Imagine running into a movie theater and yelling “fire!” But just as people are starting to panic, you add, “I mean … not yet … but maybe at some unknowable point in the future.”
That’s a fair description of where many of us tracking the U.S. fiscal outlook find ourselves at this moment. For years, I wasn’t an alarmist about the national debt. During the Biden administration, I even criticized those calling for more austere budget policy; I thought that fiscal austerity would do more harm than good.
Our fiscal reality has changed significantly since those days, and so has my stance on public debt. Here’s why:
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The basic budget math has worsened as the interest rate on our national debt has climbed closer to the economy’s growth rate. If the compounding debt consistently grows faster than the economy, we risk entering a debt spiral.
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Our annual deficits, currently about 6 percent of G.D.P., are way above where history says they should be. We’re not in a recession, but we’re borrowing as though we were.
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Politically, neither party shows any interest in addressing the problem. President Trump and Treasury Secretary Scott Bessent, in fact, are aggressively creating the very risks I worry about.
Mr. Trump does so by explicitly trying to manipulate the Federal Reserve to lower the nation’s debt payments.
Mr. Bessent may be even worse, abandoning the steady hand that’s essential for being Treasury Secretary for hedge-fund swagger. He’s flexing on markets — “I am the house now,” he said, referring to the Treasury’s recent purchase of Japanese yen to support the dollar — by daring currency and bond markets to bet against him. They did. The traders quickly waved off his swagger, and bond yields rose.
Given all those pressures, can I do no better than to predict that the sky may, at some point, fall? It will if the debt spirals upward, and lenders demand higher interest payments to compensate for the higher risk. That could force the government to cut spending and raise interest rates at a speed likely to cause a nasty recession.
I can’t tell you when these risks will become realities, for at least two reasons.
One, financial crises, including debt crises, rarely unfold in a linear fashion. Things can go south (north, really, if we’re talking about rates) rapidly. Scared money heads for the exits in a hurry.
In October 1987, the Dow fell 23 percent in one day, the largest drop on record. Stocks were overvalued, as Ryan Cummings and I have argued they are now, and automated “portfolio insurance” algorithms fed on themselves, defensively selling shares as prices fell, leading to faster price declines that drove even more selling.
In mid-September 2008, against the backdrop of the bursting housing bubble, a money-market fund “broke the buck.” That is, a fund considered completely safe could pay only 97 cents on each invested dollar. It triggered asset sales and collateral calls that cascaded through the system, helping to initiate the deepest recession since the Great Depression.
In September 2022, debt markets hosted a similarly sudden, nonlinear event in Britain. By proposing deficit-financed tax cuts (sound familiar?), Prime Minister Liz Truss triggered a sharp sell-off in British bonds, causing yields to spike. That was bad, but it was the feedback loop that followed that led to a meltdown. Quickly rising rates generated collateral calls at pension funds that had borrowed heavily and bet the wrong way — they had to start unloading whatever they could, quickly — pushing yields higher and triggering an even deeper sell-off.
True, our debt markets are much more embedded into global finance than those of Britain, and the dollar’s reserve currency status also provides insulation. But the biggest A.I. companies have rapidly become highly leveraged, and it is far from fanciful to imagine a spike in interest rates (or insufficient returns on their investments) persuading investors to sell off those stocks. In the interim, our government is competing for capital with the tech firms, which keeps upward pressure on rates. President Trump just suggested that if Republicans win the midterms, he’ll send every American adult $5,000, adding another $1 trillion to the debt. It’s extremely unlikely he’ll deliver, but the recklessness of the proposal caused “jitters in the bond market that the Trump administration has been struggling to contain,” The Times reported last week.
The second reason no one can time any financial blowup is a circularity in the system. The bond market can turn on itself in ways that take the debt outlook from sustainable to unsustainable, even without a Truss-style triggering event. (Economists call this “multiple equilibria”— we’re not paid to be plain-spoken.) If creditors think that U.S. debt is safe, the Federal Reserve is credible and the Treasury seems to know what it’s doing, then perceived risk and actual interest rates stay low. That’s positive equilibrium.
If lenders start to question those comforting propositions, watch out. They will demand higher rates, which raises interest costs, making the debt harder to service. That’s negative equilibrium.
It’s easier to reside in the benign equilibrium when the public debt is 40 percent of G.D.P., as it was in 1990, versus 100 percent and rising, as it is today. As Goldman Sachs analysts recently put it: “Higher debt increases vulnerability to unfavorable surprises.” (Yes, Japan’s public debt ratio is twice that of the United States, for reasons that are unique to Japan. It, too, though, is seeing new rate pressures.)
I don’t associate words such as “benign” and “equilibrium” with Donald Trump. Indeed, the Trump administration’s disregard for historical norms of fiscal management raises investors’ fear of “fiscal dominance.” This is the term for when the government, worried about the cost of servicing its debt, tries to force the Fed to lower interest rates. Additional worries might include subtler forms of default, such as stretching out maturities so that investors are still paid what they’re owed, but later than originally agreed.
Should investors get spooked enough to panic and dump their U.S. debt holdings, couldn’t the Federal Reserve step in and buy the debt, neutralizing the sell-off? Not necessarily, especially if it views the underlying debt fundamentals — the three signs I ticked through above — as problematic. Sure, if the central bank is captured by the White House, it can engage in any degree of reckless intervention. But that will only exacerbate investors’ underlying concerns and accelerate the crisis.
My best guess is that if we continue down our current path, some degree of reckoning, one with the potential to force a sudden, painful debt consolidation, will occur within a decade.
There’s still time to avoid this fate. We don’t need to balance the budget, to fix Social Security immediately and fully or to hit an arbitrary deficit target. But we do need the government to signal to investors that it understands the risks. The best way to do so is to stop digging a deeper debt hole, or even to dig more slowly. Any sign of reawakening in Congress in response to the data will send a potent, positive signal to investors.
It could come in the form of both tax increases and spending cuts. My point here is not to go through the relative merits of the different ways to stop digging. It’s to say that even though I can’t tell you the day and time when the fire will ignite, I can tell you that we’re getting closer. And doing so at a rate that even this nonalarmist finds alarming.
Jared Bernstein is a distinguished policy fellow at the Stanford Institute for Economic Policy Research and a senior fellow at the Center for American Progress.
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