The immense debt of the United States is a perennial concern in economic and financial circles that periodically makes headlines. If a few months ago it was the downgrade of the U.S. credit rating by one of the major agencies that sparked the debate, now the reason has been the ‘reprimand’ from the International Monetary Fund (IMF) to Washington for the large deficits that the country is accumulating and the rapid growth of public debt. The truth is that the U.S. is earning significantly less than it is spending, and this trend is solidifying, which is not reassuring when speaking of the world’s leading economy. The challenging outlook has led some analysts to consider drastic measures to plug – or rather stop – an increasingly large hole. A seasoned strategist at Société Générale even invokes financial repression as a solution to this “fiscal dysentery.”
In its latest fiscal monitor, published last April, the IMF reports that the U.S. closed 2023 with an 8.8% deficit of Gross Domestic Product (GDP). While in 2022 the deficit had narrowed to 4.1% of GDP after 11.1% in 2021, the jump in 2023 and the hefty projections for 2024 and 2025 (6.5% and 7.1% respectively) have raised alarms once again. The magnitude of the problem not only prompts the organization to focus on the numbers but also to use strong words, denouncing the “notably large fiscal deviations” shown by the U.S.
The reproach extends to the problems this entails for the rest of the world. “The relaxation of fiscal policy and the increase in debt levels, coupled with the tightening of monetary policy, have contributed to the rise in long-term public debt yields and increased volatility in the U.S., which has increased risks in other countries through interest rate spillover effects,” reads the report.
“There isn’t much that surprises me in the world of economics and finance these days, but the latest IMF report on the U.S. fiscal situation left me momentarily speechless. After digesting the report more thoroughly, I thought about writing some reflections on where we might be headed in the coming years. Recent events have taught us to think the unthinkable,” reflects Albert Edwards, the seasoned strategist at Société Générale.
For the analyst, while the mainstream media focus on the differences between presidential candidates Trump and Biden ahead of the November elections, there is something that is not talked about as much and on which both (and indeed the two parties vying for control of Congress) seem to agree: an ever-growing fiscal deficit is not a cause for concern.
Edwards acknowledges his surprise at the 8.8% figure despite the Inflation Reduction Law sponsored by Biden and loaded with investments in the U.S. already hinting at a sizable deficit. With permission from what happened during the pandemic, the 5.8% deficit recorded in 2019, with Trump in the White House and his fiscal relaxation for businesses in full swing, also does not bode well.
To summarize what is happening, the analyst repeatedly speaks of “fiscal dysentery” and adds alarming warnings such as this statement made by none other than the Congressional Budget Office (CBO): “Starting next year, net interest costs will be higher relative to GDP than at any other time since at least 1940, the first year for which the Office of Management and Budget reports such data.”
“Wow, what a disaster! Where are we heading?” exclaims Edwards in his latest analysis, in which he also refers to the Chinese case: “If you fear that the U.S. is heading towards a fiscal precipice, the IMF data shows that China is sprinting towards fiscal oblivion.” All of this leads him to gauge that “the endgame” will involve financial repression with measures such as a yield curve control (YCC for short) that will arrive “sooner than we all think.” Although more discreetly, analysts at Bank of America (BofA) have also hinted in one of their recent weekly bulletins that yield curve control would be the “endgame” to support U.S. public spending.
“My opinion is that decades of excessively loose monetary policy have allowed governments to ruin their fiscal situation to the point where public debt/GDP ratios are on completely unsustainable paths. Just look at the CBO’s projections for the U.S. However, with an increasingly intense populist backlash against high levels of inequality, I can only see one way out of this mess for Western economies. Nothing less than financial repression including yield curve control. Yes, the same control that Japan has just abandoned,” writes Edwards.
Financial repression essentially involves keeping interest rates below the inflation rate for an extended period to allow the debt to ‘burn off,’ explains the Société Générale strategist. It is a tried and true method for governments to rid themselves of excessive debt (for example, the U.S. after World War II), he continues.
Bernd Weidensteiner, an economist at Commerzbank, months ago provided a dissertation on what happened during that period in the U.S.: “In addition to high growth, the cleaning up of public finances was also favored by the fact that the U.S. government kept interest payments low for several years through all kinds of regulations and with the help of the Federal Reserve (financial repression). Therefore, the government’s creditors had to settle for a fairly low return. Real interest rates were only slightly above zero between 1945 and 1965.”
Focusing on the aforementioned yield curve control, Ricard Murillo Gili, an economist at CaixaBank Research, defines it as the tool that allows to “set a target interest rate for a specific segment of the sovereign yield curve (for example, the 3, 5, or 10-year bond) and communicate the intent to purchase that asset in the necessary amount to maintain the interest rate at the desired level.”
Edwards (Société Générale): “While Western economists mock Japan for its yield curve control policies, that’s where I believe the U.S. and Europe are heading as intractable government deficits drive bond yields higher”
“Although unconventional, this tool has already been used on some occasions. In 1942, during World War II, the Federal Reserve agreed with the U.S. Treasury to temporarily set interest rates across the entire yield curve (as sovereign debt soared due to war financing). For example, the long-term treasury rate was initially set at 2.5%, seven to nine years at 2%, and one year at 0.875%. More recently, the central banks of Japan and Australia have also implemented a sovereign interest rate control scheme,” he elaborates.
The outbreak of COVID-19 and the need for a large stimulus led to the revival of the idea in 2020 that the Fed would reintroduce yield curve control as a more efficient way for the central bank to transmit its monetary policy without resorting to other aggressive measures such as the negative rates seen in Europe or Japan. However, the central bank turned down the idea while economists voiced lingering doubts.
“Yield curve control raises some doubts, first, about the independence of the central bank. In the 1940s, the Fed used it to deliberately lower the cost of Treasury financing, something that today could raise questions about the central bank’s independence. Second, the size of the Fed’s balance sheet could become more volatile and the Fed could lose certain control over it. Specifically, any factor that raises doubts about the Fed’s willingness or ability to implement control would force it to acquire large volumes of sovereign debt to maintain the interest rate at its target. Third, the process of unwinding this tool also raises questions. In the early 50s, when the Fed ended the agreement with the Treasury, the exit from the program was more complex than initially envisioned, and the U.S. Treasury (or taxpayers, ultimately) absorbed a significant portion of the associated losses,” CaixaBank research analysts explained in 2020.
Something that does not perturb analysts like Edwards: “While Western economists mock Japan for its yield curve control policies, that’s where I believe the U.S. and Europe are heading as intractable government deficits push bond yields up. During the next crisis, don’t be surprised to see even more japanization of the monetary policy of Western central banks.”
