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Federal Debt and the Risk of Fiscal Crisis 1 (July 2010)

handle is hein.congrec/cbo7069 and id is 1 raw text is: A series of issue summaries from the Congressional Budget Office JULY 27, 2010 Federal Debt and the Risk of a Fiscal Crisis Over the past few years, U.S. government debt held by the public has grown rapidly-to the point that, com- pared with the total output of the economy, it is now higher than it has ever been except during the period around World War II. The recent increase in debt has been the result of three sets of factors: an imbalance between federal revenues and spending that predates the recession and the recent turmoil in financial markets, sharply lower revenues and elevated spending that derive directly from those economic conditions, and the costs of various federal policies implemented in response to the conditions.1 Further increases in federal debt relative to the nation's output (gross domestic product, or GDP) almost cer- tainly lie ahead if current policies remain in place. The aging of the population and rising costs for health care will push federal spending, measured as a percentage of GDP, well above the levels experienced in recent decades. Unless policymakers restrain the growth of spending, increase revenues significantly as a share of GDP, or adopt some combination of those two approaches, growing budget deficits will cause debt to rise to unsupportable levels. Although deficits during or shortly after a recession gen- erally hasten economic recovery, persistent deficits and continually mounting debt would have several negative economic consequences for the United States. Some of those consequences would arise gradually: A growing por- tion of people's savings would go to purchase government debt rather than toward investments in productive capital goods such as factories and computers; that crowding out of investment would lead to lower output and incomes than would otherwise occur. In addition, if the payment of interest on the extra debt was financed by 1. For more details, see Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2010 to 2020 (January 2010); The Effects ofAutomatic Stabilizers on the Federal Budget (May 2010). imposing higher marginal tax rates, those rates would dis- courage work and saving and further reduce output. Ris- ing interest costs might also force reductions in spending on important government programs. Moreover, rising debt would increasingly restrict the ability of policy- makers to use fiscal policy to respond to unexpected challenges, such as economic downturns or international crises. Beyond those gradual consequences, a growing level of federal debt would also increase the probability of a sud- den fiscal crisis, during which investors would lose confi- dence in the government's ability to manage its budget, and the government would thereby lose its ability to bor- row at affordable rates. It is possible that interest rates would rise gradually as investors' confidence declined, giving legislators advance warning of the worsening situa- tion 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. The exact point at which such a crisis might occur for the United States is unknown, in part because the ratio of federal debt to GDP is climbing into unfamil- iar territory and in part because the risk of a crisis is influ- enced by a number of other factors, including the govern- ment's long-term budget outlook, its near-term borrowing needs, and the health of the economy. When fiscal crises do occur, they often happen during an eco- nomic downturn, which amplifies the difficulties of adjusting fiscal policy in response. If the United States encountered a fiscal crisis, the abrupt rise in interest rates would reflect investors' fears that the government would renege on the terms of its existing debt or that it would increase the supply of money to finance its activities or pay creditors and thereby boost inflation. To restore investors' confidence, policymakers would probably need to enact spending cuts or tax increases more drastic and painful than those that would have been necessary had the adjustments come sooner.

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