Fiscal Armageddon, Revisited

By Marc Joffe

Monday, August 31, 2026

 

Back in 2011, many fiscal hawks, including yours truly, warned of a financial crisis if the federal government failed to restrain its deficit spending. But the deficits continued, and even exploded during the pandemic, yet the day of reckoning has yet to arrive.

 

Now that relatively high interest rates are worsening fiscal conditions, it is worth revisiting those 15-year-old warnings to see whether they apply again. Can the federal government continue to run large deficits without triggering a financial disaster, or are we already living on borrowed time?

 

When speculating about the likelihood of a policy disaster, it is best to be nuanced. Otherwise, fiscal conservatives risk suffering the fate of the climate change extremists. We have now seen numerous failed warnings of climate disaster with more to come. If she is a presidential candidate in 2028, Alexandria Ocasio-Cortez will undoubtedly be reminded of her 2019 statement: “The world is gonna end in twelve years if we don’t address climate change,” made during her efforts to promote the Green New Deal. These warnings may spur action in the near term, but they destroy credibility down the road.

 

Before discussing the likelihood of a fiscal disaster, it is important to define what such a crisis would look like. There are two general scenarios:

 

1.      An explicit or implicit default on U.S. Treasuries, causing Treasury securities to lose value and likely triggering widespread disruptions across financial markets followed by a sharp economic downturn.

 

2.      Rapid price inflation (perhaps worse than the 1970s peak or the recent surge) as the Federal Reserve creates money to service the debt and economic actors lose confidence in the dollar.

 

Although many analysts dismiss the possibility of a U.S. Treasury default as unprecedented, international experience confirms that, though a sovereign issuer can create the funds needed for debt service, there is no guarantee it will do so.

 

In either scenario, various claims on the federal government would face large markdowns in real dollar terms. Affected claimants would not be limited to Treasury holders but would also include government employees, contractors, and those receiving entitlement benefits or expecting to do so. These claimants could then default on their own obligations, causing the federal payment failure to reverberate throughout the economy.

 

When I evaluated the risk of a U.S. Treasury bond default in 2011, I focused on the ratio of net interest on the debt to federal revenues. This ratio is theoretically more attractive than debt-to-GDP because the numerator factors in interest rates in addition to the amount of debt, whereas the denominator considers the government’s ability and willingness to tax economic activity. Countries with low interest rates (like Japan) and/or high taxation (like France) should be able to avoid a sovereign debt crisis even with very high debt-to-GDP ratios.

 

The last major default on federal debt, which took the form of abrogating Treasury bond gold clauses in 1933, occurred when the interest-to-revenue ratio reached 30 percent. Similar levels preceded major sub-sovereign defaults in the Anglophone world around that time: Arkansas, Alberta, and New South Wales.

 

Above that level, it is plausible to think that political leaders decide (implicitly or explicitly) that interest costs are crowding out other spending priorities to such an extent that default becomes a viable option. A sovereign nation with a widely used fiat currency, such as the contemporary United States, could address interest-rate crowd-out either by defaulting or by issuing more debt. But taking this latter option would likely necessitate creating large volumes of new reserves, triggering the inflation scenario I outlined above.

 

Modeling from 2011 indicated that the U.S. would hit the 30 percent interest-to-revenue threshold by now. A long-term forecast by the Congressional Budget Office (CBO) that year, its alternative fiscal scenario, the one widely viewed as more realistic, showed that in 2026, net interest would account for 6 percent of GDP and revenue would be 18.4 percent of GDP, yielding an interest-to-revenue ratio of 32.6 percent and placing us in crisis territory.

 

In reality, the 2026 ratio is coming in at around 20 percent. The CBO’s revenue forecast was not too far off: 17 percent of GDP rather than the 18.4 percent forecast. The big miss was on interest expense, which is only about 3.4 percent of GDP compared with the 6 percent forecast.

 

The reason that interest expense was much lower than expected was that interest rates remained low into 2022. The CBO projected the average interest rate on all federal borrowing to reach 5 percent by 2015 and 5.2 percent by today. Instead, it fell to less than 2 percent in the early 2020s and has only reached 3.45 percent most recently. Older Treasury bonds issued during the low-rate years continue to hold down the government’s average interest cost.

 

So, the low interest rates of the 2010s and the pandemic period appear to have forestalled the predicted crisis. But now that rates have returned to more normal levels and older, low-interest bonds are rolling off, interest expense is surging. This year’s total of just over $1 trillion is almost triple its 2021 level in nominal terms, and more than double its share of GDP.

 

It therefore appears that after a long reprieve over the last decade, we are once again headed toward the crisis we hawks warned about 15 years ago.

 

We should recognize, however, that the current trend is not immutable even without policy reform. Interest rates could go back down. If the current boom in AI infrastructure collapses, there will be less competition for borrowed funds, and thus lower rates for other borrowers, including the U.S. Treasury. Or, if the AI boom continues and accelerates economic growth, we could see a sharp rise in federal tax revenues, making high interest costs more affordable.

 

Now we will have to catch a break to stop the surge in interest expense that is already underway. Unlike in 2011, we are clearly on the road to something awful.

 

It is time to dust off the old warnings and demand a renewed focus on federal debt and deficits. It may already be too late to avoid the feared markdown of claims on the federal government, but we can still take action to minimize and phase in these adjustments rather than face the disorderly unwinding that now seems to be our destiny.