Populism is threatening to supercharge America's fiscal crisis

Recent turbulence in bond markets suggests that investors aren’t immune from anxieties about debt and inflation. The question is, are they anxious enough? On one particular point, I’d say the answer is no. They’re paying too little attention to the possibility of outright public-debt default.

Recently, I argued that given the current dysfunction in Washington, it was hard to imagine Congress ever exerting fiscal control — that default through inflation has actually come to seem more plausible. But what about overt default? Investors still see U.S. government debt as entirely free of that risk. Loss of value through inflation is one thing, and not exactly unheard of. But a refusal to pay 100 cents on the dollar? That isn’t priced in. It’s unthinkable.

As unthinkable as a new era of Smoot-Hawley tariffs and deliberate global economic fragmentation. As unthinkable as a $1.776 billion taxpayer-funded settlement of a lawsuit that the U.S. president brought against his own administration. As unthinkable as the collapse of the UK’s two main political parties, and the prospect of Prime Minister Nigel Farage. As unthinkable as surging populism across the European Union, endless war between Ukraine and Russia, Iran collecting tolls at gunpoint in the Strait of Hormuz, the dismantling of NATO...

It might be time to retire the term "unthinkable."

Populism of left and right hasn’t given much thought to the sanctity of government debt. Post-neoliberal politics has no use for fiscal discipline — hence the unchecked surge in global public debt, with the U.S. in the vanguard. But at some point, the issue can’t be avoided. The supply of debt will eventually outweigh investors’ appetite for it, so prices will fall and yields will rise. Higher interest rates will hit working families through the cost of credit and mortgages. And populist politicians will say it’s unfair.

The UK bond market wobbled on news that Andy Burnham would challenge Prime Minister Keir Starmer for leadership of the Labour Party. Last year, Burnham told an interviewer that the government shouldn’t be "in hock" to bondholders. The quote recently resurfaced and rattled investors; Burnham said his remark had been taken out of context. But the sentiment he’d expressed was telling. Who put bondholders in charge of economic policy?

Disdaining investors who expect a return on their investments tends to be self-defeating, of course — as Burnham found out in a small way and former Tory Prime Minister Liz Truss experienced more brutally in 2022. But learning that lesson doesn’t solve the problem. If debt keeps growing unsustainably, governments must sooner or later raise taxes, cut public spending and/or undertake some form of debt "restructuring." The question is whether today’s populist politics can avoid that third option by doing enough of the first two.

It seems unlikely. The populist right wants to cut taxes and, eager though it is to crack down on welfare "cheating," it’s unwilling to squeeze the biggest and most expensive benefits. The populist left wants to vastly increase such benefits and pay for this and everything else by raising taxes only on the rich. Neither approach has the remotest chance of success. Which leaves "restructuring" through inflation or by other means — and brings attention back to the question of what’s fair.

In the populist mind, bond investors are as far removed from working families as you can get. Some are wealthy — capitalist oppressors, you could say. Many are retired and spending down their savings — parasitic boomers, in other words, who rigged the system for their benefit and are now bleeding younger generations dry. A lot of them are foreigners, with no right to be heard on matters of domestic policy. It’s only fair, surely, that these exploiters, cheats and outsiders are made to bear their share of the burden.

As I said, one time-honored way to restructure debt is to squeeze it in real terms by means of inflation. In the U.S., the challenge to central-bank independence has underlined this possibility. For the moment, though, the Federal Reserve seems determined to abide by its dual mandate of price stability and maximum employment. The new chair, Kevin Warsh, has the unenviable task of staying on friendly terms with the White House, which continues to call for lower interest rates, while guarding his reputation as a diligent central banker. Now that he has landed the job, the latter might count for more.

In addition, taken too far, the inflation remedy has big political drawbacks. People don’t like it. Populist politicians dismiss affordability at their peril.

The options for other forms of debt restructuring range widely. One expansive category goes by the name "financial repression." It includes measures such as capping interest rates, directing credit and introducing capital controls — all with a view to moving flows of finance toward the government at less than market interest rates. Arguably, quantitative easing (when the central bank puts government debt on its balance sheet) also qualifies when it’s used not as monetary policy (to stimulate demand when interest rates can’t be cut any further) but as fiscal policy (to lower the government’s cost of borrowing). All such measures are taxes on savers. They buy short-term relief at the expense of longer-term growth.

Finally, when and if a debt crisis hits, there’s outright default. In this worst-case scenario, economists advocating "haircuts" for bondholders are never hard to find — because the only alternative might be crippling fiscal austerity. Indeed, we might reach a point where no amount of fiscal tightening can contain the problem: The economy would contract so abruptly that higher taxes and lower public spending can’t match the decline in debt-servicing capacity.

The danger in ignoring this prospect isn’t that the U.S. will breach some particular level for the ratio of public debt to GDP and trigger dire consequences. It’s that investors will eventually take narratives of fiscal stress and its consequences seriously. When they do, long-term interest rates will rise, making those narratives more plausible, pushing interest rates higher, and so on. The classic financial unravelling: gradually, then suddenly.

Today’s populists are entirely unperturbed. The longer they delay, the harder it will be to check this shift once it starts. Refusing to think about the unthinkable is the surest way to make it happen.

This column reflects the personal views of the author and does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners. Clive Crook is a Bloomberg Opinion columnist and member of the editorial board covering economics. Previously, he was deputy editor of the Economist and chief Washington commentator for The Financial Times.