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Debt Fatigue and the Climacteric in U.S. Economic Growth


John Merrifield and Barry Poulson




The Climacteric in U.S. Economic Growth


Economists in the U.S. are debating whether the economic recovery from the coronavirus pandemic will be V shaped, U shaped, or W shaped. Whatever the pace of recovery from this recession, the assumption was that in the long term the U.S. will recover to rates of economic growth experienced prior to the pandemic. An alternative view is that the U.S. is experiencing a ‘climacteric’ in economic growth.


A ‘climacteric’ in economic growth refers to long term retardation and stagnation in economic growth beyond the short term economic shock of the pandemic. The term ‘climacteric’ was first introduced to describe the slowdown in economic growth experienced by Great Britain at the end of the 19th century, and by the U.S. in the early twentieth century (Poulson and Dowling, 1973). This secular retardation in economic growth reflected slower growth in factor inputs and factor productivity.


The U.S. is experiencing a climacteric in economic growth in the 21st century, comparable to that in the early 20th century. The Congressional Budget Office (2019a, 2020f) documents this secular retardation in economic growth. Over the past three decades real GDP growth averaged 2.5 percent per year. The CBO projects that over the next three decades the annual rate of economic growth will average 1.6 percent. The CBO finds that the economic outlook for 2020-2050 has deteriorated significantly compared to previous forecasts.



Table 1. Real GDP Growth (Percent Annual Rate of Growth)


1990-2019 2020-2030 2031-2040 2041-2050 2020-2050
2.5 1.6 1.6 1.5 1.6



Source: Congressional Budget Office 2020f.




The CBO finds that over the past two decades economic shocks have been a source of retardation in economic growth. Total output has been about half a percent below potential output, and this is projected to continue in the long term. This reflects the fact that during and after economic downturns actual output has fallen short of potential output to a greater extent and for longer periods of time than actual output has exceeded potential output during economic booms (Congressional Budget Office 2015). Each of the recent economic shocks has been more severe and has left actual output even further below potential output.


The CBO finds that retardation in economic growth in coming decades reflects slower growth in factor productivity as well as factor inputs. Over the next thirty years the average annual rate of growth in productivity is projected to be just under 1.3 percent, nearly 0.3 percentage points slower than the average annual rate of growth over the past thirty years (CBO 2020f p.20).


Slower growth also reflects the impact of fiscal policies, most importantly, the influence of increases in public debt. The CBO notes that there is considerable uncertainty regarding the impact of these variables.


“Another source of uncertainty is the global economy’s longer term response to the substantial increase in public deficits and debt that is occurring as governments spend significant amounts to attempt to mitigate the impact of the pandemic and the economic downturn” (CBO 2020d p.5).





Debt Fatigue in the U.S.


The climacteric in U.S. economic growth is directly linked to debt fatigue and unsustainable growth in debt. The following figure traces the primary balance and debt as a share of GDP in the post-World War II era.


Figure 1. Primary Balance and Debt as a Share of Gross Domestic Product, percent.




Debt Fatigue
of GDP 60.0
0.0 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 2019 2022 2025 2028
primary balance/GDP debt/GDP


Source: Congressional Budget Office 2020a.


The debt/GDP ratio fell during the post-World War II era until the mid-1970s.While the government ran deficits in most years, the deficits were modest and more than offset by the growth in GDP. From the mid-1970s until the early 1990s the government consistently incurred deficits exceeding the growth in GDP, marking the beginning of unsustainable growth in debt.


During the ‘Great Moderation’ of the 1990s the government incurred lower deficits, and generated surplus revenue from 1998 to 2001. The debt/GDP ratio was reduced to levels comparable to the 1970s.





Debt fatigue is most evident during the last two decades, and is linked to the economic shocks experienced during these years. The first economic shock was the relatively mild recession in 2001. Countercyclical fiscal policy in these years again boosted deficits and the debt/GDP ratio. During the economic recovery from that recession, deficits were reduced and the debt/GDP stabilized.


The financial crisis in 2008 resulted in the sharpest recession of the post-World War II era. The deficits incurred during that recession were greater than that incurred in any other post World War II recession, and resulted in a sharp discontinuous increase in the debt/GDP ratio. In the years following that recession deficits were reduced, but the debt/GDP ratio continued to increase. It is at this point that debt fatigue becomes most evident. Even before the coronavirus pandemic the government again incurred trillion dollar deficits increasing the debt/GDP ratio at an unsustainable rate.


The CBOs most recent forecast captures the devastating impact of the coronavirus pandemic on the budget and the economy (CBO 2020b). Deficits are projected to grow to unprecedented levels, 17.9% of GDP in 2020, and 9.8% of GDP in 2021. Debt held by the public is projected to increase to 101% of GDP in 2020 and 108% of GDP in 2021. The CBO projects continued growth of debt to more than 195% of GDP over the next three decades (CBO 2020f).


