America’s Debt Problem Is Ultimately Political
Washington is unwilling to raise taxes or cut the deficit. As markets increasingly fear that inflation will be used to erode the debt burden, the Federal Reserve may eventually be forced to act. A commentary by Lorenzo Bini Smaghi
The most significant economic statistic released this week is that US public debt has exceeded $40tn, its highest level on record.
By itself, however, this figure means little unless it is assessed against the country’s capacity to service its debt over time. That depends, in particular, on the trajectory of debt relative to gross domestic product and on the cost of interest payments.
US public debt has already reached 125 per cent of GDP. The year-end figure is expected to be revised upwards by at least a couple of percentage points.
Interest payments now absorb almost 20 per cent of US tax revenues, more than double the share recorded a decade ago.
By international comparison, in Japan, which has the highest public debt among advanced economies, debt servicing accounts for about 15 per cent of tax revenues. In Italy, the figure is below 9 per cent.
The solution to the US problem appears relatively straightforward: increase tax revenues, which are low compared with the average for advanced economies, at about 30 per cent of GDP against 36 per cent across the G7.
In the current political climate, however, few measures appear more difficult to implement, in the US or elsewhere.
This became clear after the Supreme Court ordered the US administration to refund the revenues collected through the illegal tariffs imposed last year. The repayments will be financed through additional borrowing, meaning a higher deficit and more public debt, rather than through new taxes.
With the midterm elections due in early November, the administration has carefully avoided announcing any new taxes, apart from reintroducing import tariffs in a different form. It is apparently hoping that Americans still believe such measures have no direct effect on their purchasing power.
Even after November, it seems unlikely that the administration will attempt to reduce the budget deficit, given that the country will vote again in 2028, this time in a presidential election.
Financial market participants have understood that America’s public debt problem is first and foremost political. The rise in long-term interest rates, driven by a wave of selling in fixed-rate government bonds, reflects concerns that a solution will continue to be postponed and that the issue will not be addressed until serious market tensions emerge.
That view has been reinforced by the unconvincing statements of Treasury Secretary Scott Bessent, who has argued that economic growth will solve the debt problem.
In reality, US public debt has doubled over the past 20 years even though economic growth averaged more than 3 per cent.
Extraordinary interventions in the US Treasury market have further increased uncertainty. The Treasury has purchased long-term securities in the market while issuing new short-term debt.
This highly unusual operation, which would have been regarded as a de facto debt restructuring had it been carried out by an emerging economy, failed to produce the desired results. Long-term rates did not fall as expected.
This failure came shortly after another unsuccessful intervention, conducted jointly with Japan’s finance ministry and intended to strengthen the yen. That operation had only a temporary effect.
These financial operations have reinforced the impression that the administration lacks a credible strategy to address the problem and restore confidence. Its only response has been the familiar attacks on the Federal Reserve for failing to lower interest rates.
As a result, investors increasingly believe that the only solution to America’s increasingly unsustainable debt trajectory will be to monetise the debt through inflation.
Inflation remains elevated in the US, driven not only by commodity prices but also by strong domestic demand supported by the budget deficit.
The more this interpretation takes hold, the more US government bond yields will tend to rise. Given the dollar’s central role in the international monetary system, the effects will spill over into the bond markets of other advanced economies.
History suggests that there is only one way out of this vicious spiral of expectations: a sharp increase in interest rates by the central bank.
Kevin Warsh, the new chair of the Federal Reserve, was not appointed to administer this bitter medicine to the US economy. But like all central bankers, he will not want to be remembered as the man who monetised the public debt and allowed inflation to rise.
In the end, he will do what is necessary, whether Donald Trump likes it or not.
A previous version of this article was published in the Italian daily Il Foglio
IEP Bocconi does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.
