In this game of musical chairs, no one will want to be caught last with $325 trillion in rapidly eroding debt

The author is a lawyer by education who deals with and is involved in technology. He manages a cryptocurrency investment fund and resides in the US. He is the author of the book "A Brief History of Money" and records the podcast KanAmerica.com. On Twitter @ChananSteinhart

During the month of July, the yields to maturity (interest rates) on long-term US government bonds (30 and 10 years) jumped by more than 7.3%. Nevertheless, in its decision about a week ago, the Federal Reserve decided to leave its base interest rate unchanged. The decision should not come as a surprise. Between inflation threatening to rear its head and the economy and state budget groaning under the burden of interest, the Fed chose the middle path. But the interest rate dilemma is not expected to disappear, and in any case, the bond market is only limitedly affected by its interest rate decisions. According to Ray Dalio, the American investor and founder of the Bridgewater hedge fund, the events regarding interest rates these days are nothing but a built-in part of what he calls the "debt death spiral."

Ray Dalio: Without reforms, a crisis is inevitable

Few have studied the rise and fall of powers as Dalio has, who founded one of the largest hedge funds in the world. Dalio has dedicated years to studying cycles of debt, money, geopolitics, and empires. According to him, the US is currently in the late stage of the debt cycle and has entered a phase he calls the "debt death spiral." Its following characteristics include a continuous erosion in the value of the dollar, stubborn inflation, and ever-increasing interest costs.

Dalio argues that such processes do not happen in a day, but over years. He predicts that by the beginning of the thirties of this century, the government will struggle to sell the huge sums it needs to finance the debt and roll over what has come due. Following his assessment, the US will enter a period of stagflation, including a continuous devaluation of the dollar's purchasing power, deepening social and political tensions, and a gradual loss of its status as the dominant power in the world. Dalio believes that the US has already passed the point of no return in the process, and therefore the question is not whether a change will occur, but what the solution to the debt problem will look like. Will it be achieved through intentional or uncontrolled inflation, or through a political-economic "package deal." In his opinion, without significant reforms, a period of deep financial, social, and geopolitical crisis is inevitable.

Dalio is not alone. According to Jeffrey Gundlach, one of the most well-known and influential bond investors in the world, on the current path, the pool of debt buyers will gradually shrink, while the government's financing needs will continue to grow. As trust erodes, more and more investors will turn their money to alternative assets like gold, commodities, foreign assets, and short-term bonds. At some point, the Federal Reserve may find itself facing an almost impossible choice: to allow yields to continue to climb while risking recession, sharp declines in markets, and financial instability, or to intervene as the buyer of last resort and purchase government bonds in large volumes.

Such intervention may stabilize the bond market in the short term, but financing government debt through the central bank will eventually lead to the weakening of the dollar and increased inflationary pressures. According to Gundlach's scenario, a crisis in the bond market is not expected to look like a sudden one-day crash. It will be a slow process in which demand for bonds is gradually eroded and financing costs climb, until the Fed is forced to intervene. The price will be paid by the public and investors — in higher inflation, lower real yields, and erosion in the value of the dollar.

Renowned economist Professor Kenneth Rogoff, a former senior official at the International Monetary Fund, also believes that a crisis is approaching. He agrees that sovereign debt crises almost never end in one dramatic event, but are usually a slow and continuous process in which the debt burden grows until it weighs on the entire economy. Continuous growth in public debt turns into an increase in interest due to investor demand, an increase in the government's interest expenses, and a reduction in money available for investment in infrastructure, education, health, or innovation. Thus, the economy experiences a general slowdown, precisely when the country needs growth to deal with the debt. According to Rogoff, developed countries almost never reach an official default. Instead, they tend toward more sophisticated solutions to reduce the debt burden: inflation that erodes the real value of the debt, or "financial repression."

By "financial repression," he refers to policies that encourage or force banks, pension funds, and financial institutions to hold an increasing portion of their assets in government bonds, even though the interest on them is kept artificially low. Thus, the debt is not officially written off, but its value is eroded and transferred to savers, who receive a negative real return on their savings.

At the same time, the economy enters long years of slow growth and even stagflation. This is, in Rogoff's opinion, the most likely scenario for a developed economy with high debt like the US. Not a sudden collapse, but years of moderate to high inflation, financial repression, weak growth, and a gradual erosion of real wealth.

---

Are there assets that can change the debt picture?

In the discussion about US debt, the debate focuses on the liabilities side of the balance sheet. Some argue that this is a distorted view. Two of these prominent voices are Scott Bessent, the US Treasury Secretary, and Stephen Moore, who served as chairman of President Trump's Council of Economic Advisers, both of whom are economists and capital market professionals. According to them, the federal government has a huge asset column on its balance sheet: land, gold, mining rights, energy resources, infrastructure, intellectual property rights, and other financial assets. According to Bessent, "the US has one of the strongest balance sheets in the world, but it is not managed like a balance sheet."

