31 Oct 2023
This Merlin Weekly Macro looks at government debt problems in the US, as Biden’s administration continues to “Go real big” on both spending and borrowing.
That slogan of Joe Biden’s should be branded into his political hide.
For the second time in 10 months the US government has been placed in financial special measures. Its funding is now relying on a supervised emergency drawdown account to be able to continue functioning. Were it a failed hospital trust or school, the regulators would have fired the board and taken control; that does not happen with governments. This is the world’s biggest and most influential economy we’re talking about: 25% of global GDP; proprietor of the principal global reserve currency; the geographic home of the International Monetary Fund, the World Bank and the United Nations. Certainly, the current administration is fiscally incontinent. But to end up here not once but twice in a year, surely that is more than careless. Reckless? Incompetent? Financially illiterate? Or just relying on wishful thinking that if they plough on regardless with government policy it will all be all right in the end, everyone will forgive and forget. Janet Yellen, Biden’s hapless Treasury Secretary is every bit as culpable in this embarrassing mess; as the most recent Chair of the Federal Reserve, she’s supposed to be a financial and economic expert!
Not specifically in relation to the debt emergency, nevertheless Biden’s lack of awareness of what messages the rest of the world receives about the state of the US economy and his cavalier governance was highlighted a few days ago. Jerome Powell, incumbent Chairman of the Federal Reserve has made it clear that in his fight to restore price stability at the 2% average inflation rate, one of his biggest worries is real wages growing faster than headline prices and the extent to which wage inflation risks becoming an embedded problem. While the debt crisis was rapidly brewing last week and bond yields were spiralling upwards, Joe Biden was playing to the gallery joining a picket line of striking car workers, dressed in a baseball cap and brandishing a bullhorn, whipping up the troops and shouting slogans for more pay. “You deserve what you earned, and you’ve earned a hell of a lot more than you’re getting paid now!”, he bellowed. At what point in the middle of a national funding crisis did his political advisers think it a good idea to field the President of the United States as a latter day Che Guevara, and giving all the impressions of actively undermining the efforts of the authorities, to demonstrate US fiscal probity to the international investment community?
Whether the Biden administration is incompetent or incontinent, or casually determined to be in contempt of Congress, the Republican opposition is in no better position. With finely balanced congressional maths in the Senate and the House and the Republican Speaker having been fired by his own side for his collusion with the government, every day that passes while the warring Republican camps bicker and fight in their own internecine spat about Kevin McCarthy’s replacement is another day wasted before the 45-day funding limit expires. That simply raises the risk of another hastily fudged solution to avoid the guillotine either of the US government defaulting on its loans or suspending all government services.
The US is in a deep debt hole. To those who say ‘again’, the reality is the US never climbed out of the original hole. The essence of the problem? That with the abandon of the unreformed alcoholic’s perpetual craving for booze, the Biden administration has the same problem with money: it is hooked on debt; it cannot stop spending cash, much more than it is allowed. It is demonstrably incapable of working within the debt ceiling limits laid down by Congress. If it were a corporation seeking to borrow, it would already be deemed uncreditworthy given its propensity brazenly to keep breaking its covenants: it would be bust.
As American government debt sailed through $33 trillion dollars in September, a third greater than the size of the US economy, Congress had set a deadline of 1st October to reach yet another budgetary accommodation and to prevent a shut-down of all public sector services and wage payments. As is becoming the norm, no agreement was reached, merely a one-minute-to-midnight imposition of a legal condition securing interim, time-limited emergency funding, a sticking plaster for 45 days while a substantive budget is renegotiated.
Why deja vu? Because this is the second time this year. We were here only three months ago in June: in similar circumstances, a half-baked last-minute compromise on debt and spending was reached with the Republicans five months after the government breached its previous debt ceiling of $31.4 trillion in January.
There is a direct cost to investors. Along with the narrative we described last month that the Federal Reserve cannot rule out further interest rate increases and to expect interest rates to remain elevated for longer than markets would like, the additional financial risk arising from debt piling on top of debt is a powerful contributory factor behind the significant spike in US government bond yields. This week, the US 10-Year Treasury reached 4.81%, the highest since 2007 and the beginning of the Global Financial Crisis (it only retreated from its peak as markets responded to the OPEC meeting on Wednesday reaffirming current oil production volumes which caused Brent crude immediately to fall $10 to $84); in context, at the beginning of April it was 3.3%. The warning signs were all there in July when Fitch, the independent ratings agency, downgraded the creditworthiness of US debt from AAA to AA+ (essentially ‘safe as Fort Knox’ to ‘still almost as safe as Fort Knox, but there is an attic window wide open for someone to pinch the family silver’). As bond yields rise in fixed income markets, the price of those bonds goes down (the reverse also applies).
