There is some good news and some bad news about our public debt problem. The good news is that, contrary to what many are now warning, our unsustainable public finances will not lead to a dollar crisis or a burst of inflation anytime soon. The bad news is that this will be because the Federal Reserve will be forced to cut interest rates aggressively and flood the market with liquidity through its bond buying activities. It will be forced to do so in response to another and more vicious round of the regional banking crisis triggered by the problems in the commercial property sector.
On one thing everyone can agree. Our public finances are on a dangerously unsustainable path. One indication of our budget problems is that at a time of cyclical economic strength, when the government’s budget should at least be in balance if not in surplus, the deficit is around six percent of GDP. Another indication is that Washington is showing no sign of seriously addressing the government’s chronic budget deficit problem. According to the bi-partisan Congressional Budget Office, these deficits will soon take our public debt to a record level of well over 125 percent of GDP surpassing the level reached at the end of the second world war.
As chronicled in Ken Rogoff and Carmen Reinhart’s magisterial book, “This Time is Different: Eight Centuries of Financial Folly,” history is littered with examples of countries that have defaulted on their debt when they have been on unsustainable debt paths. That has generally been the case because their governments had borrowed in a foreign currency over which they had no control.
The United States case is different in that our government borrows in dollars that the Federal Reserve can always print to cover the deficit. This makes it highly improbable that our government will ever default on its debt. However, the money printing that would be required to finance our government could lead to a dollar crisis and to a surge in inflation. It could also invite the return of the bond market vigilantes and cause financial market turmoil.
In a shot across the bow, Moody’s recently downgraded the US government’s credit rating to negative on concern about our country’s debt trajectory and about Washington’s political dysfunction. Judging by Washington’s reaction to that downgrading and by the most recent messy episode of Congress avoiding a government shutdown, there appears to be little appetite in Washington to make the necessary spending cuts and tax increases to put our public finances on a more sustainable path. This heightens the prospect that in the end our poor government finances will lead to a much-feared dollar crisis and inflation surge.
Before we get to that day of reckoning, it is more than likely that by early next year we will have another and more vicious round of the regional bank crisis. Already as a result of the Fed’s high interest rate policy, the US banking system is nursing mark to market losses on its bond portfolio of around $1.5 trillion. This puts it in no position to make the large loan loss provisions that they will need to make on the more than $3 trillion that they have loaned to the commercial property sector. The regional banks are particularly vulnerable in that commercial property loans comprise 18 percent of their loan portfolios.
Heightening the chances of a regional bank crisis within the next year or so is that fact that around $930 billion in commercial property debt comes due this year. With office vacancy rates at record levels as many workers are allowed now to work from home, it is difficult to see how property developers will be able to service these loans without a substantial debt rescheduling. This is especially the case considering that these loans will have to be rolled over at much higher interest rates than those at which they were originally scheduled.
Washington should take advantage of any delay in our public debt day of reckoning to put our public finances on a more sustainable path. However, judging by Washington’s past performance, no matter which party is in control, I would not suggest holding your breath for that to happen.