Biden Administration Faced With Looming Sovereign Debt Trap
In the 2-year period between 2008 and 2010 something peculiar happened to the U.S. Federal Budget. In 2008 the Federal Government in the United States spent $253 billion on interest incurred by the national debt, representing 8.5 % of all federal outlays. Over the next two years federal budget deficits skyrocketed due to stimulus and other fiscal programs undertaken in the wake of the Global Financial Crisis. Obviously, massive deficit spending greatly increased the national debt. However, instead of the expected increase in annual interest payments, the amount allocated for debt interest payments by the Federal Government actually declined to $196 billion, representing only 5.7% of the Federal budget, a sharp decline from only two years previously.
How was this seemingly impossible mathematical trick accomplished? The answer is surreal in its simplicity. The Federal Reserve, by monetizing the debt and exercising other monetary levers at its disposals, sharply reduced interest rates across the board. In the case of short term interest rates, they were in some cases reduced to virtually zero ; in essence, free money. It is only for that reason that interest paid on the national debt plunged while the overall debt ballooned due to continuous and massive deficit spending.
Will the incoming Biden administration be so lucky? Unlikely. After massive deficit spending in President Trump’s final year in office, primarily due to a Coronavirus relief bill that increased borrowing by more than $2 trillion dollars on top of the already large structural deficit, a President Biden is set to add a new and even larger Covid stimulus relief package during his first year in office. So clearly, the national debt will continue to grow at a rapid rate.
What about interest rates? If it could, the Fed would keep interest rates at zero almost forever. But it can’t. On the horizon are warning signs of high inflation. In the period after the Global Financial Crisis low inflation enabled central banks worldwide to prime the pump and run the printing presses. This time there is decoupling of major trading relationships: U.S. and China; U.K. and Eurozone. As supply chains fragment, costs will be driven upwards. Furthermore, there exist geopolitical tensions that threaten to drive up commodity prices, should they worsen. Political instability within the United States itself creates elevated risks, which in turn stimulate inflationary pressures.
Any meaningful uptick in the rate of inflation will compel central banks, including the Federal Reserve, to begin raising interest rates. Once that happens, the massive deficit spending of the Biden administration that is now projected will unleash a sovereign debt trap, condemning the American and other economies, large and small, to stagflation, meaning higher inflation and a highly depressed economy. The handwriting is on the wall. In a worst case scenario, the U.S. government will default on its national debt, with seismic repercussions. Alternatively, the Biden administration could attempt to reduce the national debt through hyperinflation, which will induce it s own calamitous impact on the nation’s social stability.