How a Debt Crisis Unfolds in Five Steps

To wrap up 2025 I thought I would send out what I consider to be a foundational article – one that is evergreen and not topical just to the moment: “How a Debt Crisis Unfolds in the Five Steps.” It is important for understanding my long-term view on the market and I will likely send it out again to be sure everyone reads it.

I will, however, take a short look back at 2025 and note that the market looks to be closing where I predicted it would at the beginning of the year – and I reiterated that prediction in the spring, summer and fall. That prediction being that the S&P will rise 15% to 20%. Currently, it is up about 18% year to date so I suspect it will end right on target.

Now on to the foundational article. Although this is not meant to address a specific short term issue, the concern over a US government debt crisis is getting greater with the price of gold surging and lots of articles in the press about a possible government debt crisis, in particular Ray Dalio’s book “How Countries Go Broke.” I will write a short description of how such a crisis would actually unfold. In explaining the process, it will also be easy to understand why it takes time and doesn’t happen all of a sudden.

It’s important to understand the mechanics involved in a debt crisis since much of the discussion about how such a crisis might end is not really grounded in reality. Some scenarios have a debt crisis ending with the government going bankrupt, much like a corporate bankruptcy. Or, the Fed just decides (or is forced) to inflate away the debt. Another common scenario is that fiat currency collapses all over the world and is replaced by gold.

None of these scenarios take into account how modern governments and central banks would actually respond to a debt crisis or, more importantly, how it occurs in the first place. The real steps are fairly straightforward, but they challenge some current, or should I say, comfortable assumptions about our economy and government.

So here goes a simple step by step scenario for a real debt crisis:

Step 1: Run Massive Deficits and Accumulate Massive Debt

The government runs large annual deficits and accumulates massive debt. This is in itself is not a problem. It might be considered irresponsible or even immoral by some but, in and of itself, huge borrowing and huge debt doesn’t cause any big problem. In fact, just the opposite -- it provides a big boost to the economy and to asset markets. It also makes it easier for Congress to tax less and spend more. That’s something that gets strong tacit approval by voters. They like more benefits with less taxes.

Rising debt payments can simply be rolled over from year to year, and increased interest can simply be paid by more borrowing.

This is where we are today, so no crisis yet.

Step 2: The Government’s Demand for Borrowed Money Pushes Up Interest Rates but the Fed Increases the Supply of Money to Keep Rates from Rising

The only real problem from massive borrowing is that it causes interest rates to go up. That’s because massive borrowing greatly increases the demand for money which causes the cost of money, interest rates, to rise. In economics this is called the “crowding out effect” since government demand is crowding out private demand for money.

However, this very real problem can be solved simply by increasing the supply of money. That will reduce the cost of borrowing money (interest rates). This is just simple supply and demand economics. The Fed can increase the supply of money by printing money electronically to buy government bonds, T-bills or government backed mortgage bonds or all three.

We have just started printing money in early December and it is expected we will print about $40 billion per month. That will likely vary from month to month but it could become more standard and even increase when the new Fed Chairman, likely a money printer, takes office in May.

We have just begun this step, so no crisis yet.

Step 3: The Increased Supply of Money Eventually Creates Monetary Inflation

This is the most important step toward a debt crisis. When this step begins depends entirely upon how quickly that printed money turns into inflation. In an earlier time, such as the 1970s, this happened fairly quickly. The usual rule used by economists for how quickly printed money created inflation was variable but tended to be around 18 months. Economists called this the “lag factor.” It was the time lag between printing money and getting inflation.

However, as we saw after the massive money printing during the Financial Crisis and more recently the massive money printing after Covid, little monetary inflation was created. And certainly nothing in proportion to the amount of money created.

What inflation we did get from Covid was transitory because it was mostly due to supply and demand imbalances that faded as the pandemic faded and economies re-opened.

Hence, we have no real idea how long it takes for printing money to create inflation in the post-Financial Crisis Era -- Economists have completely ignored this question: So, it’s very hard to say how long this step will take. A couple of years after the beginning of significant money printing? A few years? Maybe more. It’s hard to say but given the recent history of inflation it could take quite a while.

