In the words of a veteran investor, watching the U.S. bond market today is like sitting in a packed theater and smelling smoke. You look around for signs of other nervous sniffers. But everyone else seems oblivious.
Yes, the federal government shut down this week. Yes, we are just two weeks away from the point when the Treasury secretary says he will run out of cash if the debt ceiling isn’t raised. Yes, bond king Bill Gross has been on TV warning that a default by the government would be “catastrophic.” Yet the yield on a 10-year Treasury note has fallen slightly over the past month (though short-term T-bill rates ticked up this week).
Part of the reason people aren’t rushing for the exits is that the comedy they are watching is so horribly fascinating. In his vain attempt to stop the Senate striking out the defunding of ObamaCare from the last version of the continuing resolution, freshman Sen. Ted Cruz managed to quote Doctor Seuss while re-enacting a scene from the classic movie “Mr. Smith Goes to Washington.”
Meanwhile, President Obama has become the Hamlet of the West Wing: One minute he’s for bombing Syria, the next he’s not; one minute Larry Summers will succeed Ben Bernanke as chairman of the Federal Reserve, the next he won’t; one minute the president is jetting off to Asia, the next he’s not. To be in charge, or not to be in charge: that is indeed the question.
According to conventional wisdom, the key to what is going on is a Republican Party increasingly at the mercy of the tea party. I agree that it was politically inept to seek to block ObamaCare by these means. This is not the way to win back the White House and Senate. But responsibility also lies with the president, who has consistently failed to understand that a key function of the head of the executive branch is to twist the arms of legislators on both sides. It was not the tea party that shot down Mr. Summers’s nomination as Fed chairman; it was Democrats like Sen. Elizabeth Warren, the new face of the American left.
Yet, entertaining as all this political drama may seem, the theater itself is indeed burning. For the fiscal position of the federal government is in fact much worse today than is commonly realized. As anyone can see who reads the most recent long-term budget outlook—published last month by the Congressional Budget Office, and almost entirely ignored by the media—the question is not if the United States will default but when and on which of its rapidly spiraling liabilities.
True, the federal deficit has fallen to about 4% of GDP this year from its 10% peak in 2009. The bad news is that, even as discretionary expenditure has been slashed, spending on entitlements has continued to rise—and will rise inexorably in the coming years, driving the deficit back up above 6% by 2038.
A very striking feature of the latest CBO report is how much worse it is than last year’s. A year ago, the CBO’s extended baseline series for the federal debt in public hands projected a figure of 52% of GDP by 2038. That figure has very nearly doubled to 100%. A year ago the debt was supposed to glide down to zero by the 2070s. This year’s long-run projection for 2076 is above 200%. In this devastating reassessment, a crucial role is played here by the more realistic growth assumptions used this year.
As the CBO noted last month in its 2013 “Long-Term Budget Outlook,” echoing the work of Harvard economists Carmen Reinhart and Ken Rogoff: “The increase in debt relative to the size of the economy, combined with an increase in marginal tax rates (the rates that would apply to an additional dollar of income), would reduce output and raise interest rates relative to the benchmark economic projections that CBO used in producing the extended baseline. Those economic differences would lead to lower federal revenues and higher interest payments. . . .
“At some point, investors would begin to doubt the government’s willingness or ability to pay U.S. debt obligations, making it more difficult or more expensive for the government to borrow money. Moreover, even before that point was reached, the high and rising amount of debt that CBO projects under the extended baseline would have significant negative consequences for both the economy and the federal budget.”
Just how negative becomes clear when one considers the full range of scenarios offered by CBO for the period from now until 2038. Only in three of 13 scenarios—two of which imagine politically highly unlikely spending cuts or tax hikes—does the debt shrink from its current level of 73% of GDP. In all the others it increases to between 77% and 190% of GDP. It should be noted that this last figure can reasonably be considered among the more likely of the scenarios, since it combines the alternative fiscal scenario, in which politicians in Washington behave as they have done in the past, raising spending more than taxation.
Only a fantasist can seriously believe “this is not a crisis.” The fiscal arithmetic of excessive federal borrowing is nasty even when relatively optimistic assumptions are made about growth and interest rates. Currently, net interest payments on the federal debt are around 8% of revenues. But under the CBO’s extended baseline scenario, that share could rise to 20% by 2026, 30% by 2049, and 40% by 2072. By 2088, the last date for which the CBO now offers projections, interest payments would—absent any changes in current policy—absorb just under half of all tax revenues. That is another way of saying that policy is unsustainable.
The question is what on earth can be done to prevent the debt explosion. The CBO has a clear answer: “ringing debt back down to 39 percent of GDP in 2038—as it was at the end of 2008—would require a combination of increases in revenues and cuts in noninterest spending (relative to current law) totaling 2 percent of GDP for the next 25 years. . . .
“If those changes came entirely from revenues, they would represent an increase of 11 percent relative to the amount of revenues projected for the 2014-2038 period; if the changes came entirely from spending, they would represent a cut of 10½ percent in noninterest spending from the amount projected for that period.”
Anyone watching this week’s political shenanigans in Washington will grasp at once the tiny probability of tax hikes or spending cuts on this scale.
It should now be clear that what we are watching in Washington is not a comedy but a game of Russian roulette with the federal government’s creditworthiness. So long as the Federal Reserve continues with the policies of near-zero interest rates and quantitative easing, the gun will likely continue to fire blanks. After all, Fed purchases of Treasurys, if continued at their current level until the end of the year, will account for three quarters of new government borrowing.
But the mere prospect of a taper, beginning in late May, was already enough to raise long-term interest rates by more than 100 basis points. Fact (according to data in the latest “Economic Report of the President”): More than half the federal debt in public hands is held by foreigners. Fact: Just under a third of the debt has a maturity of less than a year.
Hey, does anyone else smell something burning?
Correction: Net interest payments on the federal debt are about 8% of revenues. The Oct. 5 op-ed “The Shutdown Is a Sideshow. Debt Is the Threat” misstated the payments as a percentage of GDP.
Mr. Ferguson’s latest book is “The Great Degeneration: How Institutions Decay and Economies Die” (Penguin Press, 2013).