Over the past two decades each major economic shock has been accompanied by a sharp discontinuous increase in debt. In years of economic recovery the U.S. exhibits debt fatigue in which debt continues to increase relative to GDP. Slower economic growth makes it more difficult to pursue the fiscal consolidation required to stabilize and reduce debt. The fiscal rules and fiscal policies now in place are flawed in that they have failed to prevent an unsustainable growth in debt.















Debt Fatigue and Risk of Default


Future generations of Americans will bear the burden of debt fatigue in the form of direct taxation, the hidden cost of inflation, higher borrowing costs, or some combination of the three. Higher taxation and inflation have yet to emerge; however, interest rates are projected to increase, and to diverge even further from that in low debt countries. The CBO forecasts that while the federal funds rate will remain at 0.1 percent over the next decade, the interest rate on 10 year Treasury notes will increase from 0.9 percent in 2020 to 4.8 percent by 2050 (CBO 2020f p.13).


The higher interest rates reflect increased uncertainty and risk associated with U.S. debt. The CBO (2019b) estimates the average long-run effect of interest rates ranges from about 2 to 3 basis points for each 1 percentage point in debt as a percentage of GDP.


An important proposition in this literature is a nonlinear relationship between yields and debt levels. Yields may not rise smoothly with increases in the debt levels. Yields may rise gradually at first, but eventually yields increase in a steep nonlinear way, and at some point credit markets respond by denying borrowers credit.


A study by Turner and Spinelli (2012) estimates that each percentage increase in government debt as a share of GDP raises the interest rate differential about five basis points.1 The impact of debt on interest rates depends on whether it is financed domestically or externally. In the United States, the share of debt financed externally has increased; as a result, the impact of higher debt on interest rates has also increased. This relationship holds even when taking into account


  • Turner and Spinelli (2012) measure the interest rate growth differential as the difference between the interest rate on 10-year bonds and a smoothed OECD estimate of nominal potential growth. For non–euro area countries, an increase in the government debt-to-GDP ratio (above the 75 percent threshold) raises interest rates by 2½ basis points if financed domestically, and 3½ to 5 basis points if financed externally. This helps explain why in countries such as Japan, with debt financed domestically, the impact of debt on interest rates is moderated.




the effects of quantitative easing on interest rates. Like the heavily indebted countries in Europe that are dependent on external finance, the United States has become more vulnerable to a financial crisis.


The CBO notes that as debt levels continue to rise a major uncertainty is the willingness of lenders to purchase U.S. debt (Congressional Budget Office 2019, 2020c). This has not really been tested in recent recessions because the nonorthodox monetary policies pursued by the Fed expanded the share of U.S. debt in the Fed portfolio. However, there is growing evidence that debt levels in the U.S. have increased to levels that risk default.


Some credit agencies have downgraded U.S. debt. S&P Global Ratings downgraded U.S. debt to AA+ in 2011 (


In July 2020 Fitch Ratings downgraded U.S. debt from stable to negative, citing


“-deterioration in the U.S. public finances and the absence of a credible fiscal consolidation plan”. – “Treasury flexibility, assisted by Federal Reserve intervention to restore liquidity to financial markets, does not entirely dispel risks to medium – term debt sustainability, and there is growing risk that U.S. policy makes will not consolidate public finances sufficiently to stabilize public debt after the pandemic shock has passed” (


Fitch further noted that the U.S. has the highest debt of any AAA rated sovereign. Fitch has become pessimistic regarding U.S. debt even though the county has a higher debt tolerance level than other AAA sovereigns.


High deficits have often led to debt crises, but there is considerable uncertainty regarding the debt levels where a country risks default (Reinhart and Rogoff 2009; Reinhart, et al 2003). IMF guidelines (2013) set public debt benchmarks at 85% of GDP for advanced countries, suggesting that debt in the U.S. has now increased to levels that risk default.






Causes for Debt Fatigue in the U.S.


Debrun et al (2018) explore the causes for the growth of debt in high debtor developed countries, contrasting the experience of a high debtor country, Japan, with that of Germany, which has had more success in limiting the growth in debt. There are many parallels between the growth of debt in Japan and the U.S.; therefore it is worth exploring the causes for debt growth examined in Debrun et al (2018) to determine their relevance for the U.S.


Debrun et al (2018) suggest four possible explanations for why high debtor countries allow debt to grow at unsustainable rates:


“Implicit or explicit strategy of eventually defaulting.


Confusion between trend and cycle: the authorities observe lower growth and adopt expansionary policies that fail to deliver the expected boost


Conflict with the central bank that responds by raising interest rates


Lack of domestic support for fiscal discipline, which leads to destabilizing budgetary cycles when fiscal fatigue sets in.” (Debrun et al 2018:16)


The first explanation can be ruled out for both Japan and the U.S. For strategic reasons, it would be too costly for either country to default on debt. The best evidence for this in the U.S. are the extraordinary measures taken by the Treasury to meet debt obligations in periods when actual debt approaches statutory debt limits.