For sure, we can completely throughout the old “lag factor” time frame of past economics. However, nobody has really updated the lag factor to account for what happened after the Financial Crisis. In fact, if you google “lag factor time between money printing and inflation” you will still find that Milton Friedman’s old estimate of 4 – 29 months with an average of 16 months coming out at the top of the list. You might also find a listing of about 12 to 24 months.

Nothing has been done to update this old data. To me, it’s obvious that there is a glaring lack of insightful economic research into the realities of modern money printing and inflation. Outside of the lack of focus on productivity in economics, I consider this one of the economics professions’ greatest failures today.

What I can confidently say is that as long as printing money does not create inflation, we will print all the money that is needed to keep interest rates from rising from massive government borrowing.

But, for arguments’ sake let’s assume that at some point we will print enough money to create monetary inflation and Step 3 begins. I think this is very likely to happen because I do not see the government slowing down its massive borrowing. In fact, I see it rising, thus creating a greater need for money printing to keep interest rates from rising.

So, let’s say we get 5% inflation (up from 3% today). Although consumers may not like that, the financial markets could easily ignore it. That’s because inflation only bothers the financial markets when it forces up interest rates. Rates go up because who wants to lend money at 4% when inflation is 5%? That’s an immediate losing proposition. However, the markets could ignore that for a while. Inflation-adjusted interest rates have gone negative before and could do so again.

This step could take many years.

No crisis yet.

Step 4: Interest Rates Are Rising Due to Rising Inflation

However, higher inflation rates of 6%, 7% or 8% could start to put upward pressure on interest rates. But there is an easy solution to those rising rates: The Fed can just print money to buy more bonds to keep interest rates lower than inflation. So, the game of “kick the can” continues once again.

The only problem is that, once you have monetary inflation, increasing the supply of money may lower rates, but it will also fairly quickly increase inflation.

This step could take a year or two.

No crisis yet.

Step 5: The Crisis Can Begin

This is where a debt crisis first becomes possible. Although the Fed can fight rising interest rates, which are being forced up by inflation by printing more money, at some point this fix can run into market problems. One problem is that private bond buyers start to dry up and the Fed is having to buy more and more of the bond market. Although the Fed can easily buy bonds at 5% when inflation is 8%, many private investors will back away over time since it is a losing investment. The higher inflation gets the more of a losing investment it is.

The bond and stock markets will begin to lose faith that the Fed can control inflation. The Fed can work hard to keep bond markets stable, but keeping the stock market stable will be hard. At some point, the stock market will start to have big drops that the Fed has a hard time controlling with big increases in money printing.

Ultimately, they won’t be able to save the market by printing more money because printing more money at that point becomes a big negative for investors. At that point, there is no way for the Fed or Congress to save the stock or bond markets.

The crisis begins.

Why Won’t the Fed Let Rates Rise Much Higher than 5% or 6% So They Don’t Have to Print So Much Money?

Letting interest rates rise asset prices are very high due to historically low interest rates is a recipe for an asset price collapse and a consequential financial market collapse. That’s not just bonds, but stock and real estate too. The normal reaction by the Fed will be to do whatever it takes to avoid a massive financial crisis – one that would be much, much bigger than the Financial Crisis of 2008-9.

In the 1980s we could raise interest rates without creating a financial crisis because the Dow was at 1,000 not 48,000 like it is today. Same for real estate. We are now in an era of high priced assets and a government debt that will be nearing $50 trillion by the time such a crisis might occur. This is a very different economy from the early 1980s. It is now much, much more interest rate sensitive.

Heading Toward a Debt Crisis, But It Could Take Time Because We Will Do Whatever We Can to Postpone It as Long as We Can

So, adding up the total time each step takes gives us a debt crisis timeline of anywhere between 5 and 10 years, maybe longer. So, although we are headed in the direction of a debt crisis, as Ray Dalio and others say, the time it takes to become a crisis could be quite a while given the likely responses to postpone the crisis that the Fed (with the support of Congress, the President, Wall Street and the voters) will make at each of the five steps. Nobody wants a debt crisis to happen. They will do what they can to postpone it as long as they can. It’s human nature.