Related Links

• The Effects of Higher Borrowing Costs: Insights from Sovereign Default Models
• What Does the CDS Market Imply for a U.S. Default?
• Government Debt and Deficits: Does the U.S. Spend Beyond Its Means?

Transcript

Tim Sablik: Hello, I'm Tim Sablik, a senior economics writer at the Richmond Fed. My guest today is Grey Gordon, a senior economist in the Richmond Fed's Research department.

Grey, welcome back to the show.

Grey Gordon: It's great to be back. Thanks for having me.

Sablik: Today, we're going to be talking about an Economic Brief that you just published, hot off the digital press. Listeners can find a link to that paper on the show page. In it, you examine the effects that rising borrowing costs can have on a nation's economy. It's a very timely topic, given that U.S. lawmakers recently concluded a debate over the debt ceiling that came down to the wire.

As you know, in your article, the possibility that a nation might default on its debts can raise its borrowing costs, as creditors demand higher interest rates to compensate them for the increased risk. U.S. debt has historically been viewed as very safe, which has allowed the U.S. to borrow at low interest rates. Did borrowing costs change during the recent debate over the debt ceiling?

Gordon: Yeah, they definitely did. The best way to tell is to look at Treasury yields around the "X-date." This X-date concept was super important — the day when the government would no longer be able to pay all its bills. That's when there would be some payment uncertainty. No one knew precisely when that was, but they had it narrowed down to a pretty tight window.

If you looked at Treasury bills that were due before the X-date, those were expected to be paid for sure. But there was more uncertainty about bills after the X-date. Those bills that would pay out before the X-date were trading at a premium relative to those that paid out after the X-date, and that difference was about 1 percent a year in yields. That's quite a substantial amount.

Sablik: Gotcha.

Getting into the work that you did in your Economic Brief — in economic models of sovereign default, a country facing higher borrowing costs will typically respond by either cutting spending or raising taxes or some combination of the two, since higher borrowing costs make more borrowing an unattractive option. What happens to the economy in this scenario?

Gordon: When government spending is cut, that tends to result in less employment. Part of that is the government will be directly employing fewer people. There's also an indirect effect where the government will not be contracting as much, not requesting as many supplies from private business. That will reduce business for them and reduce employment.

In addition to the government spending cuts, higher taxes reduce the returns to labor and firm creation. That also tends to reduce both employment and investment.

However, it is possible that the higher taxes might appear as smaller transfers. For instance, with the start back up of student loan payments, that will be around $300 per month per household of payments that are owed by them that weren't owed for the past two years. That might incentivize people to work more, and those sorts of wealth effects on labor supply could actually cause employment to increase.

One additional effect is that because many of the creditors of the U.S. government live abroad, the taxes that are used to pay for that government debt are being sent abroad, many of them. That tends to increase the current account.

Sablik: Another point that you make in your article is that, although cutting spending and raising taxes may be a cheaper option than borrowing when borrowing costs go up, it's likely to be politically unpopular. So, lawmakers might choose not to reduce borrowing, even when facing rising costs. What would happen to the economy in that scenario?

Gordon: In many sovereign default models, what you find the sovereign optimally doing is sharply reducing debt when default risk increases. The benefit of sharply reducing debt is that it takes the default risk component of interest rates and sends that [risk] much smaller. That gives a short-term pain in which you have to raise taxes and cut spending to pay down debt. But it gives a longer term gain in that the interest rates that the government is paying are much smaller after that.

Now, what you asked was what if the government does not do that. What if the government chooses not to significantly decrease its debt burden? The easiest case to think about is when the debt-to-GDP ratio just stays constant. The U.S. debt-to-GDP ratio right now is about 120 percent. If interest rates were to rise by one percentage point and stay like that for an extended period of time, then to cover that extra debt service burden the tax rate would have to go up by 1.2 percentage points or so … indefinitely. That higher tax rate creates a small but steady drag on the economy, which eventually sucks significant amounts of strength from the economy. That's long-term pain for short term gain, which most sovereign debt models will say is suboptimal.

