What You Need to Know
- Government bailouts in response to the 2008 financial crisis and spending to support the economy during the pandemic have caused U.S. federal debt to jump to $28 trillion last year.
- The main reason that exploding federal deficits and debts haven’t bothered financial markets is low and declining interest rates.
When it comes to the Federal Reserve and monetary policy, there are no shortages of talking heads who say the central bank can’t raise interest rates too much or else it would trigger a “debt bomb.”
What this means is that because the federal debt is so high, even a relatively small increase in rates might force the government to borrow even more just to service the debt.
This is a nice theory, but the numbers don’t add up. Interest rates paid to service the debt would need to double to get back to the 1991 peak of debt financing costs as a percentage of GDP — which didn’t touch off a debt bomb then —and much further for financing costs to explode.
Government bailouts in response to the 2008 financial crisis and, more recently, spending to support the economy during the pandemic have caused U.S. federal debt to jump to $28 trillion last year, or 123% of gross domestic product.
The amount outstanding has risen from $3 trillion two decades ago. And debt should continue to climb with annual budget deficits forecast to be around $1 trillion or more annually over the next decade.
Recent Borrowing, Buying of Treasurys
But the rise in borrowing hasn’t caused a big jump in market rates, and Modern Monetary Theory says there’s virtually no limit on federal borrowing and deficits. Indeed, money to fund the deficits has been ample.
Much of it came from consumers who saved $1.9 trillion from their April 2020 fiscal stimulus checks, $508 billion from the January 2021 payments and $1.4 trillion out of what they received in March 2021, according to the Federal Reserve Bank of New York.
Congress appropriated about $5 trillion in pandemic relief, and as those funds circulated, some were used to finance federal deficits. Also, the Fed purchased $4.8 trillion in Treasurys since the pandemic commenced in early 2020 as its assets surged from $4.2 trillion to $8.9 trillion.
Foreigners have also been important buyers and own $7.7 trillion, or 31%, of Treasurys outstanding. They’ll no doubt buy more as they seek a haven after the Russian invasion of Ukraine.
Also, Asians are robust producers and exporters but anemic consumers. So, the resulting “saving glut” has resulted in a $975 billion U.S. current-account deficit that is financed by increased foreign ownership of U.S. assets, including Treasurys.
The aging baby boomers are another source of funds to finance federal deficits. As people age, they shift their portfolios to less-risky investments, including U.S. government obligations.
All this demand for Treasurys has exceeded the supply, as shown by the drop in the 10-year Treasury note interest rate from 8% in the early 1990s to 1.8% while the yield on 30-year bonds has fallen from 8% to 2.1%.
The decline over the years in inflation, the major determinant of Treasury bond yields, also exerted downward pressure on borrowing costs.