When banks rescue the government

The deficit of the US government isn’t small. Even before the extension of the 2017 tax cuts, the Congressional Budget Office estimates that the budget deficit will average 5.9% of GDP over the next decade. In comparison, the UK’s budget deficit is expected to be 3.8% of GDP in 2025, declining to 3.3% next year. How do you finance such persistently high deficits?

Projected US budget deficit

Source: CBO

The problem of financing persistent deficits is a real one. If you can’t find buyers for your government bonds, the situation very quickly spirals out of control and a country risks default. Exhibit A to I: Argentina defaulted nine times since its independence in 1816. Exhibit J: Greece in 2011. Exhibit K: The UK’s ‘mini debt crisis’ after Liz Truss’ ‘mini budget’.

The US has been in a much more comfortable situation because of the dollar’s status as a reserve currency and the large trade and current account deficits the country runs. These imply that foreigners need to hold dollars whether they like it or not. If the US had a persistent current account surplus, fewer international investors would need to hold dollars (and buy Treasuries) making it harder for the government to finance its large deficits.

The problem is that as debt/GDP-ratios increase, more and more buyers of government bonds will become cautious about future deficits because they fear the risk of the government negating its promises (either through default or by inflating debt away) increases. Who will replace international and domestic buyers when this happens?

As I write this, there is a lot of chatter about a possible Mar-a-Lago Accord in the US, where the US strongarms foreign countries into weakening the US Dollar (i.e. strengthening their own currencies) and/or exchanging existing US Treasuries for ultra-long-term Treasuries with extremely low or zero coupons. Let’s ignore for a moment that this kind of exchange would be a default by the US government and likely create all kinds of turbulence in global financial markets, I think there is a better way to solve the problem of high deficits, high interest burden and reduced demand for the Dollar from a lower trade deficit.

An elegant analysis by Olivier Jeanne from Johns Hopkins University provides an intriguing answer. He shows that once debt/GDP-ratios climb above 100% to 120%, the demand for government bonds changes. For debt levels below this threshold, private sector buyers (households, businesses, institutional investors) tend to buy about two thirds of newly issued government debt while banks (which include both commercial banks and the central bank) buy about one third of the debt.

But once government debt surpasses the threshold, banks and in particular the central bank step in as not only the major but the exclusive buyer of government debt. Practically 100% of newly issued debt gets bought by the central bank and banks in a form of financial repression designed to keep long-term government bond yields low.

How much government debt is sucked up by banks and the central bank?

Source: Jeanne (2025). Note: Threshold denotes the debt/GDP level at which debt absorption by banks picks up.

This is what happened between 2010 and 2020 when the government bonds bought by the Fed or the Bank of England as part of QE nearly matched the cumulative government deficits during those years. Central banks in the US, the UK and other countries indirectly financed government deficits by buying bonds in the secondary market at roughly the same speed as the government issued new bonds.

By doing this, the price of money is reduced, and bond yields are kept artificially low allowing the government to continue its deficit spending while servicing an ever-growing amount of debt.

Given the decade of high deficits projected for the US together with the increasing risk premium demanded by bond investors, I dare go out on a limb and guess that at some time in the not-so-distant future, the Fed will introduce quantitative easing again just to prevent a meltdown of the Treasury market and the global financial crisis such a meltdown would create.

As I have discussed here, this is part of the monetary policy of the future. It’s a world where central banks may hike interest rates to fight inflation while at the same time repressing long-term government bond yields through quantitative easing. And this weird kind of monetary policy may arrive sooner than many people expect.