From Debt Ceiling Crisis to Debt Crisis
The U.S. government teeters on the brink of defaulting on its payment obligations over the next few weeks as the debt limit threatens to bind in early June. There’s been extensive coverage about the potential for catastrophic impacts on the economy if Congress and the President do not raise the debt ceiling. What’s missing from the debate is serious consideration of the potentially catastrophic longer‐term scenario the United States could face if spending and debt continue growing unabated.
Current debt limit discussions are indicative of the myopia that characterizes the federal budget process. A debt limit crisis presents a short‐term legislative impasse of politicians’ own making. There’s an easy and certain way out of the immediate problem: increase the debt limit. A full‐fledged fiscal crisis, however, is a much more uncertain, longer‐term, and yet far more damaging scenario with no easy way out. And it becomes much more likely if legislators continue borrowing like there is no tomorrow.
The relevant question isn’t whether to raise the debt ceiling. Instead, the debt ceiling deadline should serve as an action‐forcing event during which lawmakers halt the unsustainable growth in the debt.
As someone who cares deeply about the future of the United States and the well‐being of current and future generations, I am frustrated by the misguided focus on short‐term political considerations at the debt limit. Meanwhile, the longer‐term debt crisis continues to unfold.
A study in the National Tax Journal, co‐authored by Leonard E. Burman, Jeffrey Rohaly, Joseph Rosenberg, and Katherine C. Lim, lays out why a catastrophic U.S. debt crisis is a likely outcome of current fiscal policy and how it could play out. Below, I summarize their findings in the hopes that this will clarify why legislators and the public should be much more concerned about the prospects of a future U.S. debt crisis.
What are the risks of a U.S. debt crisis, and how could it affect the economy and individual Americans?
A U.S. debt crisis would have significant negative consequences for both the economy and individual Americans. A fiscal crisis could lead to a rapid increase in interest rates, inflation, and unemployment. This could trigger a recession and severely reduce economic growth. These modelled effects are based on observations of how debt crises played out in other countries. While there is no decisive threshold at which countries experience debt crises, as debt grows, the likelihood increases. Burman et al. write:
“Nearly one‐fifth of countries that defaulted or required debt restructuring had external debt (held by foreigners) of less than 40 percent of GNP (Gross National Product), and more than half of countries experiencing debt crises had debt levels below 60 percent of GNP. Thus, 60 percent might be viewed as a rough barometer of high risk for budget failure. However, nearly one sixth of countries did not reach a crisis point until their debt level had exceeded 100 percent of GNP.”
At this time, foreign holdings make up about one‐third of U.S. government publicly held debt. In case of a fiscal crisis, the government’s ability to respond would be limited. Below are some of the potential impacts.
Higher interest rates. A debt crisis could lead to a sudden increase in interest rates, which would make it more expensive for the government, consumers, and businesses to borrow money. This could slow down economic growth and potentially lead to a recession.
Decline in the value of the U.S. dollar. A debt crisis could also cause a decline in the value of the U.S. dollar, which could lead to inflation and reduce the purchasing power of Americans’ savings and investments.
Market volatility. A debt crisis could cause significant volatility in financial markets, which could lead to losses for investors and pension funds. This could also lead to a decline in consumer and business confidence, which could further reduce economic growth.
Steep and sudden cuts to government services. A debt crisis could constrain government services, forcing sudden and steep cuts to government programs with significant consequences for vulnerable Americans who rely on these programs for their livelihoods. Congress should reduce spending on these programs in a responsible way that allows affected individuals to find alternative sources of income, a possibility that could be precluded by a debt crisis.
Damage to the United States’ international standing. A debt crisis could damage the United States’ reputation as a stable and reliable borrower, which could make it more difficult for the government to borrow in the future and undermine the current standing of the U.S. dollar as a global reserve currency.
Why might a U.S. debt crisis come on suddenly instead of building over time?
