About the author: David Beckworth is a Senior Research Fellow at the Mercatus Center at George Mason University and a former International Economist at the US Department of the Treasury.
After the collapse of the Silicon Valley Bank and the forthcoming interest rate decision by the US Federal Reserve, questions about financial stability in the US have taken center stage. Beneath the surface, for better or for worse, something amazing has happened to US taxpayers: the burden they are exposed to from the national debt has decreased dramatically over the past three years. The reasons for this should be part of the Fed’s calculations as it navigates the situation.
This largely unnoticed development may seem counterintuitive given that the national debt has increased by about $5 trillion over the same period. But at the same time, the market value of US Treasuries has risen from a peak of 108% of the economy to its current level of 85%. This is one of the fastest declines in the US debt burden, bringing its value close to pre-pandemic levels.
However, this sharp drop is also the reason why we are now facing increased financial stress. Much of the windfall benefit, which benefits taxpayers, has been at the expense of bondholders, including banks, which suffered large losses on their bond investments. It is therefore important to take a closer look at how this rapid decline in debt burdens came about and what this means for financial stability.
The origins of the dramatic shift begin in spring 2020. The dollar size of the economy fell sharply as federal spending soared. These developments increased both the debt burden, shrinking the tax base from which the debt could be paid, and the public debt. In addition, interest rates fell to almost 0%, making existing Treasuries worth more because they were paying a higher interest rate.
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In other words, bondholders suddenly had a better-than-expected yield on their government bonds, and taxpayers footed the bill. Taken together, these three developments have pushed taxpayers’ debt burden to 108%.
However, the dollar size of the economy quickly recovered from the pandemic shutdown and was trending again in mid-2021. As a result, the debt ratio fell by around nine percentage points. Next came the inflation spurt, which further reduced the debt burden by 14 percentage points to the current level of 85%. This happened through two channels. First, high inflation has pushed the dollar size of the economy about $1.89 trillion above pre-pandemic trend.
Second, the surge in inflation naturally prompted the Fed to raise interest rates sharply, driving down the market value of government bonds by about $1.9 trillion. The fate of the bondholders therefore changed. They were suddenly holding bonds that were worth a lot less than they expected, both adjusted for inflation and relative to other newer interest-bearing securities that were paying more.
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In short, bondholders paid for much of the debt reduction through higher inflation. To be clear, bondholders are also taxpayers, but they’re just a subset of taxpayers. Furthermore, the loss is more acute and visible to bondholders than the prospect of a lower future tax burden for taxpayers.
This remarkable transfer of wealth away from bondholders was not limited to the $24 trillion Treasury market. Other fixed income markets such as the $12 trillion mortgage-backed securities market and the $10 trillion corporate bond market also saw large falls in market value. This is a key reason why banks holding such securities are currently under stress. A recent study found that such assets are overvalued by $2.2 trillion in the US banking system due to mark-to-market losses. This loss means that many banks would not be able to meet all of their depositors’ claims should they flee en masse.
The precarious situation of the banks is a major problem for financial stability, as US regulators have found. This is also why the US government insured all depositors at the recently failed Silicon Valley Bank and Signature Bank, and why the Fed decided to accept collateral at par rather than market value in its new liquidity facility. Regulators fear a market-to-market time bomb on US banks’ balance sheets. These are bondholders who have unknowingly given their debtors a large wealth transfer and may not be able to afford it.
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There are many reasons we have arrived at this point, but probably the most important is the Fed’s rapid rate hikes over the past year. Most bondholders, including the Fed, were surprised by the speed and magnitude of the rate hikes, given the expectations raised by the past decade of low interest rates and the Fed’s own forecasts just a year ago. The Fed is hoping these rate hikes will end the inflation spurt, but in the meantime they have damaged banks’ balance sheets and hampered future credit creation. Hopefully this will end the high inflation in an orderly manner and not as a financial crisis.
We live in amazing times. There is no easy way forward, but we hope the Fed can successfully navigate these difficult waters.
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