Countries around the world – including the U.S. – worry about financial markets
James Carville, a former presidential adviser to Bill Clinton, famously said that if he died, he wanted to be reincarnated as the bond market, so that he could “intimidate everybody.” Why are governments intimidated by financial markets?
In short, modern governments often have to borrow money on international markets to finance their activities. They do this by issuing bonds — debts that they agree to pay back in a given period, providing interest payments in the meantime.
During the last two decades, 77 national governments issued bonds on international markets. The median government issued bonds in seven out of 12 calendar months, taking on new debt or rolling over or converting old debt. Governments regularly issue bonds that mature at different times, or are issued in different currencies, to manage their outstanding debts.
If markets won’t buy a government’s bonds — or will only buy them in return for punitively high interest payments — then the government is in big trouble. A government with a need to quickly refinance some of its outstanding debt (so that it doesn’t default) will find itself in even deeper trouble.
Additionally, poor countries often have to borrow money in dollars rather than in their own currency, since financial markets often worry that these currencies will not retain their value. What happens if financial markets are no longer willing to buy bonds issued in dollars? In that case, the government has to find a way to generate dollars. This can be difficult, especially if the country’s currency doesn’t buy as many dollars as it used to.
Financial markets can get spooked by political events, especially unexpected political events. On the night when Donald Trump was elected, the Mexican peso fell by 12 percent. This month, the price of French debt on international markets has risen and fallen rapidly, as investors debated the possibility of a far-right electoral victory by Marine Le Pen.
Investors keep buying U.S. debt (so far)
U.S. Treasury rates have remained relatively stable since Trump took office. This implies that investors in U.S. bonds aren’t too worried about the risk that the United States will default on its debt, or be unwilling or unable to pay its future obligations. Even though Trump’s election victory surprised many investors, they see the news about potential tax cuts, regulatory loosening, and infrastructure spending as positive.
The U.S. certainly owes a lot of money (compared to the size of the economy, as well as in absolute terms). However, it also has a lot of advantages when it borrows on international markets. It has low inflation. The dollar’s global role helps create strong demand for U.S. Treasury bonds, which are issued in dollars. And the U.S. is a democracy. Several studies suggest that democracies like the U.S. are better able to borrow internationally than their non-democratic counterparts. This is not just because democracies are wealthy: investors think that democratic political institutions are less risky.
Investors may be starting to change their minds about the U.S.
Some investors have begun to worry that Trump’s statements and actions on trade policy, exchange rates, multilateral financial regulation and foreign policy signal trouble for the global economy. On February 10, Fitch Ratings, a company that rates the riskiness of government debt, warned that the U.S. administration “represents a risk to international economic conditions” and that “U.S. policy predictability has diminished.” The U.S. is projected to hit the debt ceiling on March 16, meaning that Congressional debate could raise the specter of U.S. politicians threatening to default on US debt.
When investors are nervous, the U.S. government has to offer higher interest rates on Treasury bonds to persuade them to buy U.S. debt. This means either bigger fiscal deficits, or less money for the U.S. government to spend on other things.
When investors are nervous about the U.S., governments abroad hurt, too
Increases in U.S. Treasury rates matter to the rest of the world. U.S. rates set the tone globally for investors interested in buying government debt. Investors like to get high returns from relatively safe assets and U.S. Treasury bonds are considered the least risky asset one can buy on international bond markets. When U.S. Treasury rates are low, investors are more willing to take risks by buying other governments’ bonds, hoping to get a higher return. But when U.S. Treasury rates are high, investors can get high returns when investing in relatively safe U.S. bonds. This effectively sucks liquidity out of global markets, making it harder for other countries to borrow. As we demonstrate in a new paper — and as others have established for earlier periods — governments’ ability to issue bonds depends on U.S. Treasury rates.
Non-democracies are likely to hurt the most
We also find that U.S. Treasury rates affect the ways in which investors think about the risk of lending money to non-democratic countries. When U.S. Treasury rates are low, investors are willing to take on all kinds of risk in exchange for higher returns — including political risks inherent in lending to less creditworthy non-democracies. But when U.S. Treasury rates are high, investors are more attentive to the reductions in political risk that democracies provide, reducing their demand for autocratic debt.
What this means is that if investors start getting nervous about the Trump administration, non-democratic governments will be hit particularly hard. They will find it hard to borrow more money, which will also affect their ability to repay outstanding debt and, likely, their domestic political and economic stability. This could lead to a new wave of defaults.
Countries’ ability to borrow money from financial markets is determined in part by global trends that they can’t control. If financial markets start worrying about Donald Trump, it will be bad news for the U.S. economy. Very likely, it will be even worse news for poor countries, and especially for non-democratic poor countries.
Cameron Ballard-Rosa is assistant professor of political science at the University of North Carolina at Chapel Hill.
Layna Mosley is professor of political science at the University of North Carolina at Chapel Hill.
Rachel Wellhausen is assistant professor of government at the University of Texas at Austin.