The Era of Free Money Comes to an End: What It Means for the United States and its Allies
There is growing concern about the impact of rising bond yields on the American political system and the global dominance of the United States. The era of “Pax Americana” since World War Two is under threat as the end of free money adds a toxic ingredient to the mix of domestic political conflict and global challenges facing Washington.
One of the consequences of high bond yields, coupled with a large fiscal deficit and increasing sovereign debt, is the difficulty faced by politicians in effectively governing the country. President Joe Biden is currently experiencing this struggle as he seeks Congressional approval for $106 billion in military aid for Israel and Ukraine, as well as funding to counter China’s influence in the Indo-Pacific region.
The federal government not only needs funds to bolster defense capabilities but also to invest in pensions, healthcare, low-carbon technologies, and compete with China for influence in developing nations. Unfortunately, higher interest rates will significantly increase the cost of servicing the country’s borrowings.
This issue is not limited to the United States alone. Many other wealthy nations will also struggle to finance both domestic and international priorities. In fact, these countries may face an even tougher challenge in achieving fiscal stability due to less promising growth prospects compared to the United States.
In response to increasing threats from Russia and China, American allies in Europe and Asia are increasing their defense spending. However, this money has to come from somewhere. Post-Brexit Britain, for example, has reduced its foreign aid budget, which in turn undermines its soft power.
The recent decision by the Federal Reserve to keep short-term interest rates steady reflects the uncertainty surrounding the need for further rate hikes to control inflation. However, even without further increases, short and long-term rates are significantly higher than they were in the 15 years following the global financial crisis up until Russia’s invasion of Ukraine in 2020.
While the current rise in borrowing costs may simply be a reversion to the long-run average after a period of artificially low rates set by central banks, the consequence is that a generation of politicians grew up with the belief that money was readily available. As a result, they spent money excessively on various issues, including addressing the Covid-19 pandemic and combating climate change.
According to the International Monetary Fund, U.S. public sector gross debt has nearly doubled from 65% of the gross domestic product in 2007 to 121% last year, and is projected to rise further to 137% by 2028. This is primarily due to the expected fiscal deficit of 8.2% of GDP this year, which is still anticipated to be 7.0% in five years.
The United States benefits from the dollar’s status as the world’s reserve currency, which allows it greater flexibility in accumulating debt compared to its allies. It is unlikely to face a situation similar to the short-lived mini-bond crisis experienced by Britain when Prime Minister Liz Truss attempted to reduce taxes while increasing spending. On the other hand, the euro crisis demonstrated that members of the European single currency cannot accumulate debts without consequences, as evidenced by recent jitters in the Italian bond market.
Paul Tucker, author of “Global Discord” and a former deputy governor of the Bank of England, states that Washington will eventually need to bring its borrowing under control. Ideally, this should occur through a reasoned debate on spending priorities and options for raising taxes, such as implementing carbon pricing. However, if a chaotic process unfolds, international programs could be sacrificed.
The breakdown in political consensus has led to challenges in approving Biden’s significant request for military aid. Moreover, it has resulted in repeated standoffs over raising the government’s debt ceiling, which prompted Fitch to downgrade the U.S. government’s credit rating from AAA to AA+ in August.
China, the United States’ arch-rival, faces even more severe debt problems. Its population is aging rapidly, and it is highly exposed to the effects of climate change. Including private borrowing, China’s debt totals three times its national income, according to data from the Bank for International Settlements. This is in contrast to the United States, where total debt is about two-and-a-half times GDP. Furthermore, much of China’s borrowing has been used for unproductive investments, resulting in local governments, property companies, and shadow banks burdened with bad debts.
Consequently, China must also prioritize its spending. It has already scaled back its Belt and Road Initiative, an infrastructure plan designed to attract developing countries. China is not confronted with the same interest-rate challenges, as it does not rely on overseas capital to finance its debt. The yields on its 10-year government bond are only 2.67%, nearly two percentage points lower than their U.S. counterpart. However, this is a reflection of the efforts to support China’s sluggish economy.
Nevertheless, the significant yield gap with the United States presents its own challenges by exerting downward pressure on the yuan. Although China has substantial domestic savings, these funds are mostly restricted by capital controls. However,
More detail via Reuters here… ( Image via Reuters )