The US government holds about 28% of the country's land. Various estimates place the value of these lands in the range of $3-5 trillion, and in even more optimistic scenarios, higher. One possibility is the establishment of a dedicated body that will generate revenue from this asset, and thus issue bonds backed by these assets. In addition, the US holds the largest gold reserve in the world, 8,133 tons. This gold is not recorded on the US Treasury's balance sheet at market price, but at a price of $42.2 per ounce. As a result, this gold appears on the balance sheet at a value of only about $11 billion, while its economic value at current market prices is already approaching a trillion dollars. If the price of gold continues to climb, say to $12,000 per ounce, the US gold reserves would be worth about $3.14 trillion. In other words, the US Treasury could, through a mere accounting update, increase its assets by more than $3 trillion compared to the value currently recorded.

Thus, the federal government, at least potentially, has assets and not just debt, and their scope is very significant. In recent years, the idea of using them has moved from the margins of the macro world to the center of the discussion. But can such a move really help the American economy?

The short answer is maybe. When investors buy US government bonds, they are buying trust. They are trying to assess whether the government will be able to meet its obligations over decades, without deteriorating into high inflation or eroding the value of the dollar in other ways. Therefore, if the government were to present a balance sheet in which part of the debt is backed by real assets like land, natural resources, etc., it is possible that some investors would see this as strengthening the balance sheet — and would be willing to settle for a lower yield on government bonds. However, if the whole move amounts to nothing more than an accounting revaluation of land and gold, without a real change in budgetary policy and, consequently, political priorities, it is likely that the impact will be short-term only and the markets will treat it as a cosmetic financial exercise.

At the end of the day, one question will remain: does America have the political capacity to produce a real "national package deal." One that includes real tax increases alongside partial debt and asset write-offs, accompanied by dramatic cuts in Social Security, Medicare, and the defense budget. Such a deal would also require structural reform, at least in the healthcare sector. Or will it deteriorate into inflation, stagflation, financial repression, and actual default.

---

What if the process shortens from a decade to a year or two?

Dalio, Gundlach, Rogoff, and others have put forward pessimistic forecasts, but they contain an element of some optimism. The assessment that the process will be relatively slow and somewhat controlled. In this window of time, the increase in productivity due to artificial intelligence may greatly help in dealing with the deficit and debt. But what if, because of modern media and social networks, the process accelerates?

The US bond market today stands at almost $60 trillion, about half of which has a maturity date of 5 years or more. What will happen when more and more investors realize that holding American bonds guarantees a loss and erosion over time, both due to the decline in the value of the dollar and due to inflation? Will an increasing exodus from this market begin, as central banks and international state institutions have been doing for several years. Will the disappearance of buyers from the bond market push interest rates and inflation higher and higher — not in a decade, but in a year or two?

As we have already seen today, the interest rate (yield to maturity) on bonds is skyrocketing. If the trend accelerates and, say, 10%-20% of the bond market (about $60 trillion) disappears over a period of 12-24 months, without the Fed intervening, the interest rate could double or even triple itself. Since the yields on 10-year government bonds form the basis for interest rates in the entire economy, the meaning of such a jump is an "interest rate shock" that will paralyze the economy and crash the stock market.

At the same time, such an increase would double or more the federal government's interest payments, increase the deficit by at least 50%, and force Washington to issue more and more debt, just to finance its existing obligations. Under such circumstances, it seems that the Fed would intervene and purchase the demand gap in government debt, itself or through commercial banks. But such printing would only spike inflation within 18-24 months, approaching the territory of the inflation that existed in the seventies of the last century (above 20%), and so on, until complete loss of control.

Capital owners will try to find shelter in real assets

The US is responsible for about a quarter of the global economy and almost a third of global debt, which amounts to $325 trillion. A crisis in the US bond market will spread rapidly to other economies. In such a scenario, many capital owners, private and public, will try to find shelter in places less vulnerable to continuous erosion in the value of money, i.e., in real assets, such as gold, metals, agricultural land, and commodities.

According to a Fed report from February of this year, the cash market today in the US stands at about $17.5 trillion, of which about $7 trillion is in checking accounts. The total amount of bonds with maturity dates of 5 years or more is about $31 trillion. It is easy to imagine what will happen in the real asset market if only a third of the cash market and a quarter of the bond market over 5 years try to find shelter in such assets.

For this reason, Dalio has for some time recommended holding 5%-15% of the investment portfolio in gold. In his view, there is no one "magic asset" that protects against every scenario; his central principle is diversification between assets that react differently to different economic situations. Other assets he recommends are commodities like energy, industrial metals, agricultural produce, and even Bitcoin. Specific stocks can also protect during an inflationary period in his opinion, especially those with a strong balance sheet and basic products. Another asset is short-term government debt (up to 6 months), in which Warren Buffett's investment company holds almost a third of its assets (about $400 billion), an all-time high.

The world today is very different from what it was 100 years ago. And yet, hundred-year-old warning lights from Germany are flashing. Debt with no way out, built on its ever-increasing rollover, will eventually lead to a dramatic erosion in the value of lenders' assets. We do not know how things will unfold, but there is a reasonable assumption: when the financial musical chairs game begins, no one will want to be caught last, holding $325 trillion in debt whose value is rapidly eroding.