Washington is worried about debt default, when it should be worried about balance-sheet fatigue
America's debt is a growing problem - but people are debating the wrong issue, says an MIT economist.
Two new working papers circulated by the authoritative National Bureau of Economic Research show the double squeeze the U.S. dollar and the Treasury market are facing both overseas and at home.
The first, from a team of European Central Bank and Banque de France economists, show how official demand for dollar assets is waning as central banks increasingly seek sanctuary in gold after Russian assets were frozen following the launch of the war on Ukraine in 2022. It's a topic that has certainly been discussed, but the paper quantifies that shift, finding nonaligned countries have moved nearly one-third of total reserve portfolios away from foreign-currency claims.
Perhaps the more intriguing new paper comes from Massachusetts Institute of Technology economist Ricardo Caballero, who talks about a safe-debt Laffer Curve. The Laffer Curve represents the theory that, at a certain level, revenue actually starts to fall rather than rise as tax rates increase. Caballero's novel idea is that, at a certain level, federal debt actually hurts aggregate demand rather than helps it.
That is not the debate people are having after gross federal debt crossed $40 trillion - the standard discussion is over sustainability. "The familiar concern is fiscal stability: mounting debt may become unsustainable and end in implicit or explicit default. I ask a different question," he writes. "Suppose the sovereign remains solvent and its debt remains safe. Can a larger stock of safe public debt nevertheless become a drag on aggregate demand?"
Caballero, who once chaired MIT's economics department, argues that rising debt is challenging the ability of the intermediaries to supply the balance-sheet space, market making, and rollover capacity needed to warehouse them. The phrase he uses is absorption premium, the financing term on one dollar of debt.
As the Treasury absorption premium rises, the government will reduce purchases. At high levels of debt, the economy still benefits from households getting and then spending the safe stream of income they receive from bonds; it's just that the positive effect is outweighed by this absorption cost.
On his numbers, the marginal Treasury absorption cost has more than doubled, rising from about 80 basis points in the first quarter of 2015 to 187 basis points in the first quarter of 2026. He estimates the wealth benefit to be 330 basis points. So, for now, U.S. debt issuance is helping the economy but less than it did a decade ago. The tipping point, he says, is getting closer.
Using the Congressional Budget Office's projected 2026 borrowing pace, he finds one year of debt issuance erodes an additional 18 basis points of the remaining margin. And, he warns, it won't just be 18 basis points each year - because absorption costs are convex, this depletion will accelerate if debt continues to outpace financial capacity.
The markets
U.S. stock-index futures were mostly lower as oil prices jumped. Treasurys were calm after the big gyrations following Fed Chair Kevin Warsh's speech at Jackson Hole.
Key asset performance Last 5d 1m YTD 1y S&P 500 7711.76 0.49% 2.96% 12.65% 19.37% Nasdaq Composite 26,402.42 0.85% 4.05% 13.60% 23.06% 10-year Treasury 4.718 1.70 3.90 54.60 48.50 Gold 4489 -4.69% 9.20% 3.62% 27.66% Oil 86.14 1.37% 7.59% 50.04% 34.57% Data: MarketWatch. Treasury yields change expressed in basis points
The buzz
The U.S. struck Iranian rocket launchers, and Iran said it fired missiles at a U.S. airbase in Jordan.
President Donald Trump late Friday said the U.S. had struck a deal to control Venezuelan oil supplies. The U.S. plans to take a 35% passive stake in a Venezuelan oil company and will secure preferential rights to purchase 20% of its production at cost, the Wall Street Journal reported, citing people involved in negotiating the agreement.
PG&E's stock $(PCG)$ fell 10% after California legislators rejected a bill that would limit utilities' wildfire liability.
Key economic data due this week include the Institute for Supply Management's manufacturing index on Tuesday, and the nonfarm-payrolls report on Friday. Earnings are coming from companies including Broadcom and Dell.
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-Steve Goldstein