There has been growing concern about the sustainability of sovereign debt in the United States and around the world. While the United States has never directly defaulted on its debt, many people are wondering whether a US debt default might be on the horizon. In this article, I explore the sovereign debt crisis, whether the United States is already in a national debt death spiral, how likely a US debt default is and in what form it would happen.
While the United States has never directly defaulted on its debt, the government has indirectly defaulted on its debt at least two times in recent history.
In 1933, president Roosevelt declared a nationwide bank holiday and issued Executive Order 6102, which outlawed gold ownership. All Americans were asked to turn in their gold to combat the Great Depression.
At the beginning of the Great Depression, the United States and most other countries were still on the gold standard. In the case of the United States, this meant all paper money was backed to 40% by physical gold. Americans were able to redeem their banknotes for physical gold at any time.
However, as the Great Depression took hold of the country, many banks failed. Depositors panicked to withdraw their money from banks, which led to bank runs that further exacerbated bank failures. Multiple banks went bankrupt and closed on a daily basis, leading to the total loss of money for depositors that held their life savings in these banks. This was before FDIC insurance existed.
In order to stop bank runs, president Roosevelt declared a national bank holiday to prevent depositors from withdrawing their money. Many banks never reopened. Those that did, reopened with severe restrictions and withdrawal limits.
Shortly after ordering the national bank holiday and preventing Americans from withdrawing their deposits, Roosevelt issued Executive Order 6102, which outlawed gold ownership in the United States. All Americans were asked to hand over their gold bullion, coins and gold certificates. People that didn’t turn in their gold were threatened with large fines and up to 10 years of prison.
The reason why Roosevelt confiscated the gold of American citizens was in order to expand the money supply. As part of Keynesian counter-cyclical government spending, printing money is thought to stimulate growth and help navigate recessions and depressions.
By preventing American’s from owning gold amounts in excess of $100, Roosevelt ended convertibility of paper money into physical gold and took the United States off the gold standard. Many other countries in Europe had already gone off the gold standard.
In 1934, the United States government repriced gold at $35 per ounce, effectively devaluing the existing paper money.
As part of the gold standard, the United States government had an obligation to redeem paper money into gold. But since Roosevelt wanted to spend more money to stimulate the economy, he broke the promise to redeem paper money into physical gold.
This can be seen as an indirect default of the United States government.
After World War II, the United States entered into a monetary agreement with the rest of the world known as the Bretton Woods system. As part of the Bretton Woods system, only the United States was required to keep gold in its reserves. All other countries around the world held US dollars in their reserves.
While Americans weren’t allowed to own gold or redeem paper money into physical gold, countries that signed the Bretton Woods agreement were still allowed to do so. This is known as the gold exchange standard.
In 1971, president Nixon ended the gold exchange standard and announced, as part of what would become known as the “Nixon Shock”, that sovereign nations weren’t allowed to convert their paper dollars into physical gold anymore.
Nixon severed all connections to gold, and from 1971 onward, all currency became fiat currency. Money wasn’t backed by anything anymore except the faith and credit of the United States government.
Paradoxically, Nixon ending the gold window can be seen as the second US debt default in history. It wasn’t a direct default of course. But until 1971, the United States had contractually agreed that sovereign nations could redeem their paper money into gold.
Halting this redeemability meant the United States defaulted on its obligation to convert US dollars into physical gold as part of the Bretton Woods agreement.
First, president Roosevelt defaulted on American citizens by failing to fulfill the obligation to redeem paper money into gold at any time. Secondly, president Nixon defaulted on sovereign nations around the world by closing the gold window.
Saying there is no US debt default history isn’t quite true.
This gold standard note from 1928 still contained the sentence “Will Pay To The Bearer On Demand”. In 1933, this phrase became obsolete but remained on the paper money until 1963.
So has the US ever defaulted on its debt? Not directly, but it defaulted indirectly by going off the gold standard in 1933 and closing the gold window in 1971.
After the “Nixon Shock”, currencies weren’t pegged to gold anymore in any way. The world went on a fiat standard and central banks could issue as much currency as they wanted. The consequences of the “Nixon Shock” are illustrated on a website called WTF happened in 1971.
