A drastic solution to exploding US government debt

0:06Pushkin. The U.S. government has a big$1 trillion line item this year, but it's not for food stamps, it's not for Medicare, it's not for the military, it's for interest payments. Big debt, big deficits, and rising interest rates are putting pressure on the U.S. government's finances. Today on the show, why people are talking about the U.S. busting out a radical wartime policy to deal with the debt. This is Unhedge, the markets and finance show from the Financial Times and Pushkin. I am reporter Ethan Wu, joined here today in the New York studio by U.S. markets editor Jen Hughes, who recently went to a conference that I I think can only fairly be described as the last safe space on Earth for men wearing bow ties.

0:56Hi there, Ethan. And I might not disagree with that. You were just at a conference hosted by Jim Grant of the legendary Grant's Interest Rate Observer, which for people that don't know, it's like reading a highbrow literary magazine, but like in finance. Yeah, the New Yorker for finance, I call it. So I went there recently and Jim Grant is famous for his bow tie. for being bearish. His cartoon in the magazine is actually a bear with a bow tie. And there were many, many, many other bears in the room who all worry about the same things, slowing US growth, rising US deficits, the debt problem as they see it in the US.

1:39You come out of that after a day and you're quite scared about the economic outlook. Let's put it that way. Yeah. Yeah. Yeah. Did you come back feeling rattled by all the pessimism? Well, it was the other day, in fact, a few weeks back. So I've recovered now. Your optimism has helped me. Okay. I do my best. I do my best. And you've written about this conference and some of the ideas that you gleaned from it in today's Unhedge newsletter, which was very good. I think we want to get to some of those ideas. But maybe we should take a second and just back up to why people are worried about the debt and US fiscal policy and the deficit and so forth.

2:15And I think a couple things have changed, right? One is that the politics, I think, have started to look a little worse. Once upon a time, and maybe this is just a fairy tale, but it used to be, you know, Democrats were the spending party and Republicans were the, you know, fiscal conservatism party. You know, that may or may not have been true, but Donald Trump's presidency really, I think, put an end to that notion because he passed a big, you know, trillion dollar plus deficit increasing tax cut. And so now you have kind of a situation where both political parties are inclined to add to the deficit.

2:46That's one issue. A second issue is that interest rates, as we talk about on pretty much every episode of Unhedged, have gone up a lot. And that really matters for debt and deficits because you want to have, ideally, interest rates lower than your growth rate. That means your capacity to pay back debt grows faster than the debt itself. If those start to become closer, or if potentially interest rates even exceed your growth rate, then you're in a little bit more trouble. You're in a situation where the debt could grow faster than your ability to repay it. And I think those two things changing have given a lot of investors anxiety about where's this really going to end?

3:23Absolutely. And this is what this conference was talking about a lot. The idea that spending is unlikely to come under control in the next year or so. We've got election. Politicians campaigning and running for office don't usually talk about cutting spending or raising taxes. So you're going to have a growing deficit. It's certainly not going to get cut. So at Jim Grant's conference, I mean, what sorts of scenarios are we really talking about that would get them so scared about the debt and deficits? Like, what do they have in mind that could go wrong here? It's really a change in market sentiment at some point.

3:58It could be a shock to the market. It could be unexpected expenditure, political problems, and there's enough of those in Washington right now. Heaven forbid another war somewhere that the US needs to start funding or wants to get involved in, a politician gets ill. Who knows what happens? But there'd be some shock. The bond market will react. Prices of bonds will fall and their yields will rise. And the risk is that in this sort of jittery, scared environment, they rise more quickly. They become what the central bankers would call disorderly. And a market out of control freaks everybody out, especially when it's the US treasury market.

4:36And I think that brings us to some of the more radical fixes being discussed at Jim Grant's conference. And one in particular is yield curve control, as you write about in your piece. And just to explain this, this is a central bank policy where essentially they make an open-ended commitment to buy however much government debt is necessary to cap yields, to peg yields to where they want it to be. So, for example, the central bank could declare the 10-year yield will rise no higher than 1%. And if markets say, we don't believe you, we're going to sell bonds at 1.05%, then the central bank jumps in and purchases whatever quantity of bonds is necessary to force the market back down to 1%.

5:23It's a really intense form of monetary intervention. It's also a point where the central bank and the government are almost acting together. Yes. So central bank independence is also an issue. But that's a separate discussion for a politics podcast sometime. But how did yield curve control in a US context come up at this conference? It didn't surprise most people in the room, but it did surprise me, at least not from the people I looked around at. Because I think of yield curve control as what you do in the case of Japan, which Bank of Japan is still involved in. in trying to spur an economy that's gone nowhere for two decades and been struggling with deflation.

6:03Australia introduced it briefly during COVID to try and boost the economy there in the early days of pandemic lockdowns. So it's part of the economic jumpstart toolkit. And you look at the US and say, but hang on, we've got growth. This isn't our problem. But here, the way it came up in the conference was this sense that, like it was used in World War II in the US, where because government spending is so high, you need to suppress the cost of that government spending so you control the yield curve. This is what the US did in World War II, that they didn't actually explicitly tell the bond market that's what they're doing at the time.

