The scariest thing about our soon-to-be unprecedented federal debt is that there’s so much we don’t know about its consequences. At a recent TPC event, a bipartisan group of budget analysts agreed that a debt crisis experienced by the world’s largest economy would probably be bad, but they couldn’t predict when the crisis would occur or how it would play out.
Most concerning, they couldn’t imagine forestalling the eventual crisis unless the public and politicians feel actual negative consequences from the run-up in debt. That might not happen until too late.
Why borrow?
It makes sense to take on debt to make large productive investments. It’s why businesses borrow to build a factory or purchase equipment and why households borrow to buy a home. The investment pays off over many years so borrowing matches the outlays with the returns.
For similar reasons, governments borrow to invest in infrastructure or national defense or to stimulate the economy during a recession. We might also borrow if we think future generations will be much richer than we are.
But none of those factors are the dominant explanation for why we have borrowed so much over the past few decades. Instead, we are borrowing primarily because policymakers see the political cost of borrowing as much less than the cost of raising taxes or cutting spending.
This might work out very badly
Fifteen years ago, colleagues and I warned of a “catastrophic budget failure,” a sudden crash in the market for Treasury bonds akin to the bursting of the subprime mortgage bubble, which precipitated a world-wide financial crisis in 2008.
In doing the research for that paper, we asked some prominent macroeconomists if we could recruit someone to build a model of the Treasury securities market with the hope of predicting the timing and severity of the collapse. The academics agreed this was a pressing issue, but they doubted such a model could be built for the US because we don’t know enough to produce a realistic model. There are models of debt crisis in emerging market economies because there are many historical examples. But there’s no evidence upon which to base a model of a crisis in the largest economy in the world.
We know what we don’t know
Here are some questions that we can’t answer:
Q: When will the debt crisis occur?
A: Nobody knows. In 2009, Carmen Reinhart and Kenneth Rogoff wrote This Time Is Different: Eight Centuries of Financial Folly, a long historical survey of debt crises. One conclusion was that debt above 60 percent of gross domestic product (GDP) put countries in the red zone for a budget crisis.
To put that in context, US debt is now about 100 percent of GDP. Some of their conclusions came into question after the book was published, but even taken at face value, it’s not clear how much the struggles of Greece, Zimbabwe, and ancient Syracuse tell us about the US.
What we do know is that a delayed fiscal doomsday is still doomsday—but worse. In a debt crisis, interest rates would rise to reflect the greater perceived risk of government default. If interest rates increased by one percentage point at current debt levels, the additional debt service costs would equal one percent of GDP.
If the same increase happens when debt has doubled relative to the size of the economy, the additional interest payments would be two percent of GDP. That is more than the revenue collected by the corporate income tax. And, of course, the risk of default would rise as interest costs increase, which produces the bubble scenario.
Eventually, default would be a certainty and nobody would want to purchase government bonds at any interest rate.
Q: Will the dollar lose its status as the world’s reserve currency?
A: It might. Foreigners want to invest in US businesses, which boosts demand for US dollars. The dollar is said to be the reserve currency because central banks around the world hold at least part of their reserves in dollars or dollar-denominated Treasury bonds. This eliminates the risk of foreign exchange volatility for the US government and American businesses.
The dollar has this enviable status in large part because US government debt is considered a safe asset. The threat of a debt crisis could obviously undermine that perception. And, even before a crisis becomes imminent, the perception that the US political system cannot manage its fiscal situation might discourage foreign investors and consumers from holding dollar-denominated assets.
At the moment, Congress and the President have not even managed to keep the federal government fully open, let alone address much more intractable long-term budgetary pressures.
If loss of confidence in our fiscal management costs the US dollar its status as reserve currency, we might have to issue some of our debt in another currency (such as euros or renminbi). If the value of the dollar plummeted (for example, because the demand for dollar-denominated assets declined), that would accelerate the collapse of the Treasury debt market.
Q: Would our foreign adversaries try to exploit a debt crisis to weaken the US?
A: Maybe. James Fallows in the Atlantic interviewed a Chinese official in 2009 who warned, “Be nice to the countries that lend you money.” The implied threat was that China could roil the market for US treasury securities. The risk is probably less now that foreigners hold a much smaller share of US Treasury bonds than they did in 2009, but the risk isn’t zero.
Q: Wouldn’t the Federal Reserve make a debt crisis impossible?
A: Possibly. The Fed has unlimited ability to purchase government debt (Treasury bonds, notes, and bills). It buys and sells debt and sets short-term interest rates to help achieve its dual mandates of maximum employment and stable prices.
However, in the event of a debt crisis, the Fed might have to purchase many trillions of dollars in debt every year because most Treasury borrowing is short-term. Most of the debt would come due and have to be refinanced within a few years.
Such large infusions of cash into the economy would tend to be inflationary—violating the Fed’s mandate of price stability—especially if the economy was otherwise running near full employment. In this scenario, preventing the Treasury bond bubble from bursting poses a significant risk of collateral damage: inflation.
To counter that inflation, the Fed might simultaneously raise interest rates, but that would risk producing a recession. And that scenario assumes the Fed remains independent; if not, there is another set of risks, which could be magnified in a debt crisis.
Taking our chances on debt
As TPC’s panel of budget experts pointed out, it would be much easier to achieve sustainable fiscal policy now than in the unpredictable future, when the debt is much larger.
Or we could keep playing budget roulette and hope for the best.