During the last 50 years, the United States’ sovereign debt ballooned. In 1929, the year the stock market crashed, US sovereign debt was at $17 billion and the debt to GDP ratio was 16%.
On January 31st 2022, US sovereign debt surpassed $30 trillion. The debt to GDP ratio grew to 129% in 2020 after the Federal Reserve engaged in unprecedented levels of Quantitative Easing in response to the Covid-19 pandemic.
Governments can only pay back their debt through taxation or printing money. After 2013, the debt to GDP ratio of the United States surpassed 100%, which means the outstanding US government debt is more than what the entire US economy produces in a year.
A debt to GDP ratio of over 100% indicates that sovereign debt is unsustainable.
When the United States government wants to spend more money than it collects in tax revenue, it has to borrow this money.
The way the United States government borrows money is by issuing government bonds which can be purchased by individuals and corporations. However, the Federal Reserve can also purchase US government bonds through Quantitative Easing, Yield Curve Control or monetizing debt.
This is why a government that issues debt in its own currency theoretically cannot go bankrupt. In case there aren’t enough private buyers of government bonds, the Federal Reserve can “monetize the debt”, or in other words, pay off the debt by printing money.
Since the Global Financial Crisis, the Federal Reserve has engaged in high levels of Quantitative Easing. Due to supply and demand, when the Federal Reserve buys sovereign bonds, it bids up the prices of sovereign bonds.
The Federal Reserve acts as ultimate “dumb money” buyer of government bonds. It announces when it starts buying government bonds and how much per month. For example, the Federal Reserve announced that it would start it’s Quantitative Easing program in response to the Covid-19 pandemic and buy $120 billion worth of assets per month.
Investors could front-run the Federal Reserve by buying government bonds and other assets before the Quantitative Easing program started, in the hopes of being able to sell these assets at a higher price later on.
When the prices of bonds increase, their coupon rates drop. A bull run in the sovereign bond market means that there is a lot of demand for treasury bills, notes and bonds. This demand pushes down the interest rates of medium and long-term government debt.
The 10-year treasury note is considered the risk-free rate against which all other assets are measured.
As long as the sovereign debt market is in a bull run, medium and long-term interest rates continue trending downward. This is great for the US government since it can borrow money cheaply. And that’s exactly what the government has been doing for the last few decades.
As short-term interest rates were kept low, and medium and long-term interest rates were pushed down by the bull run in the sovereign bond market, the US government could go on an unprecedented debt binge.
For a more detailed breakdown of bond math and the bubble in sovereign bonds, you can read our article The Everything Bubble: Is the Biggest Financial Crash In History Coming?
In response to increasing inflationary pressures, the Federal Reserve has announced that it will hike the Federal Funds Rate several times in 2022. Additionally to announcing several hikes, the Federal Reserve started tapering its purchases of US government bonds.
Markets responded by starting to sell off. Many technology stocks dropped as much as 50%. The NASDAQ plunged 10% in a matter of a few days as investors rotated out of risk assets.
As long as no “Too Big To Fail” company gets under significant pressure and faces insolvency due to rising interest rates and crashing markets, the Federal Reserve will try to continue tapering its bond purchases and hiking the Federal Funds Rate.
But as the Federal Reserve tapers its purchases of government bonds, a significant buyer is removed from the sovereign bond market, which puts downward pressure on government bond prices and pushes up their interest rates.
As interest rates increase across the yield curve, the borrowing cost of the US government increases.
This is a major problem since the United States is already at a debt to GDP ratio over 100%. With already unsustainable high debt levels, an increase in borrowing costs for the US government puts more pressure on the existing debt.
The US government rolls over most of its debt by issuing more debt. This might work well in a low or zero interest rate environment. But if interest rates of US government bills, notes and bonds increase, rolling over the debt becomes more expensive. For a government that is already above 100% debt to GDP, an increase in borrowing costs is devastating.
Interest payments on existing debt account for a growing part of US government spending. If debt is rolled over into the future by issuing new debt at higher rates, interest payments become an ever bigger percentage of US government spending.
To pay the interest, more money needs to be borrowed.
This creates a dangerous dynamic.
