Markets fear that the US will monetise its record debt. The way out

The most significant statistic published this week concerns the US public debt, which stands at over 40 trillion dollars – the highest level in history. In itself, this figure is not particularly meaningful unless it is assessed in relation to the country’s ability to sustain the cost over time, which depends in particular on the dynamics of the debt relative to the country’s gross domestic product and on the interest payments. As a proportion of GDP, US debt has already reached 125 per cent. The year-end figure is set to be revised upwards by at least a couple of percentage points. The interest burden on the debt accounts for almost 20 per cent of US tax revenue, more than double the figure for the previous decade. To draw an international comparison, in Japan – which has the highest public debt among advanced economies – the debt burden accounts for around 15 per cent of tax revenue. In Italy, it is less than 9 per cent.

The solution to the US problem appears fairly straightforward: increase tax revenue, not least because it is relatively low compared with the average for advanced economies (around 30 per cent of GDP, compared with the G7 average of 36 per cent). However, in the current political climate, there seems to be no measure more difficult to implement – in the United States, but not only there. This became apparent following the Supreme Court ruling which ordered the US administration to refund the revenue obtained from the illegal tariffs imposed last year. The refund will be made by taking on new debt – that is, a higher deficit and public debt – rather than through new taxes.

In the run-up to the mid-term elections in early November, the Administration has been careful not to announce any new taxes, save for the reintroduction of import duties in a different guise, under the illusion that American citizens still believe such measures have no direct impact on their purchasing power. But even after November, it seems unlikely that the Administration will seek to reduce the public deficit, given that there will be another election in 2028 (in that case, the presidential election).

Financial market participants have realised that the US public debt problem is, first and foremost, a political one. The rise in long-term interest rates, linked to the sell-off of fixed-income securities, reflects concerns that a solution will continue to be postponed and that the issue will not be addressed until serious market tensions arise.

This view has been reinforced by the unconvincing statements made by Treasury Secretary Scott Bessent, who claimed that the debt problem will be resolved through growth. In reality, US debt has doubled over the last 20 years, despite growth averaging over 3 per cent.

Extraordinary interventions in the US government bond market have further contributed to the uncertainty. The Treasury purchased long-term bonds on the market in exchange for the issuance of new short-term bonds. This unusual operation – which, had it been carried out by an emerging-market country, would have been equated with a full-scale debt restructuring – did not produce the desired results. Long-term rates did not fall as hoped.

This failure comes hot on the heels of the joint intervention with the Japanese Treasury, which was aimed at strengthening the yen but had only a temporary effect.

These financial manoeuvres have reinforced the impression that the Government lacks a genuine strategy to tackle the problem and restore confidence. Except, perhaps, for the usual attacks on the US Federal Reserve, which is accused of failing to cut interest rates.

This is fuelling the belief amongst financial market participants that the only solution to the increasingly unsustainable dynamics of US debt is the monetisation of debt through inflation. Inflation remains high, even in the United States, driven not only by commodity prices but also by domestic demand underpinned by the public deficit. The more this interpretation is fuelled, the more US government bond yields will tend to rise. This will have knock-on effects on the bonds of other advanced economies, given the central role of the dollar in the international system.

History shows that there is only one way out of this vicious spiral of expectations: a drastic rise in interest rates by the Central Bank. The new Chair of the Federal Reserve – Kevin Warsh – was not chosen to administer this bitter pill to the US economy. But like all central bankers, he will certainly not want to go down in history as the one who monetised public debt and fuelled inflation.

In the end, he’ll do what needs to be done, whether Donald Trump likes it or not.