Imagine that five or even 10 years from now we have another crisis, which we surely will. It might be another, worse, pandemic, or a war involving China, Russia, or the Middle East. Imagine the US follows its present trends of partisan government dysfunction, so an impeachment is going on, as well as a contested election, and militias even roam the streets of still-boarded-up cities. Add a huge economic recession, but without any reformed spending promises.
At this point, the US has, say, 150 percent debt to GDP. It needs to borrow another $5 trillion–$10 trillion, or get people to hold that much more newly printed money, to bail out once again and pay everyone’s bills for a while. It will need another $10 trillion or so to roll over short-maturity debt. At some point, bond investors see the end coming, as they did for Greece, and refuse. Not only must the US then inflate or default, but the normal crisis-mitigation policies—the firehouse of debt relief, bailout, and stimulus that everyone expects—are absent, together with our capacity for military or public-health spending to meet the shock that sparks the crisis.
Interest rates do not signal such problems. They never do. Greek interest rates were low right up until they weren’t. Interest rates did not signal the inflation of the 1970s, or the disinflation of the ’80s. Nobody expects a debt crisis, or it would have already happened.
As noted above, there is no defined limit to the debt-to-GDP ratio that policy makers can use for guidance. Countries can borrow a huge amount when they have a decent plan for paying it back. Countries have had debt crises at quite low debt-to-GDP ratios when they did not have a decent plan for paying it back. Debt crises come when bondholders want to get out before the other bondholders get out. If they see default, haircuts, default via taxation, or inflation on the horizon, they get out. Sound long-term financial strategy matters.
We cannot tell when the conflagration will come. But we can remove the kindling and gasoline lying around. Reform long-term spending promises in line with long-term revenues. Reform the tax code to raise money with less damage to the economy. The Treasury and Fed should secure long-term government financing, locking in low interest rates. And spend only as if someone has to pay it back. Because someone will have to pay it back.
John H. Cochrane is a senior fellow at the Hoover Institution at Stanford University and distinguished senior fellow at Chicago Booth. This essay is adapted from two posts on his blog, The Grumpy Economist.