Oh, how times have changed.
Little more than a decade ago, peripheral European countries found themselves pushed to the very brink by global markets. Their governments had steadily accumulated too much debt over the years, especially after the financial crisis; the collapse of growth and anemic recovery years then undermined their ability to service those debts.
First Greece and Ireland, then Portugal and Spain saw their bond yields jump to the point that they ultimately had to request international bailouts. Investors notoriously referred to the group of troubled countries as the "PIIGS" (including Italy), and the situation wasn't brought under control until Mario Draghi in 2012 famously declared that the European Central Bank would do "whatever it takes" to stop the crisis.
But fast-forward to today, and Greece's 10-year government debt yield--which peaked at almost 50% during the euro debt crisis--is now at just 4.5%, lower than America's 4.9%. So too is Spain's (3.9%). And Portugal's (3.6%). And Ireland's (3.3%). Only Italy's is ever so slightly higher.
In fairness to Greece, its borrowing costs first dipped below America's in 2019. But that was back when global investors were still piling into sovereign debt. Now, they're piling out. A decade ago it was U.S. investors rolling their eyes at peripheral Europe's fiscal profligacy. But have we now put ourselves in their former predicament?
That is the question Charles Calomiris asks in a recent piece for the St. Louis Fed. "The prospect of this occurring soon in the United States is no longer far-fetched," he warns, speaking specifically of what's known as "fiscal dominance." That's the fancy term for when government debt and deficits wind up "dominating" the central bank's ability to keep inflation low.
In peripheral Europe's case, fortunately, major European economies like Germany were in fine enough shape to come to their smaller peers' rescue without calling their own finances into question. But America is "too big to fail." It needs trillions, both now and decades into the future, to fill its projected deficits. Where, absent the central bank, will that money come from? And at what cost?
"The current combination of government debt and projected deficits is not feasible as a matter of arithmetic, because it would result in an outrageously high government debt-to-GDP ratio," of 566% by the end of this century, according to the government's own projections, Calomiris notes. But the only way to "bend the curve" is to sharply lower deficits, which are mostly driven by fixed spending on Medicare and Social Security (and now, high interest payments). The loss of central bank debt buying post-pandemic has unmasked these challenges.
"Ultimately, it seems likely that the U.S. will either have to decide to rein in entitlements, or risk a future of significantly higher inflation and financial backwardness," he cautions. That's because absent deficit reform, if Treasury investors continue to blanche, the government may face the prospect of a "failed" bond auction which it simply withdraws if the interest rate investors demand is too high.
In that case, the only choice left is to fund deficits through money-printing, and/or the hope that a large one-time inflation increase lowers the debt-to-GDP ratio enough to leave room for still-large deficits to grow it again. Either option imposes a "tax" on society, either on consumers or on bondholders, which is also a standard-of-living shock.
Calomiris warns that the Federal Reserve may also resort to more subtle monetization of the debt by (a) ending payment on bank reserves, and (b) simultaneously requiring banks to hold very large non-paying reserves at the Fed. "This potential policy change implies a major shock to the profits of the banking system," he warns. (And if there's any "bright spot" in such a scenario, it may be for fintech players who benefit from the resulting disintermediation of banks.)
And while this is all extremely unpleasant to ponder, the only way to head it off is significant fiscal reform out of Washington--in pretty short order. That's what makes the continued lack of Congressional Republican leadership so unnerving to markets. Back in 2012, Mario Draghi could at least declare "whatever it takes" to curb the crisis. As Calomiris makes clear, we ought not to hope that we start hearing the same thing from Chair Powell or today's Federal Reserve.
See you at 1 p.m!
Kelly
Click HERE to sign up for this newsletter in one easy step.
To hear this as a podcast, subscribe to "The Exchange" and pick "From the desk of..."