Buyers have lost trust: Debt and politics in the USA are on a collision course

The author is a lawyer by training who works and is involved in technology. He manages a cryptocurrency investment fund and lives in the USA. He is the author of the book "A Brief History of Money" and records the podcast KanAmerica.com. On Twitter @ChananSteinhart.

The American economy has stood and grown on four legs over the last 50 years: the status of the dollar, the constant growth in general and federal debt, its international and military status and power, and its place in the development of technology. All of these fed each other and created trust. This trust made the dollar the world's reserve currency (even though units of it were printed without stopping), and government bonds a "risk-free" asset, allowing the government to borrow money endlessly at zero interest.

This trust, combined with deterrence, led countries to seek closeness to the USA and pay it in hard economic currency. They prevented its rivals from challenging its core economic interests, including the dominance of tech giants.

This system allowed the USA to do things that no other country can do for long: finance huge deficits, conduct expensive wars, deal with crises through monetary expansion, and solve almost any political-economic problem by massively increasing the debt.

Debt economy: where will the money come from

In the eighties of the last century, the US federal debt was less than a trillion dollars. Today it is approaching 40 trillion. At the same time, the debt of households, companies, and local governments has also continued to climb, from about 14 trillion in 1990 to about 80 trillion today.

Today, the total debt in the American economy is about 118 trillion dollars. The rate of debt growth has spiraled out of control, and according to moderate estimates by the Congressional Budget Office, the government debt is expected to grow by an average of about 2.5 trillion per year over the next decade.

At the same time, the debts of the rest of the economy are expected to grow by 5-6 trillion per year. In total, according to the current growth rate, the American economy will add about 50 trillion dollars of debt in the next five years and about 110 trillion in the next decade. These are unprecedented numbers. And the question is, where will this money come from.

New money is created in two ways. The first is direct printing by the central bank. For example, after the 2008 crisis and the outbreak of COVID, the Fed printed trillions of dollars, and at its peak, the balance sheet reached 9 trillion dollars. With the dollars it printed, the Fed bought government bonds and mortgage-backed securities.

But most of the money produced in the economy does not come from the central bank, but from commercial banks, through a mechanism known as fractional reserve banking. And this is how it works: suppose a person deposits 100 thousand dollars in a bank, and the reserve ratio is 10%. Accordingly, the bank keeps 10 thousand dollars as a reserve and lends 90 thousand to another client. That client uses the money to buy an apartment or a car, for example. The sellers deposit the 90 thousand dollars back, and from their new deposit, the bank keeps 10% (the reserve ratio) and lends again 81,000 dollars. This amount also finds its way back to the bank as a new deposit, and again the bank keeps 10% and lends the balance. The process repeats itself again and again until after 10 rounds, the picture is this: cash originally deposited - 100 thousand dollars. Total deposits in the banking system: one million dollars. Total new loans created: 900 thousand dollars.

That is, on the basis of 100,000 dollars of "real" money, the banking system can create up to a million dollars of deposits, with 900 thousand dollars of them actually being new money created through credit provision. If, for example, the reserve ratio were 5%, then the new money created in the form of debt would be 1.9 million (100,000X20-100,000) and so on.

However, in practice in the USA, reserve requirements for most types of deposits have been completely abolished. Therefore, a bank's ability to grant credit tends toward infinity, limited only by its own decisions, or partially by capital requirements and Federal Reserve rules. Today, most of the money we use was created by banks in the form of credit. In the modern economy, money is debt and debt is money. And it is the main, if not the only, engine of the money world.

But money production alone has no meaning; its movement is what affects the economy and society. It is what creates price increases, rich and poor. In 1985, Israel switched from the old shekel to the new shekel, at a rate of 1,000 old shekels to one new shekel. The change was made at once, throughout the economy, and the deletion of the zeros had no effect. Because deposits, wages, and product prices lost three zeros together. Only the gradualness in money production, and its slow and gradual movement within the economy, leads to price increases, growing gaps in wealth distribution, and other side effects that come with producing more and more currency units.

The system is more sensitive to changes in investor confidence

With the rise in inflation, interest rates returned to levels not seen in almost two decades, and along with them, the interest costs of the US government. Today, almost one in every five dollars that the government collects in taxes goes to interest payments, which is equal to almost 50% of all its discretionary spending, including for security (i.e., excluding expenses fixed by legislation such as Social Security).

The growing deficit, and the interest on the debt growing at a rate higher than the economy's growth, force the government to increase the debt more and more, just to finance the interest payments. As long as investors continue to purchase the debt, this system can continue to function. However, it is becoming increasingly sensitive to any change in investor confidence. Any break in trust translates into demands for higher interest rates. The interest rate for 30-year bonds is already at a 19-year high, and that of 10-year bonds is hovering close to this peak. A rise in interest rates deepens the deficit and requires the issuance of additional debt. This increases inflation, erodes the dollar, and leads to a further rise in interest rates, and so on - a cycle that is very difficult to stop.

The increase in debt burden and the lack of trust in the American political and economic system will eventually quickly bring the government to a crossroads of difficult choices: dramatic cuts, tax increases, and recession, or conversely, inflation that spirals out of control.

