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Bond vigilance is re-emerging in the sovereign debt market. This was shown with merciless clarity by the brutal sell-off of UK bonds that toppled British Prime Minister Liz Truss. Can the financial discipliners of the global investment community now turn their disruptive talents to the US Treasury market?
As well as brutally attacking the sitting president, such a challenge would destroy the role the United States plays as the world's leading provider of safe assets during global crises, while at the same time threatening the dollar's position as the preeminent reserve currency.
For many, the idea is simply inconceivable. In a recent speech, Federal Reserve Governor Christopher Waller declared that trips to the dollar in the financial crises of 2008 and 2020 were “the ultimate proof that the US dollar is the world’s reserve currency and is likely to remain so.”
Yes. After all, the dollar is supported by the largest and most liquid debt market in the world. They have what economists call network externalities: widespread acceptance that leads to broader use. Backed by the world's largest economy, the currency is a magnet for about 60 percent of all central banks' foreign exchange reserves.
We also note that despite the shrinking share of the US economy in global output, the result was only a gentle decline in the dollar’s relative share in global reserves. However, Governor Waller conspicuously failed to mention the larger reason to believe that Treasuries are no longer a very safe store of value.
This is not horribly dysfunctional US policy. Nor is the dollar weaponized thanks to geopolitics. Nor again the potential competitive threat from other central banks' digital currency plans. Rather, it is a rising public debt that now exceeds 97 percent of GDP, a level not seen since World War II.
A comparison with the immediate post-war period is instructive. The United States succeeded in reducing its debt-to-GDP ratio from 106% in 1946 to 23% by 1974. But the debt was essentially domestic, while today nearly a quarter of it is in foreign hands. For about half of the period up to 1980, real interest rates in advanced economies were negative. Carmen Reinhart and Belén Sperancia estimated that the annual liquidation of debt in the United States and the United Kingdom thanks to negative interest rates averaged between 3 percent to 4 percent of GDP annually.
This arose from a policy of financial repression involving direct lending by institutional investors and government captive banks, caps on interest rates, and capital controls. In the three decades after the war, the growth rate of national output also exceeded the interest rate on government debt most of the time. The result: a massive debt contraction.
With today's global capital flows and deregulated markets, financial repression will become unenforceable. The Federal Reserve has raised interest rates to help achieve its 2 percent inflation target, and ultra-low interest rates are gone. On the other hand, the Congressional Budget Office expects the US deficit to rise by about two-thirds in the next decade, with interest payments representing three-quarters of this increase. This stems from excessive morally hazardous debt as a result of years of ultra-loose monetary policy.
Even the Treasury Department declared that the public debt burden was unsustainable. This means that its supposedly safe debt securities – the focus of global markets – are potentially unsafe. Treating this problem requires controlling financial conditions, which means reducing debt. Some hope in a polarized United States, whether under Joe Biden, Donald Trump or someone else.
The demise of the dollar's dominance has long been expected, but it never happened because other countries are unable to match the supposed safety and liquidity of US Treasuries. However, this logic may collapse in the face of a deep-rooted problem identified by economists Ethan Elzetsky, Reinhart, and Kenneth Rogoff. They claim that demand for safe dollar debt threatens to strain the US government's ability to support it when the tax base dwindles. In this case we are in territory similar to the collapse of the Bretton Woods exchange rate system in the early 1970s, which unleashed two decades of high inflation and perpetual financial instability.
It is therefore safe to expect that the relative financial soundness of sovereign borrowers will become a more pressing concern for official reserve managers. If the guards are struck, the nature of the flight to quality will be redefined, in the ensuing firestorm, as financially profligate countries are hit by financial crises. At the same time, fiscal conservatives who generate few safe assets will take a hit from uncontrollable bond market bubbles. Policymakers must start contingency planning now.
