Rich countries are falling into a huge debt trap that cannot be reversed.

Last month, the Congressional Budget Office (CBO) reported that the federal budget deficit for the fiscal year ending September 30 had hit $1.7 trillion. That’s close to 7% of GDP. Shortly afterwards, the International Monetary Fund forecast that the deficit will continue at the same level for at least the next five years. Meanwhile, government debt has tripled since the senator’s day to around 120% of GDP.

Investors don’t appear to share Senator Dirksen’s sense of irony in the face of these gargantuan numbers. After climbing steeply throughout 2022 and then stabilising in the first half of 2023, the market for U.S. Treasury bonds has sold off sharply again in the last three months, aggressively pushing up yields on long-dated bonds. Recent trading sessions have teetered on the disorderly, with the 30-year U.S Treasury yield rising above 5% amid intraday swings of 20 basis points or more.

YIELDS ON 30-YEAR US TREASURIES AT 15-YEAR HIGHS

Demanding higher yields may be a rational response to swelling deficits and debt. Yet jittery investors also make the situation worse. Uncle Sam’s interest expenses leapt by a third to $711 billion in fiscal 2023 – more than the total bill for Medicaid and just shy of a year’s worth of defence spending. Unlike many corporations and households, the U.S. government did not lock in the low interest rates of the last decade by issuing long-dated debt, preferring instead to skew funding towards bills and short-term bonds. That strategy has left it heavily exposed to the pain of higher rates. Last week, the legendary investor Stanley Druckenmiller dubbed it “the biggest blunder in the history of the Treasury”.

That may not be an exaggeration. The fear stalking financial markets is that the government of the world’s largest economy – and the issuer of its only true reserve currency – is at risk of falling into a debt trap, as a vicious circle of higher borrowing costs and larger deficits sends the stock of debt on an uncontrolled upward spiral.

That concern is beginning to catalyse a shift in the all-important market for U.S. government bonds. Normally, investors in official American fixed income securities are primarily engaged in the humdrum business of pricing the Federal Reserve’s next policy moves. Now, they are trying to aim off for the existential question of whether the public debt is sustainable.

How should investors grapple with this unfamiliar exercise? The key lies in assessing the limited range of options available to the U.S. government to bring its gigantic debts under control. Given the similar predicaments of other developed economies, the question is also directly relevant to other members of the G7 group of industrial powers.

G7 NATIONS HAVE HIGH AVERAGE DEBT-TO-GDP RATIOS

The conventional framework for analysing debt sustainability is a simple model which combines the three essential factors which determine the path of public debt as a proportion of GDP: an economy’s growth rate; the government’s so-called “primary” fiscal balance, which excludes the cost of servicing debt; and the interest rate the government pays on its outstanding debt.

The first route back to sustainability is thus to achieve higher growth. If real GDP accelerates, the denominator in the debt ratio does the work. Unfortunately, boosting the overall productivity of the economy is hard to engineer. President Joe Biden’s formula of boosting spending behind a wall of trade protection may flatter the debt ratio in the short term. But the history of economic populism shows it tends to leave a nasty hangover. If the U.S. is running a fiscal deficit of 7% of GDP when the economy is growing at a nearly 5% annual rate, as it did in the last quarter, investors are right to wonder what the budget shortfall would swell to in a recession.

The second route out of the debt trap is to target the primary fiscal surplus, choosing a combination of spending cuts and tax hikes that will stabilise the public debt. These parameters are in the government’s control, at least in theory. Yet G7 countries face familiar challenges to this approach. Much of the spending driving deficits is related to the social entitlements of ageing populations which are hard to cut. Meanwhile, taxes in countries like Britain are already historically high.

That leaves the third route to debt sustainability – keeping real interest rates low. In practice, that involves financial repression: the practice of compelling financial institutions, and ultimately the central bank itself, to supply the government’s funding needs at below the market-clearing interest rate. Inflation is allowed to run hot, but financing costs are kept down. Pursued for too long, it is a strategy which can severely corrode the depth and efficiency of financial intermediation. But in the short run, it allows a government to tame the debt ratio without fiscal austerity, and even if growth is sluggish. Given the starting point for many countries, it may well be the least-worst option.

Yet this route out of the impasse is also blocked, this time by policymakers themselves. Far from rallying to governments’ sides to smooth the path to debt sustainability, central banks are doing the opposite by sticking religiously to inflation-targeting mandates and squeezing financing conditions for consumers, companies, and governments alike. Only this week the Bank of Japan – the last G7 central bank deliberating keeping longer-term interest rates in check – effectively backed away from its policy of yield curve control.

The practical difficulty of conjuring up long-term growth; the intractable politics of the primary balance; and the institutionalised absence of coordination between fiscal and monetary policy. It’s a potentially explosive mix. Until the U.S. and its fellow G7 members shift these imposing obstacles, creditors are justified in racing for the exit. Governments are indeed stuck in a classic debt trap.