South SFV Today

In 2019, Olivier Blanchard, former head of the International Monetary Fund, suggested that the United States could manage its growing budget deficits without fiscal repercussions. This perspective was common before the COVID-19 pandemic. Economist Hanno Lustig from Stanford Graduate School of Business notes, “The thinking was that the fiscal capacity of the U.S. government might essentially be unlimited.” However, he adds, “After the COVID-19 pandemic, we woke up and realized that’s not quite the right way to think about it.”

Lustig's recent research with colleagues Roberto Gómez-Cram and Howard Kung questions whether U.S. Treasuries remain "safe" debt. Their findings were highlighted at a Federal Reserve economic policy retreat in Jackson Hole, Wyoming. The researchers argue that U.S. fiscal practices are showing signs of becoming a "risky debt regime." Lustig comments, “Americans still haven’t quite fully digested the important message that the bond market was sending us during COVID.”

The study highlights spikes in Treasury rates when long-term costs for pandemic spending plans were announced by the Congressional Budget Office (CBO). These stimulus packages totaled nearly $7 trillion or 20% of GDP. Lustig states, “The government has to commit to increasing taxes or cutting spending in the future to fully offset that 20% of GDP increase.”

Lustig warns policymakers against complacency regarding Treasury yields' response to spending: “We’re conditioned to think that Treasuries are safe,” he says.

Sophisticated investors sold off long-dated Treasuries post-pandemic due to anticipated yield spikes and lack of tax increases supporting deficit spending. This led to a significant drop in Treasury value from 2020 to 2023.

From 2022 until 2024, savers benefited as short-term rates rose while long-term rates fell when the Fed stopped buying Treasuries. However, this resulted in substantial paper losses for the Fed on its purchases.

Deficits have been rising since 2001 and federal debt reached 97% of GDP by 2023. CBO projections suggest this could rise to 166% within three decades.

Lustig draws parallels with post-World War I Britain: “The U.K. ended up in serious fiscal trouble.” He suggests foreign investors may view U.S. debt as less secure than before.

To maintain investor interest in riskier debt, high Treasury yields may persist for years, imposing costs on taxpayers and bondholders.

Blanchard now aligns more closely with economists like Lustig regarding potential fiscal crises due to unfunded public debt: “At some point,” he said earlier this year, “it will happen.”