"A coming debt crisis in the US?" warns a Deutsche Bank report* by Quinn Brody and Torsten Slok.
This graph is gorgeous. US deficits have, historically, been driven overwhelmingly by the state of the business cycle, and have very little to do with tax policies and spending decisions that dominate press coverage. In booms, income rises, so tax rate times income rises. In busts, the opposite, plus "automatic stabilizer" spending kicks in.
There is a good reason past deficits did not really spook markets. They understood the deficit was a temporary phenomenon, due to temporary poor demand-side economic performance. We do not have that excuse now.
In case you thought this was some alarmist crank sheet, the report starts by quoting the latest CBO
the CBO argues that, assuming current policies and trends are not changed, "the likelihood of a fiscal crisis in the United States would increase. There would be a greater risk that investors would become unwilling to finance the government's borrowing unless they were compensated with very high interest rates."
Other countries running big debts and deficits, like Japan and currently China, also are running big trade surpluses. That means they are, as a countries, accumulating foreign assets. The US by contrast is accumulating foreign debts. DB dares to ask the question:
Historically, twin deficits have been considered a source of macroeconomic risk, including downward pressure on the exchange rate and upward pressure on interest rates. Over the last several decades, many emerging market countries have experienced severe crises and recessions when their external financing became stressed or reversed (Mexico 1994, Thailand 1997, Argentina 2002, etc.). Given these experiences, it is relevant to ask if the US could also have such an EM-style debt crisis.
It's not as bad as it looks. The US is essentially the world's biggest hedge fund, borrowing abroad to invest in risky projects abroad, and we earn the premium on doing it. But overall, we are still borrowing to finance a trade deficit.
Like me, the DB report still sees a US debt crisis as a fairly remote possibility. Still not all their reassurance is reassuring if you think about it.
There are some good reasons why our model overstates the risks of an EM-style debt crisis. Most importantly, the US exclusively borrows in its own currency, while the model includes countries that have been exposed by borrowing abroad;
Borrowing in your own currency only means that our government can substitute inflation and devaluation for explicit default, if it refuses to fix its finances.
the US has scope to raise additional revenues (its overall tax rate of 26% of GDP in 2016 is below the OECD average of 34%);
That number looks suspiciously low - I don't think it has federal, state, and local and all taxes in it. At all levels, we're spending north of 40% of GDP. And raising a lot more revenue would mean middle class taxes like a VAT. Finally, debt crises are choices, and the main issue is really whether our government will raise nearly 10% of GDP in taxes to fund entitlements, reform the entitlements, or let the country drift to crisis.
the US dollar is the de facto global reserve currency.
This last point is significant. Figure 12 shows that almost two thirds of global official reserve assets are held in US dollars. One out of every four dollars lent to the US Treasury comes from the foreign official sector. These institutions need a safe, deep, and liquid place to park their reserves.
That our debt is currently held as reserves by foreign official sectors with the above-stated need should not be quite so reassuring. It is a source of one-time demand for our debt, not for eternal expansion of that debt. Those are also "hot money" investors. A demand for safety can evaporate pretty quickly if everyone starts to worry about a dollar crash.
The appeal of Treasuries is further boosted by the US's military strength, the nation's cultural appeal, and strong domestic institutions.
I'm delighted that anyone feels that way about the US right now, especially the latter. Doubts may already be starting
...Treasuries tend to rally in episodes of market stress, even when US economic growth slowed sharply in 2008 or when China devalued its currency and signaled potential selling of its Treasury holdings in 2015. This is not happening today, which is why investors need to pay attention to whether an EM-style debt crisis is about to play out.
DB also cites a nicely fiscal-theoretic prior analysis that the 70s inflation was led by fiscal, not just monetary, troubles:
As we wrote earlier this year (see: 2018-02-22 US Economic Perspectives), a similar pro-cyclical fiscal policy was deployed in the 1960s and resulted in higher inflation. The magnitude of the divergence is set to be even more severe in the current episode.
The report concludes with a number of technical indications that demand is softening for U.S. treasuries, just as we are starting to issue a boatload of them. Short duration, meaning a huge amount is rolled over; softening foreign purchases, expectations of more devaluation meaning our apparently high yields aren't so high, and declining bid to cover ratios.
My candidate for best figure caption ever:
Like DB, I agree it's not imminent. It will need a precipitating event like a recession, war, or crisis. Except that when it is imminent, it already happened.
The conclusion is sensible:
The world needs safe, liquid assets. Historically, this need has been filled by Treasuries- and it still is. Demand has thus far been inelastic [sic] despite the increase in supply (Figure 19). Treasuries have rallied for 30 years, rates continue to slide lower, and the stock of debt continues to expand. Eventually, however this will become unsustainable. We cannot say exactly what level of debt (85% of GDP? 100%? 125%?) will prove to be the tipping point, but we do believe that the latest fiscal developments have increased the odds of a crisis. Investors should continue to monitor Treasury auction developments and will remain alert to any indications of softening demand.
([sic] because selling a lot at a constant price is elastic, not inelastic.)
(*Alas, the report, of a type previously public, is only available to DB customers. Hilariously, this secrecy is, according to DB, mandated by the European Mifid II regulation, which is supposed to "increase transparency." )
Update: Daniel Nevin's chart