. The US economy, grappling with soaring budget deficits and mounting debt, faces a critical juncture that could lead to prolonged financial instability. The situation is exacerbated by the unprecedented combined federal, state, and local budget deficits, which have reached around 8% of GDP—a figure unseen in previous economic downturns.
A Historic Deficit
The scale of the current deficit is alarming. Historically, a balanced budget is expected during the later stages of an economic expansion. However, with the US economy still recovering from previous disruptions, the deficits are ballooning. If the country were to enter a severe recession from this precarious starting point, deficits could skyrocket into the mid-teens, regardless of the outcomes of the upcoming elections.
This chronic level of debt issuance threatens to strain global appetite for US Treasuries, potentially undermining the government’s ability to implement effective countercyclical stimulus measures. The ramifications could be significant, affecting global credit systems and destabilizing a financial architecture reliant on US debt yields.
Torsten Slok, chief economist at Apollo Global Management, highlighted the severity of the situation: “The US has always been special, but it is now testing the limits. Everything has held together so far, but the last two Treasury auctions have been very weak, and we’re watching it closely.”
Fiscal Excess and Economic Downturn
The current fiscal excess is starkly evident. The US economy, once booming, now faces a more acute fiscal risk as it navigates a potential recession. The drop in tax revenues and increased unemployment benefits during economic downturns highlight the vulnerability of fiscal stability. This situation contrasts sharply with past periods of fiscal discipline, such as during Ronald Reagan’s presidency, when the US managed to defeat the Soviet Union while maintaining deficits below 2% of GDP.
Today, the US federal debt stands at a staggering 122% of GDP, compared to Reagan’s 50% when he left office. The difference underscores a shift from strategic borrowing to a more reckless approach, characterized by unchecked borrowing to fund consumption rather than investment.
A Risky Path Forward
The risk of a fiscal crisis is heightened by the growing interest costs associated with this debt. Fitch Ratings projects that the combined US federal, state, and local deficit will remain around 8% of GDP, with interest costs potentially reaching 10.3% of revenues by 2025. This scenario places the US at a critical juncture, as anything above 10% is considered a red alert.
The immediate drivers of this crisis include Donald Trump’s unfunded tax cuts and Joe Biden’s expansive spending. However, the underlying issue is the unsustainable growth of entitlement programs such as pensions and Medicare, which have become increasingly costly for the government to manage.
More Read
Global Implications and Market Reactions
Foreign central banks are beginning to reduce their holdings of US Treasuries, driven by a mix of currency defense measures, geopolitical concerns, and the search for better returns. China’s holdings have declined from $939 billion to $767 billion over the past two years, and the share of US Treasuries held by foreign central banks has dropped from 25% in 2019 to 14% this year.
Japan, a major buyer of US debt, is also reducing its holdings, which could further strain the market. The shift in investment patterns is already affecting global perceptions of US debt, with large bond funds like Pimco diversifying into safer assets such as those from Australia and Canada.
The Fed’s Dilemma
The Federal Reserve faces a difficult task in managing this fiscal disorder. While the Fed has hinted at potential interest rate cuts, it remains constrained by a policy of “data dependency,” which may result in delayed responses to economic downturns. There are concerns that the Fed might resort to quantitative easing (QE) to stabilize the economy, but this could lead to further monetary disorder, compounding the fiscal instability.
The Path Ahead
The US is at a crossroads, with the potential for its fiscal disorder to evolve into permanent monetary instability. With no other country or bloc currently capable of anchoring the global currency and credit system, the world must contend with a dominant yet increasingly unpredictable American economic framework. The challenge will be to navigate this uncertain terrain and mitigate the risks associated with a “drunken hegemon” in a rapidly changing global landscape.
