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In early 2019, Olivier Blanchard, the former head of the International Monetary Fund, suggested that there was no fiscal cost to the United States from running ever-bigger budget deficits. The federal government could essentially grow its way out of overspending, and investors could be confident in the continued safety of the Treasury bonds used to finance those deficits.

This sanguine view of the United States’ fiscal health was not unusual before the pandemic. “The thinking was that the fiscal capacity of the U.S. government might essentially be unlimited,” says economist Hanno Lustig, a professor of finance at Stanford Graduate School of Business and a senior fellow at the Stanford Institute for Economic Policy Research (SIEPR). “But after the COVID-19 pandemic, we woke up and realized that’s not quite the right way to think about it. In fact, Treasuries do respond to the size of deficits.”

In a recent paper, Lustig and his colleagues of New York University Stern School of Business and of London Business School consider whether Treasuries can still be considered “safe” debt. When Lustig presented their findings at the Federal Reserve’s annual economic policy retreat in Jackson Hole, Wyoming, in August, The Economist reported that their “provocative” conclusions were the talk of the otherwise optimistic meeting.

Lustig and his coauthors demonstrate that Treasuries are exquisitely sensitive to the United States’ politically gridlocked, deficit-loving ways — a finding that challenges some longstanding assumptions. By all the measures the researchers looked at, American fiscal practices are flashing signs of becoming a “risky debt regime.”

“Americans still haven’t quite fully digested the important message that the bond market was sending us during COVID, which is that the U.S. is issuing a lot of Treasury debt, and investors are not as excited as they used to be about absorbing all of it,” Lustig says.

Looking at data from the nonpartisan Congressional Budget Office, the researchers found that Treasury rates spiked whenever the CBO announced the long-term price tag for a series of mammoth pandemic spending plans rolled out between 2020 and 2022. Designed to support the U.S. economy during the darkest days of the pandemic, the stimulus packages eventually totaled nearly $7 trillion, or 20 percent of gross domestic product.

“The government has to commit to increasing taxes or cutting spending in the future to fully offset that 20 percent of GDP increase,” Lustig says. “But most economists don’t think we’re going to run big surpluses.” The value of all Treasury debt is backed by future budget surpluses. If the government runs a deficit now, it needs to run a surplus later in order to keep the debt safe. But those budget surpluses are nowhere in sight. According to the CBO, the deficit for fiscal 2024 will be $1.9 trillion.

Lustig says that American policymakers have been lulled into complacency over the past couple of decades in thinking that Treasury yields don’t respond to spending. If the U.S. doesn’t change course, he cautions, the nation’s debt may lose its reputation as one of the world’s soundest investments. “We’re conditioned to think that Treasuries are safe,” he says. “If bad stuff happens, you go to Treasuries and you’ll be fine. But if you actually take a serious look at history, that is not what history teaches us at all.”

More than a plumbing problem

Many observers initially thought Treasuries plummeted in price after the pandemic began because the “plumbing” of the bond market wasn’t functioning properly. However, Lustig’s research shows that the facts didn’t entirely support this view.

Sophisticated foreign and private bondholders sold off massive quantities of long-dated Treasuries in a “flight from maturity” without rebalancing to shorter maturities as they did with U.S. corporate bonds. Lustig says the smart money clearly believed that long-term Treasury prices would fall dramatically when yields inevitably spiked, given that taxes would probably not rise to support the historic levels of deficit spending. (Bond prices and yields move in opposite directions.)

Lustig says professional investors who sold their Treasuries made the right bet, while the ordinary bond investors who stayed put took a bath. The value of outstanding Treasuries fell 26 percent from 2020 to 2023, one of the biggest drops since World War I. To try to stabilize the Treasuries market during the pandemic, the Fed stepped in with what Lustig calls “staggering” purchases of Treasuries. For several quarters from 2020 to 2022, the Fed bought all the long-term Treasuries the U.S. government issued. But when it stopped buying, yields surged — and prices dropped.

It was a great time for savers from 2022 until 2024, when the Fed started lowering rates. The short-term rates that savings and money-market account holders once ignored hit spectacular new highs. However, the Fed lost about $2 trillion on paper on its Treasury purchases, the opposite of what happened when it bought up debt during the financial crisis of 2007 to 2009. Essentially, Lustig found that taxpayers got a free ride during the Treasury Department’s massive pandemic borrowing, and ordinary bondholders footed the bill.

In the meantime, deficits have been steadily growing since 2001. This historic, near-permanent level of deficit spending, paid for through sales of Treasury debt, is happening at a scale previously seen only during wartime. And politicians from both parties are unwilling to consider the budget cuts or tax increases that could shrink the deficit and pay down the debt.

By 2023 the ratio of federal debt to GDP stood at 97 percent — which means that almost as much Treasury debt remained outstanding as the size of the economy. Based on the spending Congress has already authorized, the CBO projects the debt to reach . That doesn’t count local and state debt, including unfunded pension liabilities for government workers. If those amounts were included, the debt-to-GDP ratio would be closer to 150 percent — around the levels in Italy.

The end of safe debt?

The bill for this unfunded spending spree could come due in dramatic fashion. Lustig cites the example of the United Kingdom: After World War I, the British government essentially defaulted on its debt payments to the U.S., the pound stopped being the world’s reserve currency, and the U.S. assumed “the role of hegemon in the international financial system,” he says. “The U.S. should be more cognizant of the fact that this story didn’t end well for the U.K.,” Lustig says. “The U.K. ended up in serious fiscal trouble.”

Lustig thinks it’s reasonable to argue that the U.S. may have exhausted much of its ability to borrow cheaply. Foreign investors might be thinking — quite rationally — that the federal government is close to using up its fiscal capacity and its debt may not be as safe a bet as it once was.

To give investors incentives to keep absorbing increasingly risky debt, Treasury bond yields may need to stay relatively high for decades. This will incur long-term costs on taxpayers in the form of higher interest payments and costs to bondholders, who will see their assets depressed in value.

This message has yet to reach many of the policymakers who have come to rely on easy money. Lustig thinks that this signal has gotten jammed, in part due to the actions of the Fed and other central banks. “In the short run, you could say that’s maybe not so bad, because central banks helped the government finance all this extra spending during COVID and the financial crisis of 2008. But in the long run, it is unfortunate, because it still leaves a lot of Americans, especially politicians, with the impression that fiscal sustainability is still not a big concern.”

For his part, Blanchard has changed his tune to be more in line with economists like Lustig. In early 2024, he warned of a for the U.S., given its ballooning, largely unfunded, public debt. “At some point,” he said, “it will happen.”

This story was by Stanford Graduate School of Business Insights.