"The current fiscal path of the federal government is unsustainable." This sentence begins any discussion about the future of US fiscal policy and CBO uses it a lot. But when they go into detail about the increased possibility of a fiscal crisis related to our rising fiscal debt picture, it's bound to raise some eyebrows on Capitol Hill - not to mention sending shivers down some spines on both sides of the aisle.
We'd like to think that we were the inspiration for this more detailed brief. After all, we did write a paper talking about the increased risk of a debt crisis if US fiscal conditions were left on auto pilot. We looked at different possibilities of how a fiscal crisis could play out in the US, based on real-life points of vulnerability in the US economy. The paper (and others - by Len Burman and Fred Bergsten) was discussed by an impressive group of experts (including CBO Director Elmendorf) at a CRFB event.
CBO doesn't go into specific scenarios as we did. But it puts us all on notice that there's a new kid on the block: as we think about negative consequences from our rising fiscal debt, add the increased chance of a fiscal crisis to our tried and true standard list of worries (eg, the crowding out of investment, the crowding out of fiscal priorities, the need to raise taxes and/or cut spending simply to keep up with debt service on existing debt; and the lack of flexibility when faced with a new or unexpected problem domestically or internationally.)
What makes normal tough fiscal situations turn into crises? Sometimes, tough debt situations can be managed, but, under certain conditions, CBO writes, an already daunting fiscal management challenge can suddenly turn to a crisis. A country with low domestic savings like the United States is particularly vulnerable - even if its "safe haven" status has allowed it to more freely issue debt under altogether different circumstances. Another cautionary note for the United States, countries already in recession are also quite vulnerable, particularly if new borrowing requirements pop up unexpectedly and investors lose confidence.
While the lessons of fiscal crises elsewhere do not "necessarily" apply to the United States, CBO notes that their main elements can be instructive. First, the situation can deteriorate very rapidly. In Ireland and Greece, changes in interest rates happened quickly. Two years ago, interest rates on their ten year bonds were less than a percentage point higher than Germany's. Right now, the spread is at about three percentage points for Ireland and eight percentage points for Greece. In both countries, they had to undertake austerity measures, despite adverse economic conditions. In Argentina's case, the early 2000s recession exacerbated their fiscal situation, and due to their past history of defaulting on debt, interest rates quickly spiraled out of control until Argentina simply ceased to pay its creditors. It has had trouble borrowing since then.
In all three of these cases, fiscal crisis resulted in part from recessions that significantly raised each country's debt burden. Plus, there were other factors making each country highly vulnerable to a collapse in confidence under certain circumstances. In Ireland's case, the country's rapid growth path had been based on high leverage. In Greece, growth was also deficit financed, plus extremely high unfunded liabilities were hidden and announced in a fiscal information shock. Greece's fiscal credibility (and also, by the way, the eurozone's) was undermined. In these cases, to sustain financing at a reasonable interest rate cost, governments were forced to tighten fiscal policy during a recession, setting off the growth-deficit spiral.
The timing of fiscal crises underscores the importance of prudent fiscal policy during good times. The possible aftermath in the US of a sudden fiscal crisis is not pretty: restructuring of debt, inflationary monetary policy (to remedy the crisis), and drastic fiscal austerity. All of these options would be extremely painful and the first two would severely hamper the ability of the federal government to borrow in the future.
The bottom line is: why take the chance that we can muddle through? CBO has given us a warning: it is better to put our fiscal house back in order on our own terms rather than to be forced by our creditors to take a hachet to our standard of living. We still have a window of opportunity to get it right.