Reflecting investors’ rising perceptions of the cost and potential inflation risk associated with the $347bn carbon net-zero programme included in Biden’s Inflation Reduction Act, most of the recent upward pressure in US yields has been in longer-maturity Treasury bonds. Since the beginning of July, the 2-Year bond yield is little changed (5.04% today vs 4.94%, in market jargon up 10 basis points); however, out at 30 years’ maturity, in three months the yield has jumped from 3.86% to 4.91%, up 105 basis points. That the ‘yield curve’ remains inverted (i.e. the current 2-Year yield at 5.04% is still higher than that of the 30-Year at 4.91%) indicates the markets’ greater preoccupations with the immediate outlook. But the recent ‘flattening’ of the curve (in this case pushing up the longer-dated yields faster than the shorter) is at least a more rational reflection of the greater uncertainty over the longer duration before the bonds reach their maturity and are redeemed by the government.
Interest rates have been this high before, so have bond yields: the 4.8% seen this week on the US 10-Year Treasury is far from unprecedented. But what is unprecedented is the amount of debt the yield applies to. It is best looked at in terms of the size of the economy and what it can sustain: the last time US bond yields were 4.8%, in 2007, US government debt was only 55% of GDP. Today it is almost 2.5 times that at more than 130% of GDP.
The US is not alone. Governments including ours and those of France and Italy have all been in a state of denial that they are living beyond their means despite the significant change in economic circumstances as central banks responded (very late in the day, it has to be said) to the inflationary pressures arising from the twin exogenous shocks of the pandemic and Putin’s invasion of Ukraine. Even Germany is struggling. It comes as no surprise to find upward pressure on their own domestic bond yields too, despite inflation gradually receding and economies flirting with recession.
Perhaps the penny is beginning to drop in the UK with Rishi Sunak: in his speech to the Tory Conference, his “30 years of ducking the difficult decisions” was an oblique criticism of the seven successors to date of Margaret Thatcher, the last UK prime minister bold enough to put political principle before popularity (and who was unceremoniously dumped by her party in 1991). Whether Sunak is now prepared to launch all-out public sector reform, as the saying goes to walk-the-walk rather than talk-the-talk, remains to be seen. Can the leopard change its spots? Or more pertinently, after 13 years in office, can it convince the electorate it can do so? The Tories have no more than 14 months to prove their case.
But this new US crisis is not just a domestic affair only relevant to the markets and political and economic commentators. It has real world consequences of significant importance. The major contributing factor to last weekend’s debt denouement was the disagreement in Congress about incremental US funding to President Zelensky’s war chest, the lifeline keeping him in the game fighting to expel the Russian invader.
It could not have come at a more sensitive time as fractures begin to appear in the western alliance. Last weekend’s Slovakian election paved the way for the right-wing SMER party to form a coalition: despite Slovakia being a NATO and EU member state, SMER’s pro-Putin leader Robert Fico campaigned to put a blanket ban on all future Slovakian military aid to Kiev and will instead seek a conflict settlement with Moscow (last year in opposition, Fico referred to NATO troops stationed in Slovakia as ‘Nazis’, a political gift to Putin and deeply troublesome to NATO with a change of Slovakian government). Further, in a trade dispute over Ukraine flooding eastern EU economies with cheap grain, on September 15th the Polish government refused to endorse Brussels lifting the Ukrainian import ban; the ban was lifted and Warsaw announced in reprisal against Zelensky that beyond the military aid already committed, there will be no more to follow (there is a general election in Poland this weekend; to the extent polls are reliable, the incumbent right-wing PiS party and its centre-right allies are ahead of the centre-left KOS party led by former EU Council President Donald Tusk; in the circumstances, it is widely regarded as the most important Polish election since the fall of the Soviet Union in terms of Poland’s future relationship with both the EU and Ukraine).
Biden’s fiscal recklessness allied to a small but vocal minority of Republicans questioning the wisdom of the US, by a long way the biggest military aid supplier to Ukraine, fighting a proxy war in Europe at significant financial cost to the US Treasury simply encourages Putin and his allies that the Ukrainian war is winnable. It all makes the world that bit more dangerous than it already is.
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