Navigating the U.S. Debt Crisis: Is the USA Headed Towards a Financial Storm?

(This is not an AI-generated article.)

U.S. debt has ballooned to unbelievable levels. The U.S. national debt has increased by $473 billion over the last three weeks, now a national debt of $35.8 trillion, a debt of more than $100,000 to every citizen in the population. It is not only a static figure, but a moving target predicted to worsen, where a budget deficit is expected to peak at $2.8 trillion in 2024 to $2.8 trillion by 2034. This will consequently raise the debt-to-GDP ratio to an unsustainable 122%. The intentions of the government are the biggest concern because, despite the condition being so dicey, the United States has approved an additional $20 billion in loans to Ukraine as of October 24, 2024.

This reflects efforts by these entities to boost economic growth amid fears of rising inflation and debt. But these are compounded by larger problems: U.S. banks now stand at an unrealized loss of $515 billion, 7X greater than that of the 2008 crisis. The outflows from the Chinese stock market have reached a nine-year high in one week alone at $4.1 billion, even as the government has been attempting to boost the market with stimuli. Moreover, due to ‘Bull Steepner,’ the USA bond market has finally come back to normal, but historically there was not even one incidence when the USA got out of the inverted bonds market and didn’t face recession.

So, what is driving this crisis and taking us where? Let us deconstruct some current dynamics and speak to the mechanisms at play here.

1. Minsky’s Financial Instability Hypothesis hints towards a time bomb. According to the theory, long-term stability in the economy creates short-term instability. When the economy gets good, businesses and people alike borrow more, thinking there is no end to the boom. Over time, this accumulation of debt makes the economy fragile and prone to collapse when an economic shock comes. Near-zero interest rates from 2008 to 2021 encouraged both consumers and corporations to take on record debt. Interest rates jumped very rapidly to try to curb inflation. And recent sudden sharp cuts are making the financial system more vulnerable to hyperinflation and market crashes consequently. We see all the dangers Minsky warned of being realized.

2. The debt spiral: a crisis of permanence At the heart of this vicious cycle feeding the debt crisis in the US lies the government's insistence on spending more than it takes in revenues, thus there never really being a close budget deficit. When its debt matures, it needs to be refinanced at a higher interest rate. For instance, the United States presently pays some $601 billion in interest per year and continues to increase its spending. Each 1% increase in the rate boosts the annual debt load by $320 billion. This is the crux of a debt spiral—the more one borrows in order to service existing obligations, the further down one sinks, and it gets exponentially harder to dig out. But when inflation rears its head, things start getting complicated.

3. Inflating away debt: A Double-Edged Sword Traditionally, the U.S. has relied upon inflation as its way out of managing its debt load. This strategy is termed inflating away debt, that is, allowing inflation to increase so that the real value of the country's outstanding debt decreases. The idea is straightforward: if it borrows money at a low fixed rate, inflation gradually eats away the value of those borrowed dollars, making old debt less expensive to repay with money that has less value. This has been done through an action called quantitative easing (QE). The US Central Bank prints fresh money and buys government bonds in order to inject liquidity into the economy, and at the low interest rates, it retains it.

Practically, this strategy is costly. Although inflating debt may alleviate the real burden, it carries a steep price.

·???????? Uncontrolled Inflation: The result could be a hyperinflation runaway price rise that can destroy consumer and business purchasing power. It may lead to hyperinflation, and unstable inflation—almost spiralling out of control.

·???????? It also impacts the bond market: Inflation affects bond yields because higher inflation eats away at the dollar returns that the investor wishes to get over the loss of buying power of money. Rising bond yields push bond prices down and are therefore bad for bond investors holding government or corporate paper. Loss in value of bonds hurts investors but increases the cost to the government to fund new debt.

·???????? Increases in Interest Rates: At some point, central banks have no choice but to raise interest rates to smooth inflationary forces. First and foremost, this tends to stabilize the prices but increases the cost of borrowing and tends to make it difficult for the government to service and refinance its debt. This accelerates the debt spiral further.

·???????? Savers and Fixed-Income Earners Face the Heat: Since inflation is the erosion of the purchasing power of money, savings are gradually reduced in real terms while those living off fixed incomes, such as retirees, have an increasing struggle to achieve their living standards. Inflation literally eats away at the purchasing power of anyone dependent on savings or fixed payments.

4. The Melt-up: When a Market Boom Becomes a Bust Another reason that adds complexity to this current scenario is the possibility of a meltdownhyperinflation—a pure speculative jump in asset prices away from economic fundamentals. Currently, it is the case that the stock market is becoming buoyed by some core dominant technological companies, sometimes referred to as the "Magnificent 7" (Apple, Amazon, Nvidia, etc.), and such speculative growth may one day balloon into a bubble.

Here is the risk that, even though markets seem robust enough, they are still a long way from the real economic forces beneath their surface. Then, when it finally bursts, it might lead asset prices to drop significantly and fast in ways that might also precipitate a reverse market crash. At this point, investors who mistakenly think it was a sound investment might scramble to sell, and the more of them who do could rapidly drive down prices and weaken the economy even further.

5. The U.S. Debt Crisis: A Reflection of 2007? There are scary comparisons between the climate of the current financial world and those that existed before the fiscal crisis of 2007-2008:

? Growing Debt: Both crises were fed by excessive borrowing. Today, the elevated levels of personal, corporate, and government debt indicate unsustainable lending patterns that led to the Great Recession.

? Market Euphoria: The share market, despite the warning signals, continues to be buoyant on account of the big tech giants. This euphoria is quite similar to that prevailing before the crisis, where market participants ignored red flags in favour of short-term gains.

? Tightening Credit Conditions: A lesson from 2007, is the fact that the easy credit is now coming to an end and the financial institutions have become ultra-cautious. This gives birth to all the conditions necessary for an economic disruption.

[Small fun fact: The recent Fed cut and the Fed cut before the 2007 market crash have some interesting facts.

• The date of commencement of the Fed cut cycle is the same.
• The BPS by which the cut has happened is the same. Interest in which cuts have happened is the same.
• The Fed cuts cycle was started 3 months before the crisis was triggered. (Are we also headed towards another crisis?) What Lies Ahead?]

6. BIRCS nation launched gold-backed currency

As if this was not enough, another thing that will pose the biggest threat to the USA's dominance is the launch of BRICS currency. For the last so many years, the USA was able to get away from default on debt by just simply printing the money without facing the challenge of hyperinflation as USD is a globally accepted currency. The collapse of the USD means the collapse of nations holding US bonds and the collapse of countries trading in USD. It is said that stimuli announced in 2022 resulted in prices of cryptocurrencies going skyrocketing and a later crash in cryptocurrency helped curb the excess liquidity of USD.

(Detailed explanation coming soon on LinkedIn post; stay tuned.)

What Lies Ahead?

The U.S. economy is at a crossroads. Inflation and rising interest rates are squeezing consumers by pushing the cost of debt up. On the other hand, speculative bubbles in the stock market coupled with excessive levels of debt continue to pose huge risks. If inflation continues to take off, so will bond yields; bond prices then fall, and nobody—the government nor the investors—will find it particularly easy to get out of this. Worst-case, a debt spiral, the melt-up, and the reverse market crash might lead to a serious financial crash—one very reminiscent of the 2007 crisis. As the Bank of America warns, gold is the last safe haven as U.S. debt soars. The question is: Are policymakers navigating turbulent waters, or are we heading toward another financial storm?

Please let me know your thoughts in the comments section below.