Bruce Bartlett thinks the "trigger ... will come from the credit rating agencies, such as Moody's and Standard and Poor's, which rate sovereign debt as well as that of private businesses and subnational governments.
"For at least five years these agencies have been warning that America's AAA bond rating isn't guaranteed. Any downgrade would send shock waves throughout the entire financial system because so many bonds are priced off of equivalent Treasuries, which are assumed to have zero risk of default. Thus a rise in Treasury rates, which would necessarily follow from a credit rating downgrade, would automatically raise other interest rates.
"Moreover, a credit rating downgrade would be a massive shock to the banking system because banks are now permitted to hold less capital against Treasury debt; higher capital requirements apply to debt that is considered more risky. While it is highly unlikely that Treasury debt would ever be so downgraded that banks would have to sell their holdings or raise additional capital, any downgrade would be viewed very, very negatively by banks, insurance companies, pension funds and other institutions that now hold large quantities of Treasury bonds.
"What might trigger such a downgrade? The rating agencies have already told us what it will be: a rise in the federal government's interest payments to 20% of revenue, not spending. That is the limit of what the agencies view as acceptable. As noted earlier, given the status of federal interest payments as superior to all other spending, this is the logical position for the rating agencies to take. Whether they are right about 20% of revenue being the cutoff between manageable and unmanageable interest payments is an empirical question that their experience presumably informs.
"So when might we reach the 20% threshold? According to the Congressional Budget Office's forecast based on the administration's budget, that will come in about 10 years .... However, I view this projection as extremely optimistic [because monetary tightening by the Fed will lead to higher interest rates] ...
"Therefore, I think it is very likely that the 20% threshold will be reached well in advance of the year 2020."
Needless to say, the credit rating agencies have recently been criticized for being too bullish with their AAA ratings when sought by paying clients, and may think they need to be mindful of that. Also, the federal government is not a paying client, and while it could exert formidable pressure on the rating agencies not to downgrade, this might draw grudging rather than enthusiastic cooperation, and be duly noticed in the credit markets.