When interest rates in the sovereign bond market increase, the size of interest payments on existing US government debt does as well.
To counteract this problem and prevent the bull run in sovereign bonds from ending, the Federal Reserve will have to continue keeping the Federal Funds Rate low and purchasing US government bonds to prevent medium and long-term interest rates from rising.
This is known as Yield Curve Control (YCC). When the short-term interest rate, the Federal Funds Rate, is already at or near zero, central banks need to engage in more extreme monetary policy.
While Quantitative Easing pushes down long-term interest rates without this necessarily being the goal, the Federal Reserve can use Yield Curve Control to set a specific target for long-term bond yields and purchase however many bonds is necessary to achieve the goal.
The problem with Quantitative Easing and Yield Curve Control is that they put additional pressure on the already high levels of inflation. Despite some disagreement on the topic, Quantitative Easing and Yield Curve Control, the way it was done and will be done after 2020, is inflationary. There is a great video by Heresy Financial that explains why the recent form of Quantitative Easing is inflationary.
This means the Federal Reserve is in a pickle. With inflation at 7.5%, how can it fight inflation without pushing up interest rates and bankrupting the United States government?
Although high inflation isn’t popular among Americans, the truth is that it’s the only way the US government can avoid a hard default on it’s outstanding debt.
As long as bond interest rates are kept below inflation, the US government can “inflate” away its debt. Inflation is actually great for anyone who borrows money. Hugo Stinnes, a German industrialist, made fortunes during the German hyperinflation by borrowing money and investing.
By the time he had to pay back his debt, he could do so with money that was worthless. While he still owed the same amount, the actual purchasing power of the owed money was close to zero.
A loaf of bread cost 160 marks in Germany at the end of 2022. A few months later, a loaf of bread cost 200 billion paper marks.
If someone were to hypothetically take out a loan of 200 billion marks in 1922 (which was of course impossible), and invest in real estate, commodities and businesses, by the time the loan had to be paid back, the value of the investments soared while the owed amount was equivalent to just a loaf of bread.
In other words, you would have purchased 200 billion worth of assets on credit and then paid back the credit with a loaf of bread. Hugo Stinnes did this to a lesser extent during the German hyperinflation.
Another way of looking at this is that Stinnes’ debt was “inflated” away. While inflation and hyperinflation hurts most people, it benefits those who borrowed money prior to the inflation.
Governments are the biggest borrowers in the world, with the United States leading the way. But how do you “inflate away” $30 trillion in government debt?
The United States currently has over $30 trillion in outstanding debt with a debt to GDP ratio of 122%.
As Lyn Alden points out, if the US government were a company, it would be rated as a junk bond with a high risk of default. But since the US government has the Federal Reserve as ultimate backstop, it won’t directly default on its debt.
The government has a high debt/revenue ratio, and then also has negative income. If it were a company, that would put it down near the bottom of junk bond status at imminent default risk, rather than just normal junk bond status. The financial situation, if analyzed like a company, is abysmal.
But of course, the US federal government is not a company. Since the federal government issues its own currency and effectively controls its own central bank when necessary, it can’t nominally default unless by choice. When push comes to shove, it can have the Federal Reserve create an infinite amount of new base money to buy federal government bonds as needed, and hold interest rates below the inflation rate, and below the nominal GDP growth rate.Lyn Alden on Government Debt
The good news is that individuals and corporations that bought government bonds and hold it until maturity will get their money back. The bad news is that this money will have lost its purchasing power because the Federal Reserve has to print money to pay back the debt.
Paying back debt by printing money rather than through taxation is a recipe for disaster.
Let’s take a closer look at how this works.
The more Quantitative Easing, Yield Curve Control and debt monetizing the Federal Reserve has to resort to in order to keep interest rates low and bail out the government, the more inflation will spiral out of control.
When US government bond yields are kept below inflation rates, individuals and corporations that own government bonds are effectively losing money.
A bond coupon rate of 2% with an inflation rate of 7.5% results in a 5.5% loss for bond holders.
True inflation numbers are likely higher than reported by the Consumer Price Index (CPI), which means bond holders are losing significantly more purchasing power than the graph above indicates.
As more private investors and companies realize that government bonds are a losing investment, they will stop buying US government bonds in the future.