6:41But that's a whole different scenario. And that's why it fits with the whole worry about too much spending and spending out of control. That's a great point. And just to reiterate, yield curve control in a modern context is almost like a monetary defibrillator. You use it when the economy is like flatlining and you need like a shock monetary policy, the most extreme you can really get. Historically in the US, it's only ever been used in wartime, like you said. And you can kind of understand why it would be used in wartime. You've got these new massive military spending commitments that are of prime importance to the government.

7:17And you want the monetary authority, the central bank, to essentially ensure that all that government borrowing needed to finance the war effort gets digested in an orderly way. But now today, we are talking about historic peacetime fiscal deficits. And I think that's probably why yield curve control is on the margins back in the discussion a little bit in the US. Yeah. I should add that it's nobody's central scenario. We have this next year. And if we ever got to yield curve control, it's a very extreme case. But that's why it's good to have the discussion now before it becomes a likely part of the toolkit.

7:56Yeah. And I want to underline your point that it's not anyone's base case, because if there was a big increase in long-term treasury yields because markets were scared of the fiscal outlook, probably, one has to imagine, what would happen is, well, you have an increase in borrowing costs for companies, and you have an increase in mortgage rates. And it's actually hitting real people's finances. And that puts pressure on politicians to either raise taxes or cut spending or some combination of both to get the fiscal trajectory back on a more sustainable course. We're talking about a situation where the politics are so deadlocked, which, you know, not totally implausible, that that political pressure is not exerted or no consensus can be come to.

8:41And you need a more extreme monetary intervention to prevent markets from melting down. Yeah, because the one thing that none of us want to see, nobody in the world should really want to see is a complete meltdown in the US treasury market. The big thing in its favor is it's the reference market for the entire world. All other debt is normally priced in relation to treasuries. So having a meltdown there would have global consequences. Should we be scared of yield curve control in the US? Should we be scared of that scenario? I traditionally associate talking about this type of stuff with the panicked financial blogs, like Zero Hedge or whatever it is.

9:19Should we be reassured by this? I mean, it seems like a tool in the toolkit if necessary, but not anyone's base case. Well, we're talking about this in a world where you could say that monetary policy hasn't been textbook style since the global financial crisis, since 2008. The Fed has still got a massively bloated balance sheet from all the bonds it's bought through quantitative easing when it was keeping interest rates at zero, buying bonds, et cetera, et cetera. So we're not in a sort of a textbook situation at the moment. We're still trying to get out of all that mess. So yes, having a world where the Fed could step in and do something like this is better than not having it, but even better still would be politicians realizing that they can't keep spending and the deficit comes under some sort of control.

10:08That would be, to me, a far better solution, if maybe not the most likely. Yeah. I think it's worth saying that, you know, in the Japanese context of yield curve control, I think there have been, you know, the policy has stabilized Japan. Japan is not melting down, right? That much is clear. But there have been costs. One cost is to Japanese households who hold their wealth in bank accounts. you know, if you peg long-term interest rates very, very low, then banks are not going to pay you for leaving your cash in a savings account. And, you know, in Japan, a huge number of Japanese households own no financial assets, no stocks, no bonds.

10:48They have all their money in the bank and they're not getting paid. If there was a less interventionist monetary policy, a big chunk of Japanese households would be getting some interest on their savings. And, And that presumably could contribute to their lifestyle and to their consumption habits. So it's not as if this is free, right? In some ways, you can think of it as a transfer from household savers to the government. And it will probably create inflation as well. Possibly, yeah. So savers lose out and quite possibly we all lose out if we see more inflation. I mean, the last couple of years have been our first real experience of inflation in so long.

11:28I don't really want to see more like that. Inflation in somewhere, whether it's financial assets or more generally in the economy and consumer prices, would seem like another outcome. So yeah, it's got very high cost to it. Well, I think we all hope this is just a hypothetical and we will not have to get into the messy trade-offs of yield curve control. And the problem can just be solved by level-headed politicians who come to a reasonable consensus on the future path of government spending, right? I look forward to those discussions next year. Land value tax now. Let's do it. All right, Jen, we'll be back in a moment with Long Short.

12:13Welcome back. This is Long Short, that part of the show where we go long a thing we love, short a thing we hate. Jen, you long a short something. I'm going to go long cats because I've just persuaded my husband we might be able to get a third cat. What was wrong with the first two cats? My first two cats were wonderful. I got the second one to keep the first one company. The first one didn't want a friend. The second one wants a friend. So I get a third one. Can you see where this goes in a year or two? Yeah. Much like the government debt, exponential growth from here. I am short Ray Dalio chewing on tape.

12:46This was a detail included in Rob Copeland's new book about Ray Dalio and Bridgewater called The fund. And there's a lot of disturbing details that Copeland reports in this book. But I read this one in New York Magazine the other day that Ray Dalio has a habit of chewing on tape. And I just find that rather distasteful. That is all. I would agree. It was just a parenthetical in Copeland's piece, but it just stuck with me. It was so vivid that I couldn't get it out of my head. I'm short that. Please don't do that. All right, Jen, thank you for being here. We'll have you back soon. And listeners, we'll be back in your ears on Tuesday with another episode of Unhedged.

13:22Catch you then. Unhedged is produced by Jake Harper and edited by Brian Erstat. Our executive producer is Jacob Goldstein. We had additional help from Topher Forges. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, Jacob Weisberg, and Jess Trulia. FT Premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Ethan Wu. Thanks for listening.