Wednesday, August 11, 2010

Fiscal day of reckoning

An outcome that once seemed unimaginable for the U.S. is now receiving some serious discussion--a fiscal crisis and a sudden loss of investor confidence. The CBO has written a policy brief, "Federal Debt and the Risk of a Fiscal Crisis," that describes some dire possible consequences if the U.S. does not get its public budget under control.

The CBO writes about initial manageable consequences, such as rising interest payments that would add to the pressures on public budgets, debt servicing that would also crowd out of other productive activities, and a debt level that reduces our ability to respond to subsequent economic shocks or other emergencies.

However, the CBO goes on to warn
Beyond those gradual consequences, a growing level of federal debt would also increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to manage its budget, and the government would thereby lose its ability to borrow at affordable rates. It is possible that interest rates would rise gradually as investors’ confidence declined, giving legislators advance warning of the worsening situation and sufficient time to make policy choices that could avert a crisis. But as other countries’ experiences show, it is also possible that investors would lose confidence abruptly and interest rates on government debt would rise sharply.
Without some changes in policy, the outlook isn't good. The CBO describes how under existing laws the public debt burden in the U.S. is forecast to remain high but manageable (debt will grow but so will the economy, leaving the effective debt burden to increase relatively slowly). However, many of those existing laws, such as caps on physician reimbursements under Medicare and the expiration of all of the Bush-era tax cuts, are likely to change. Under an alternative scenario, debt could grow much faster and possibly to unsustainable levels, triggering a crisis.

Sadly, neither Democrats nor Republicans are seriously addressing the issue. Democrats continue to add short-term budget boosts, like the current $26 billion aid package for states and local governments, that claim to be debt-neutral in the long run but which rely on budgetary gimmicks (for example, the aid package relies on a future change in food stamp benefits that Democrats will try to undo). Republicans don't even make this pretense, advocating unapologetically for a continuation of the unaffordable tax giveaways to the wealthy.

The policy changes needed to address the growing debt won't be easy or painless. However, relatively modest fixes can be implemented if we act sooner rather than later.

2 comments:

Roch101 said...

How much of an effect do you think the Fed's decision yesterday to start buying long term US debt will have on the possibility of a debt crisis?

Dave Ribar said...

Short-term the Fed's move should have very little effect on the prospect of a debt crisis. The Fed has essentially said that it is going to stop winding down its position. The direct effects will be to boost the demand for securities above what it would have been if the Fed had continued unwinding (that is, to keep interest rates low) and to increase the money supply (head off deflation).

The signal, however, isn't good. A key difference between countries that do and don't suffer these crises is the market's perceptions of their ability to make good on the debt. When that confidence disappears, the market dumps the government's bonds. The Fed is signalling that it expects growth to be lower in the U.S. Lower growth means less ability to make good on the debt, so a decrease in confidence.

The risks of a debt crisis in the near-term for the U.S. are very, very low, but there are risks.