Burman et al. contrast rising debt leading to higher interest rates, which could be a disciplining force for Congress, with debt accumulation as interest rates stay low, which could encourage further fiscal profligacy until gradual corrections are no longer possible. They write:
“A far worse situation would be for interest rates to stay low while we accumulate unprecedented amounts of debt only to respond very suddenly when financial markets or foreign lenders decide that the United States is no longer a good credit risk. That could produce a catastrophic financial meltdown, like the Great Recession, which was triggered by the housing bubble bursting, but with one crucial difference. If the crisis is caused by an excessive amount of government debt, the government will not be able to borrow to deal with its effects. This would be a catastrophic budget failure.”
Like recent banking crises, a U.S. debt crisis could arise suddenly because of how financial markets respond to revised information and changing economic and political conditions. Certain economic models, such as herd models and winner‐take‐all models, suggest that when investors suddenly doubt the government’s ability to pay back its debts, they may rush to sell U.S. bonds all at once. Such a sudden surge in sales could lead to a rapid rise in interest rates, making it more expensive for the government to borrow and potentially triggering a broader financial panic.
If government bond markets represent a winner‐take‐all scenario, Treasury bonds could be trading at lower interest rates than they arguably should, given U.S. government debt accumulation, until such time that another country’s bonds take the first spot. According to Burman et al.:
“The safest asset, currently U.S. government securities, can secure an almost limitless supply of cheap capital, while the next most safe asset trades at a substantial risk premium. Volatility in world markets, even if it makes Treasury bonds less safe, raises the risk premium even more — increasing the flow of capital to the United States and further depressing interest rates. This would explain why Treasury yields plummeted even as the U.S. financial sector was teetering on the brink of collapse and the economy was heading into a deep recession, and it would be consistent with the further decline in U.S. interest rates when Greece and other Euro‐zone countries experienced debt crises.”
In a winner‐take‐all scenario, the United States government could continue to borrow at low rates for as long as there is no suitable competitor to take the spot of the U.S. dollar as the world’s preferred reserve currency. Betting on the permanency of U.S. Treasury bonds being considered the safest, global dollar‐denominated asset, besides cash, could be a very risky bet over the long run. As the American Enterprise Institute’s Michael Strain so aptly wrote: “the absence of a better alternative is a thin reed for national greatness and global economic and political leadership.”
Herd models suggest that a fiscal crisis can arise suddenly because investors’ behavior is driven less by the underlying economic fundamentals, and more by the actions of other investors in the market. If a fiscal crisis triggered a Treasury sale‐off, the first investors to sell off their holdings reap significant rewards, while those who hold onto their investments could face steep losses. This creates a powerful incentive for investors to act quickly and follow one another in a panic, potentially leading to a self‐reinforcing cycle of selling bonds and increasing interest rates. The sheer size of the U.S. debt, which is approaching the country’s gross domestic product, makes the federal government’s ability to borrow vulnerable to sudden shifts in investor sentiment and changing market conditions.
What steps can policymakers take to address the root causes of our fiscal imbalance and reduce the risk of a sudden fiscal crisis?
Instead of the false dichotomy being presented by the Biden administration of raising the debt limit without conditions as the only way to stave off a crisis, the responsible choice is to adopt fiscal reforms that slow the growth in future debt when increasing the debt limit. The United States debt is highly unsustainable, growing faster than the economy toward all‐time‐record levels. The primary driver of our long‐term fiscal imbalance is entitlement spending on programs like Social Security, Medicare, and Medicaid. Any serious reform proposal must reduce spending on these programs.
Congress should consider a Better Budget Control Act to save at least $8 trillion through a combination of new limits on discretionary spending, immediate reductions to mandatory spending, and future savings from reforms to Medicare and Social Security put forth by an independent commission. Such an agreement would allow Congress to responsibly raise the dollar‐denominated debt limit without further inflating the public debt as a share of the economy. Taking steps to prevent a future fiscal crisis won’t be politically easy, but it’s necessary.