No tipping point in sight (unfortunately!)

James Hamilton @ Econbrowser wonders whether our deficits will result in a looming fiscal ‘tipping point’:

It is important to recognize that we are not proposing that creditors will all of a sudden refuse to hold dollar-denominated assets. The question instead is whether demand for U.S. Treasury debt will continue to increase every year faster than the U.S. economy can grow.


Recall that the debt itself will be growing as a result of continuing deficits. A higher interest rate and growing level of debt would mean that the fraction of federal spending that is taken up by interest expenses will grow considerably over the next decade. The CBO anticipates that, under current law (that is, assuming for example that the recent “sequester” and planned future spending reductions remain in effect), federal net interest expense will grow to 3.3% of GDP by 2023. At that point (and again assuming that the spending reductions specificed under current law continue for the decade), interest expense would be higher than either the total defense budget or the total discretionary component of the nondefense budget.

I believe this argument misses the real chain of causality. This is an argument Scott Sumner has previously made. Here are a few reason yields are low:

  • No one wants to invest in anything (companies have loads of useless cash)
  • The Fed has been buying up assets because demand is lethargic
  • The market doesn’t expect yields to increase anytime soon (because they’re forward looking, and any serious such expectations would start to materialize now)
  • Other countries run a dollar trade surplus and have nothing else to do, creating a captive demand for dollar-denominated debt
  • Banks hold excess reserves
  • We’ve hit a zero lower bound

The post rightly wonders whether demand for this debt, determined by any amalgam of the above factors, will continue to rise, keeping our yields low. While Hamilton worries about this vis-a-vis rising interest rates, I think it’s rather obvious this is a good thing.

If demand for American debt can’t keep up, here are a few reasons why:

  • Our trade deficits are declining, as manufacturing picks up
  • Unemployment is down
  • Businesses got bored of cash and decided investment might pay off
  • Banks got bored of cash and decided to lend money (because people wanted it)
  • People expect more of this to happen in the future

That all sounds pretty good to me. Eventually, any of the above five options will result in robust (vis-a-vis today) economic growth. The same automatic stabilizers that increased our deficits will bring in greater revenue, bringing deficits down.

This better economy will also (hopefully) signal a less divided political climate, that can tackle the real challenge of future Social Security and Medicare outlays. Unfortunately, the market doesn’t expect this to happen, or we’d have seen rising yields.

One final point: none of this is to say that increasing the debt servicing to GDP ratio is a good thing, it’s not. And this is another problem that is eminently solvable if the US moves its debt towards longer maturities, or even perpetuities. We’re already in the process of rolling over our debt to 30-yr bonds. This will cushion any future increase in yields. It’s not a long-run solution to anything, but it is a (seemingly) smart stopgap in between.

h/t: Tyler Cowen


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