Mammoth U.S. Borrowing Faces Lower Foreign Participation, Among Other Challenges

The Federal deficit has ballooned in the last few years, first because of a 2017 tax-cut bill that failed to produce offsetting revenue, and then because of massive fiscal spending needed to shore up a pandemic-ravaged economy. The Federal Government has to borrow enormous amounts of money to plug the hole. So far the Treasury has had no problem borrowing as much as it needed, but this deluge of debt is not without dangers.

As a result of the massive issuance, total Federal debt as percentage of GDP jumped from less than 103% of GDP at the end of 2017, when the tax-cut bill was passed, to more than 127% of GDP by last September.

The government borrows through frequent auctions of Treasury bills, notes and bonds. Last week it sold an astronomical $290BN of instruments which, when netted against maturing instruments, added $120bn to the debt. It also announced another $190BN in auctions for this week. This is now a normal state of affairs.

There is no end in sight to the waves of new debt flooding the market, especially because a new round of government stimulus is needed to prevent the economy from sinking again. Fairly depressing retail sales and unemployment numbers released last week shows that this is not a small risk.

Unless Federal revenues start to go up with a pick-up in economic activity, future auctions are likely to be even bigger. Tax increases of any significance to offset the deficit are likely to be off the table for now, as they may depress the economy further.

Given all this, it is reasonable to wonder if the government could run out of buyers. But, according to U.S. Treasury data, the opposite is the case. The U.S. Treasury is finding it increasingly easier to sell its debt.

This is the conclusion we drew after examining the bid-to-cover ratio over time for Treasury bills, notes and bonds. We found that, for all instruments, the bid-to-cover ratio has been creeping up, despite unattractively low interest rates, showing that there is growing interest for the Treasury’s auctions. (the bid-to-cover ratio is simply the amount of bids placed for new debt in auctions divided by the amount issued. For example, if the government receives $2,000 of bids for $1,000 of debt, the bid-to-cover ratio is 2).

One may be tempted to think that the U.S. can sell its debt easily because of some well-deserved stamp of approval on its debt. A few other reasons, however, are more plausible.

Virtually all European government bonds maturing as far as 10 years into the future yield negative rates. This includes not just France, the U.K. and Germany, but also Austria, Belgium, Ireland, the Netherlands, Portugal, Slovenia, Spain and Switzerland. Even Italy’s bonds maturing in 5 years or less currently have negative rates, as well as those from Bulgaria, Cyprus and Malta. In this context, the U.S. is attracting buyers simply because it offers the juiciest high-quality bonds anywhere. Since the bonds are denominated in a currency that it can print, they are virtually guaranteed not to default. Paying up is a good way to attract buyers, but it is costly.

Another problem is that the U.S. needs to find a lot of willing buyers for its growing debt. While foreign buyers have bought larger amounts of U.S. Treasuries, their growing purchases have not kept up with the faster supply of debt as the declining share of purchases by foreigners clearly shows.

Another concern is that while the bid-to-cover ratio has clearly gone up for Treasury bills (short-term instruments maturing in less than a year) that was not the case for notes (up to 10 years) or bonds (longer than 10).

To us, this is further proof that a meaningful part of the stimulus was delivered inefficiently and ended up where it was not really needed. All that cash sits idle and has to be invested somewhere. Some of it went to the stock market and pushed it to record highs, and some went to Treasuries that offer safety but minimal returns.

There are a few implications to these observations. First, if and when interest rates elsewhere rise, the U.S. Treasury will have to pay even higher rates to attract buyers. For now, interest rate differentials are clearly tilted to make U.S. Treasuries attractive, but this will not last forever.

Second, the growing amount of debt poses an increasing burden on the nation’s finances. After hitting a 45-year low in 2015, the portion of Federal tax revenue needed to pay interest on the debt shot up to a 19-year high, well above the peak of the financial crisis even though the average rate paid is hovering at a historic low. This benign environment is not guaranteed to last. If the average rate paid on the Federal debt goes up in the quarters and years to come, the burden of paying the interest will continue to increase and, conceivably, challenge the previous peak.

Finally, a lot of the buying is a result of the government stimulus. Some of it is done by the Federal Reserve system, which buys Treasuries (especially notes and bonds rather than bills) to inject money into the economy, and some of it by a public flush with the spillover produced by the inefficient delivery of help. Both will continue in the months to come, but eventually they will begin to shrink as the economy shows convincing signs of recovery.

Economic upswings are typically accompanied by higher rates. This will push up the interest burden, but it will also increase tax revenue. Ensuring that the interest burden does not get out of control is part of the difficult job facing policymakers in the not-too-distant future.

Both theory and practice, and indeed experience, show that anti-cyclical fiscal policies work best. Which means that the ideal moment for austerity (higher taxes and lower spending) is when the economy is booming, and the moment for largesse (lower taxes and higher spending) is during a recession. One of the mistakes in the aftermath of the Financial crisis was to choose austerity when the economy was weak, leading to monetary-policy-only solutions that distorted stock prices and delayed recovery. A mistake of the early Trump Administration was to lower taxes when the economy was booming, leading to an already bloated deficit by the time the economy hit the skids.

The approach of the last year has a better chance of success: coordinating fiscal and monetary stimulus to spur the economy to action, even though the process was clumsy and resulted in too much waste. The next step is to recognize the need to scale back just so when the economy is finally back on track, in order to mend fiscal accounts and reduce distortions. It’s not impossible: We did that in the 1990s and enjoyed a rare period of budget surplus. Let’s hope we can do it again.