Sablik: In other research, you've documented that while borrowing costs are limited in how low they can fall when times are good, there's essentially no limit to how high they can spike in a crisis. How should that inform a nation's choices around its debt?

Gordon: It's really important to stay ahead of the curve.

Whether the U.S. has a debt-to-GDP ratio of zero or 25 percent or 50 percent or 75 percent, it doesn't seem to matter much to the market. The market seems to think that at those levels, our debt is extremely safe. Now, there's still always some tail risk priced in, due to a small possibility of extreme events. But, by and large, the debt is essentially risk free.

However, there is some threshold of debt where the government risk premia really start to increase. And once those risk premia start to increase, they don't stop. Then the economy becomes vulnerable to all sorts of adverse shocks.

For instance, if default risk premia are significant and we enter a recession, not only do we have to deal with the recession, but we also need to deal with even larger default risk premia. Because the recession has increased default risk, we're going to be paying both for the recession and also for the higher interest rates on government debt. This negative correlation between debt service costs and GDP is a canonical feature of emerging market economies — it generates large swings in consumption and prices that significantly reduce welfare.

In contrast, if we enter the recession far away from the riskier region, far away from where default risk premia are large, then they'll stay close to zero and we'll only have to deal with the recession. There's a great benefit to being in — and staying in — the truly safe region.

Sablik: That naturally raises a big question. Are there any signs that the U.S. has reached that threshold where the risk premia on debt is starting to increase in a sustained way? If not yet, did the changes to borrowing costs that we observed during the debt ceiling debate provide any hint of where the U.S. might be in relation to that threshold?

Gordon: It seems like it should be an easy question to answer. But actually, it's a little bit harder than you might think.

Normally, when we try to measure risk premia, we'll take a country that we think is safe, say Germany, and compare government borrowing interest rates in a risky country, say Greece. That gap is what we'll attribute to a default risk component of spreads. With the U.S., it's trickier to do this because we are usually the safe country. We're usually in the comparison group.

Another reason it's difficult to look at the yields and say a certain amount is due to default risk or is risk premium is because it's often argued that U.S. debt has a convenience yield, or special pricing due to its reserve currency status. What is meant by that is that people outside the U.S. want dollars. They're willing to buy U.S. government debt at a discount relative to what people would normally be willing to pay. That distorts yields and makes it harder to infer to what extent the yields reflect default risk.

Now, a relatively direct measure of default risk comes not from government interest rates, but from credit default swaps. With credit default swaps, you can take their prices and back out implied default probabilities that will rationalize those prices.

There's a recent Chicago Fed working paper that looks at those implied default probabilities for the U.S. When I look at their time series, I don't see much of a statistical trend where you could say default risk is going up uniformly over time. For instance, in early 2011, the implied default probability was around 1.3 percent. In 2013 Q3, it was around half a percent. And in 2022 Q4, it was around 0.3 percent. In terms of the overall time series, it's looks like CDS premia have mostly been falling since 2009, so the implied default probabilities have generally been falling.

But [the large size of] these implied default probabilities … reveals a degree of weakness that's fairly disturbing. So, to the extent that those implied default probabilities accurately reflect default risk, it seems we are susceptible to quite a bit of risk.

Now, the U.S. is special in that because we have dollar-denominated debt and can generate unlimited nominal seigniorage revenue, it's unnecessary for us to ever default outright on existing nominal debt. We might experience a technical default at some point where we literally hit the X-date and have to delay some payments. But even if we managed to avoid that outcome, we should still be very cautious. Low borrowing costs are not a given, and we've seen borrowing costs can move substantially in response to perceive default risk. There are large advantages to having risk-free debt, so should do what we can to stay that way.

Sablik: Grey, thanks so much for joining me today to talk about your research and about U.S. debt in general.

Gordon: It's always fun to talk about economics. Thanks for having me on.

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