About the author: David Beckworth is a senior fellow with the Mercatus Center at George Mason University and a former international economist at the US Treasury Department.
Questions about US finance the stability is taking center stage after the collapse of Silicon Valley Bank and the upcoming decision of the US Federal Reserve on interest rates. Just below the surface, for better or worse, is an amazing thing that has happened to U.S. taxpayers: The national debt burden they face has dropped dramatically over the past three years. The reasons for this should be part of the Fed’s calculation because it directional situation.
This largely unnoticed development may seem counter-intuitive, as public debt has grown by about $5 trillion in the same period. But at the same time, the market value of U.S. Treasury securities has risen from a high of 108% in the economy to its current value of 85%. This is one of the fastest declines in the US debt burden and brings its value close to pre-pandemic levels.
However, this sharp drop is also the reason why we face increased financial stress. The unexpected returns for taxpayers have largely come at the expense of bondholders, including banks that have made huge losses investing in their bonds. Therefore, it is important to take a closer look at how this rapidly decreasing debt burden plays out and consider what it means for financial stability.
The roots of the dramatic change began in the spring of 2020. The dollar size of the economy plummeted due to a sharp increase in federal spending. These developments both increase the debt burden by narrowing the tax base from which the debt can be paid and by increasing the national debt. Additionally, interest rates have dropped to near 0%, making existing Treasury bonds more valuable because they pay higher interest rates.
In other words, bondholders are suddenly getting a better-than-expected return on their Treasuries, and taxpayers are paying the bills. All together, these three developments have lifted taxpayers’ debt burdens to 108%.
However, the dollar size of the economy quickly recovered from the pandemic shutdown and started to trend again in mid-2021. This reduces the debt-to-GDP ratio by about 9 percentage points. hundred. This was followed by rising inflation, which further reduced the debt burden by 14 percentage points, bringing it to its present value of 85%. It did this through two channels. First, high inflation has pushed the economy’s dollar size to about $1.89 trillion above pre-pandemic trends.
Second, of course, is rising inflation that caused the Fed to sharply raise interest rates, reducing the market value of Treasuries by about $1.9 trillion. The fate of the bondholders, therefore, changed. They suddenly held bonds that were worth much less than they expected, both in terms of inflation adjusted and compared to newer yielding securities that pay more.
In short, bondholders have paid off most of their reduced debt burden through higher inflation. Obviously, bondholders are also taxpayers, but they are only a small group of taxpayers. Furthermore, the loss to bondholders is more severe and conspicuous for them than the prospect of a lower future tax bill for taxpayers.
This remarkable transfer of wealth away from bondholders is not limited to the $24 trillion treasury market. Other fixed-income markets such as the $12 trillion mortgage-backed stock market and the $10 trillion corporate bond market also saw large losses in market value. This is a major reason why banks, who hold such securities, are under stress right now. ONE recent research found that such assets in the US banking system are overvalued by $2.2 trillion due to market losses. This loss means that many banks cannot cover all depositors’ claims if they run away in bulk.
The precarious position of banks is a major problem for financial stability, because noted by US regulators. It’s also why the US government’s insurance for all depositors at Signature Bank and Silicon Valley Bank recently failed and why the Fed decided to accept collateral for the loan. borrow at par instead of market value in its new liquidity base. Regulators are concerned about a market-to-market ticking time bomb on US banks’ balance sheets. These are bondholders who have inadvertently transferred a large amount of assets to their debtors and may not be able to afford them.
There are many reasons we got to this point, but perhaps the most important one is the Fed’s rapid rate hike over the past year. Most bondholders, including the Fed, were surprised by the speed and scale of rate hikes based on expectations created by low interest rates over the past decade and the Fed’s own projections. just a year ago. The Fed expects these rate hikes to stop soaring inflation, but in the meantime, they have damaged banks’ balance sheets and undermined their ability to generate credit in the future. Hopefully this will put an end to high inflation in an orderly fashion rather than a financial crisis.
We are living in a wonderful time. There’s no easy road ahead, but here’s hoping the Fed can successfully navigate through these difficult waters.
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