The first option includes cutting discretionary spending, including for security, but also in budget items fixed by legislation, i.e., Social Security and Medicare. In addition, a dramatic tax increase. All these are clearly unpopular moves, which over 80% of Americans oppose, and they also require the cooperation of Congress. That is, a politically impossible option. There is a second option: to allow, by choice or loss of control, inflation to rise significantly so that the value of the debt is dramatically eroded.

Germany transferred huge wealth from lenders to borrowers

At the end of World War I, Germany faced a huge government debt, created due to financing the war through bond issuance. The public debt grew from about 5 billion marks in 1914 to about 155 billion marks at the end of 1918 - about 150% of Germany's GDP at that time.

The debt burden was impossible and the government decided to erode it through inflation. But this very quickly spiraled out of control. Thus, in January 1920, the exchange rate of the mark to the dollar was 49. By the end of 1923, 4.2 trillion marks were needed to buy one dollar. This inflation completely wiped out the government debt.

However, the state was not the only one to benefit from inflation. The private sector also received a huge debt wipeout. Studies estimate that at least 40 billion marks of mortgage debt were almost completely eroded, along with tens of billions of marks of business loans, bank credit, and commercial debts. In total, debts of at least 200 billion marks were effectively wiped out. Since any debt of one is simultaneously an asset of another - the creditor, assets of a similar scale were wiped out. The big losers were savers, holders of government bonds, pension funds, insurance companies - anyone who held financial assets denominated in marks. In fact, hyperinflation not only wiped out the government debt but also transferred wealth on a huge scale from lenders and savings holders to borrowers and the state.

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How much of the US debt is held by foreign governments or state institutions

• 13% — Today

• 19% — Share in 2020

• 38% — Share in 2008

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Refinancing US debt has become a problem

Every year, the US Treasury must refinance trillions of dollars of bonds coming to maturity, and simultaneously issue trillions more to finance the deficit. This amount stands at 8-11 trillion dollars a year, and it grows as the debt grows. The 80 trillion dollar debt of other sectors also bears interest and needs refinancing, estimated at another 3-4 trillion per year.

For decades, debt refinancing was not a problem. Everyone had trust in America and its economy, and everyone was happy to lend it their money. China bought debt. Japan bought. Central banks in the world bought. Commercial banks held American bonds on the balance sheet as a risk-free asset. Sovereign wealth funds also financed the debts of the government and the American economy. But all this is changing.

In the last four years, central banks have been buying about 1,000 tons of gold a year, the highest rate of purchases since World War II. According to a report by the European Central Bank from June this year, for the first time in decades, gold has overtaken US government bonds as the largest reserve asset of central banks in the world. According to the report, gold currently accounts for about 27% of total reserves compared to only 22% held in US government bonds. In total, foreign governments or state institutions hold today only 13% of the American debt, compared to 38% they held in 2008 and about 19% in 2020.

The continued deterioration in general trust in the American political system will only worsen the situation. And thus, while America needs more and more buyers for its debts, its internal situation, the political extremism on both sides, the delusional economic ideas of an economic wall on one side and wild socialism on the other - actually drive buyers away.

The political system is turning into a toxic cocktail

Above all these hover the upcoming midterm elections and the 2028 elections, which raise, for the first time in history, a weighty question: will the democratic republic of the USA survive as such?

In Washington, there is a battle over a legislative initiative of the president that seeks to fundamentally change some election laws, with the goal of reducing the voting ability of various audiences. Simultaneously, political combinations have turned the elections for Congress into a joke. Over 90% of the races are considered not competitive at all, and the number of seats in Congress considered truly competitive (i.e., with a 5% gap between candidates) has recently dropped, following a series of moves to reorganize electoral districts, to only 33 congressional seats out of 435.

Simultaneously, President Donald Trump, who to this day refuses to accept the legitimacy of the 2020 results, talks about running for another term - even though this is explicitly prohibited by the Constitution. A move reminiscent of Putin and his bypassing of the term limit clause in the Russian Constitution.

While the Republican Party is actively working to build an economic wall between America and the world, the Democratic Party is undergoing a major shakeup of its own, a young and radical generation of declared socialists is taking over the party. They seek to fundamentally change what has been practiced in the American economic and political system for years, including opening the gates to mass immigration. If these are not enough, the sweeping immunity that the Supreme Court recently granted to any act done by an incumbent president clearly teaches that one should not expect this institution to be a real gatekeeper.

The American political system is thus turning into a toxic cocktail, which, even if it does not lead to riots in the streets tomorrow, is doubtful to arouse trust or appetite among investors to purchase the huge and growing American debt.

And thus, the US president is destroying international alliances, democracy, and the American rule of law, which are the basis of the entire system. And the socialist Democrats seek to fight the tech and finance industries, which are the foundation of the US economy. And in the middle, massive printing continues to erode the value of the dollar and the social fabric.

This hot potato will eventually reach the Federal Reserve's table. Will it choose to maintain a real interest rate, to prevent inflation from spiraling out of control? Or will it choose to forcibly keep interest rates artificially low, to prevent an official government bankruptcy and economic collapse? Perhaps the Fed will strive for middle ways that will force commercial banks and pension funds to buy the government debt? Or perhaps it will try to buy time through financial exercises, such as revaluing the gold in its warehouses? About the options facing the Fed and the question of the ability to defend oneself - in the next article.