In other words, the US government won’t be able to roll over its debt anymore to private investors. It can force some companies like pension funds to hold US government debt by law. But as the unsustainability of US government debt becomes more apparent, and bond holders lose a large part of their purchasing power, the Federal Reserve will have to step in and monetize the debt that private investors are unwilling to buy.
This leads to a situation where a majority of government bonds end up being purchased by the Federal Reserve with newly created money.
In case you’re wondering whether the problem can be solved with taxation, government spending or austerity, it can’t. At this point, it doesn’t matter what political party is in power and what policies are deployed in an attempt to recover from the US debt burden.
Lyn Alden explains in detail why it’s too late for austerity, and why raising taxes and stimulating growth with government spending won’t be sufficient to prevent a “soft” US debt default. You can read about it in her piece Does the National Debt Matter?
There are other reasons why the United States is in a pickle. Greg Foss, a veteran trader with 32 years of experience trading bonds, goes into great detail analyzing how a widening of sovereign Credit Default Swaps (CDS) can lead to contagion across credit markets.
Greg points out that contagion in credit markets is more severe than in equity markets. When a problem is brewing in credit markets, it will negatively impact all other markets. And right now, we have a major problem brewing in the sovereign bond market.
You can read Greg’s 40-page paper for a deep dive into the risks of widening CDS spreads in the sovereign bond market.
It’s one of the best and most thorough breakdowns of why the United States has reached a point of no return and is mathematically guaranteed to enter a debt spiral.
This debt spiral doesn’t only affect the United States. Unsustainable levels of debt are a global, unrecoverable problem.
Global debt is at around $400 trillion while global GDP is only at around $100 trillion. This means, globally, the debt to GDP ratio is at 400%. This includes all debt, not just government debt.
At this ratio, a dangerous mathematical certainty emerges. If we assume the average coupon on the debt is 3% (likely low), then the global economy needs to grow at a rate of 12% just to keep the tax base in line with the organically growing (the coupon obligation) debt balance. This does not include the increased deficits that are contemplated for battling the recessionary impacts of the covid crisis.Greg Foss on the Debt Spiral
In other words, assuming an average interest rate of 3%, the interest owed on the global debt alone is growing at a much faster rate than the global economy. Simply put, the entire world’s economy isn’t able to grow fast enough to make interest payments on the existing debt.
This means the world is already in an unrecoverable debt spiral. The only way out of this will be for central banks to print money and inflate the money supply.
Should we expect a US debt default? Yes, but not in nominal terms. A soft default in the form of “inflating away” the debt is more likely.
Since direct taxation and government spending won’t be sufficient to recover from the excessively high debt to GDP ratios that we are seeing around the world, and its too late for austerity, governments will have to pay the debt by printing money.
This expansion of the money supply leads to inflation. Inflation can be seen as an indirect tax.
Even John Meynard Keynes recognized this when he wrote:
By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some.John Meynard Keynes on Inflation
Since inflation can be seen as an indirect form of taxation, the general public will be bailing out the government. The debt will be paid with the purchasing power of citizens.
Even if every investor who bought government bonds gets back their principal plus interest, they will still have lost a significant amount of purchasing power. While the US debt default isn’t going to be nominal, it will be done softly, or in the words of Keynes, “secretly and unobserved” through a continuing process of inflation.
Under these circumstances it will make sense for investors to position themselves for both a nominal and a “soft” US debt default.
Regardless if the default is nominal or “soft”, government bonds around the world are a debasing contract and guaranteed to lose purchasing power over time. As long as interest rates are lower than inflation, holding any kind of bonds results in loss of purchasing power.
On the other hand, in inflationary and hyperinflationary environments, assets like stocks, real estate, commodities and precious metals can preserve all or at least some wealth.
Bitcoin is another diversifier that can help hedge against inflation and debasing fiat currencies. Its supply is capped at 21 million, it has been the best performing asset for the past decade and it is being adopted at a faster rate than the internet.
For a deeper dive, you can read our article about the value proposition of Bitcoin.
We are likely going to see a lot of short-term volatility in markets, so investors must brace themselves and take on a long-term perspective when deciding what assets to invest in.