What Would a US Debt Crisis Look Like?

I agree with the findings as the Fed has been able to substantially “wall off” the US Treasury market from undue foreign and exogenous risks. Although, the USG continues to pile on debt, the Fed has made certain that it stands ready to do what is needed to contain any existential risks.

I see QE and the Fed backstopping of the banking and credit sectors as ingenious and novel ways to ensure equanimity in what would be a previously unthought of set of circumstances.

In other words, we shouldn’t hold our breath waiting for a bond market catastrophe.

What Would a US Debt Crisis Look Like?

But US sovereign debt is unlikely to become a crisis, according to a paper released last week by economists at the Brookings Institution, a think tank. By “crisis” they mean “a sudden, large and sustained downturn in demand for Treasury securities.” The paper lays out four scenarios in which that could happen, and concludes that none of them is likely:

1. A big holder of Treasuries (like China) could abruptly start selling. Even China holds just 3% of outstanding US debt and a selloff wouldn’t necessarily change other investors’ view on the value of Treasuries.
2. The US could fail to raise its debt ceiling. If that happened, it might not last long — since market turmoil would prompt Congress to reconsider — plus the Fed and Treasury could temporarily calm markets.
3. The Fed — presumably under duress — could signal it’s willing to tolerate higher inflation to lower the value of US debt. The authors argue this simply wouldn’t work since so much US debt is short-term and would quickly need to be rolled over at higher interest rates.
4. The US could decide that default was its best option. Again, the authors think this option — a  “strategic default” — is unlikely because it wouldn’t solve much. It would hurt US investors, who own 70% of US federal debt, and would make new borrowing near impossible.

Instead of a crisis, the researchers see US debt as an ongoing and “ever-larger transfer of consumption from future generations to current generations.”

In theory, it’s solvable if the US cuts spending and/or raises taxes closer to the OECD average. But during an online event about the paper, David Wessel, a senior fellow at Brookings, noted a line that he said had been “haunting him.”

The chance of a debt crisis was low, the authors wrote, “so long as the US retains its strong institutions and a fiscal trajectory that isn’t vastly worse than the one currently projected.”

“There are things I used to assign a zero probability to that are now somewhat higher,” Wessel commented, and that list includes a weakening of US institutions and a worse fiscal trajectory.

The upshot of that concern, says Louise Sheiner, also a senior fellow at Brookings and one of the paper’s authors, is that the chance of a debt crisis is “not related to how much debt we have.” Instead, she says, “The kinds of things we’re worried about — [like] not following the law as we used to understand it — [we’d be] worried about that even if we had no debt.”