Experts on the federal budget often warn that excessive federal debt could eventually lead to a fiscal crisis. But what would that actually involve, and how could Washington respond to such a crisis?
The Congressional Budget Office recently sought to answer those questions, among others, in a report following up on CBO Director Keith Hall’s testimony before a Senate Budget Committee hearing in February. CBO’s explanations underscore the importance of putting the federal budget on a more sustainable course.
The federal debt is already quite large by historical standards, equaling 77 percent of GDP, and the budget office has projected that under current law it will grow rapidly in the coming decade and beyond.
At some point, CBO warns in the new report, investors worried about the size and growth of the debt “might become less willing to finance federal borrowing unless they were compensated with high returns. If so, interest rates on federal debt would rise abruptly, dramatically increasing the cost of government borrowing.”
Unfortunately, interest payments on the debt are already expected to rise rapidly in the coming decade as the government continues to run large deficits and interest rates rise at least gradually from their unusually low levels in recent years.
But CBO provides an important reminder that under certain circumstances, rates could rise more rapidly and to higher levels than currently anticipated. The resulting interest payments could put enormous additional pressure on the federal budget, which is already under strain from the growth of entitlement programs and from a badly flawed tax system.
The damage of rapidly rising interest rates, however, would not stop with the federal budget squeeze. Rapidly rising rates would slice into the market value of previously issued government securities, causing many investors to lose money.
“The resulting losses for mutual funds, pension funds, insurance companies, banks, and other holders of government debt might be large enough to cause some financial institutions to fail, creating a fiscal crisis,” CBO explains. Borrowing costs in the private sector could rise as well.
Economists, politicians and others have often debated how high the government can safely increase the debt. The budget office says there is no clear answer:
“It is impossible for anyone to accurately predict whether or when such a fiscal crisis might occur in the United States. In particular, the debt-to-GDP ratio has no identifiable tipping point to indicate that a crisis is likely or imminent. All else being equal, however, the larger a government’s debt, the greater the risk of a fiscal crisis.”
Economic conditions can be a key factor, with investors generally more concerned about high government debt in a weaker economy. Consequently, CBO says, “fiscal crises around the world often have begun during recessions and, in turn, have exacerbated them.”
If a fiscal crisis were to occur in the United States, CBO cautions, policymakers would have “only limited -- and unattractive -- options for responding.” These would be some combination of seeking to “modify the contractual terms of existing obligations,” raising inflation above expectations through monetary policy, and enacting “large and abrupt spending cuts or tax increases.”
The fact that there is no immediate prospect of such a fiscal crisis is no reason to ignore long-term trends that show U.S. budget policy on an unsustainable path. As The Concord Coalition has long argued, the best course of action would be for Washington to move forward on broad budget reforms in a timely manner.
That would not only minimize the risk of a future fiscal crisis but support economic growth and reduce the public sacrifices necessary to put the country on a more responsible path.