My March column discussed the challenges involved in balancing a federal budget that is currently $1.5 trillion or so in deficit. The necessary tax increases and spending cuts would far exceed what Americans have ever experienced. A natural question might be why the budget deficit and the national debt, which is the accumulation of all the past deficits, is even a problem. The government has consistently run a budget deficit since the 1980s without an issue. Why should we worry about it now?
My April column argued that the short-to-medium run concern is inflation, as the Federal Reserve avoids further monetary tightening so as to not make interest payments on the national debt unaffordable. This idea is called “fiscal dominance,” which means the need to manage large deficits and debt outweighs other monetary policy objectives such as reducing inflation. This is a likely reason the Federal Reserve is not further increasing interest rates in the face of inflation remaining about their 2% target.
The longer-term risk is that lenders start to question the federal government’s ability to repay what it has borrowed and stop loaning them money. This is akin to when a bank stops loaning a customer money if that person has no ability to repay what he/she has borrowed. This would mean the federal government would immediately have to balance its budget using the draconian methods described in last month’s column. This would produce a severe recession, leading to a reduction in tax revenue and necessitating further tax hikes and spending cuts to balance the budget. These would in-turn worsen the recession and require even more tax hikes and spending cuts, further deepening the economic hole. Investors would begin dumping Treasuries under the fear they would not be getting repaid, spiking interest rates. Once the dust settled, the recession would rival or even be worse than the Great Depression.
The question becomes, how much more can the national debt increase before triggering this crisis? The answer is, we don’t know. In their study of sovereign debt crises, economists Carmen Reinhart and Kenneth Rogoff in their 2010 book entitled This Time is Different talk about a “bang” moment when investors go from being confident in the government’s ability to make debt payments to losing confidence in this, thus triggering the crisis. This is what occurred in 2008 when investors suddenly lost confidence in mortgage-backed securities, which triggered the 2008-09 financial crisis.
There is simply no way to predict if or when this loss of confidence will occur. The 2008-09 crisis caught nearly everyone by surprise and the crash in mortgage-backed securities, the stock market, and bank insolvencies happened nearly instantaneously. The only thing we know for certain is that the longer the federal government goes without a long-term deficit reduction plan, the more the economy is needlessly exposed to these risks. The national debt is a completely preventable problem on which officials are failing to act.