The other explanations for the growth in debt involve failures in monetary and/or fiscal policy. For Debrun et al (2018) an important question is whether monetary and fiscal rules in place have proven to be effective constraints on debt in the long run. There is an extensive literature on this question for the U.S., extending back to the seminal work of John Taylor (Taylor 1993).2




2 For a survey of this literature see Merrifield and Poulson (2016a, 2017b).



Monetary Rules, and Monetary Policy


The role of the central bank and monetary policy has emerged as crucial in determining the success or failure of fiscal policies designed to achieve sustainable debt. In his seminal article Taylor (1993) proposed a monetary rule, since referred to as the ‘Taylor Rule’.






That rule would adjust the nominal interest rate in response to changes in inflation and output. He recommended a relatively high interest rate when inflation is above its target, or when output is above its full employment level, to reduce inflationary pressure. He recommended a relatively low interest rate in recessions to stimulate output and suggested that as a rule of thumb, when inflation rises by 1 percent, the nominal interest rate should increase by about 1.5 percent; if output falls by 1 percent, the interest rate should be decreased by about .5 percent.3 Since his original paper, Taylor and others have suggested numerous refinements to the Taylor Rule (Orphanides 2007; Davig and Leeper 2007).


Taylor (2010) follows in the positivist tradition of his mentor Milton Friedman by exploring the role of monetary policies during fluctuations in economic activity in the United States. He traces shifts in rules based and discretionary monetary policy over several decades. Taylor (2010) finds a discontinuous shift in monetary policy beginning in the late 1970s and early 1980s when the Fed pursued an aggressive policy to reduce inflation. Taylor and others find evidence that during the late 1980s and 1990s, the Fed pursued monetary rules designed to


  • On his personal website, Taylor provides the following equation for the rule he proposed.




Where R is the federal funds rate, π is the inflation rate, and Y is the GDP gap.





stabilize inflation at a full employment level of output (Taylor 2010; Clarida, Gali, and Gertler 2000). While the Fed has never committed to an explicit monetary rule, Taylor maintains that monetary policy in the late 1980s and early 1990s followed a de facto Taylor Rule:


It certainly appears that the changes in inflation and real GDP influenced the path of the federal funds rate. This evidence is especially important because monetary policy pursued during the period by the administrations of Ronald Reagan and George H. W. Bush are generally regarded as contributing to economic stability (Taylor 1993, 203).


Taylor and other economists maintain that during this Great Moderation, growing confidence in Fed monetary policy led to expectations of low inflation (Taylor 2000, 2010; Eichenbaum 1997; Feldstein 2002).


Taylor (2010) maintained that a shift back toward discretionary monetary policy occurred with the Fed’s decision to hold the target rate of interest below the level implied by monetary rules during 2003– 2005, and the interventions by the Fed during and after the Great Recession that began in 2008.


When the economy fell off a cliff in 2020 the Fed responded by reducing interest rates to close to zero and purchasing more than $2 trillion in Treasury and mortgage backed securities. The Fed has since expanded its bond purchases to include corporate bonds, and has committed to maintaining the current pace of purchasing Treasury and mortgage backed securities. Chairman Jerome Powell announced that the Fed plans to keep interest rates close to zero for years. He stated that “We are strongly committed to using our tools to do whatever we can and for as long as we can to provide some relief and stability” (Wall Street Journal 2020c, A1). Chairman Powell’s commitment to use the tools of monetary policy is a clear signal that the economic recovery from the coronavirus pandemic will be a long and difficult task. Until the recovery is complete the Fed will in effect be monetizing government debt.


Powell’s aggressive policy has been described as the ‘Powell Put’, a reference to the monetary policies pursued by Fed Chairmen dating




back to Alan Greenspan. After the 1987 stock market crash Greenspan lowered interest rates and injected liquidity to prevent further deterioration in the market. This policy has been criticized as a support for asset pricing that shifts the risk of investing from the private sector to the public sector.


There is a fundamental difference between the ‘Powell Put’ and the ‘Greenspan Put’. The aggressive monetary policy pursued by Greenspan in 1987 was followed by more than a decade of moderate monetary policy, approximating the benchmarks set by the Taylor rule. In his recent statements regarding monetary policy Chairman Powell paid lip service to the Taylor rule, stating that “Officials continued discussions about whether to tie their rate plans to certain economic outcomes, such as inflation returning to 2% and unemployment returning to its recent lows.” (Wall Street Journal 2020c, A1).


But the Fed is also considering imposing a cap on government bond yields (Wall Street Journal 2020b, B11). They would commit to purchase Treasuries in whatever amounts are required to keep borrowing costs from exceeding a specific range. This policy was pursued by the Fed during World War Two, and in the post war years to help the government finance war expenditures. The fed commitment to this policy now would aid the government in financing increased expenditures in the wake of the coronavirus pandemic.


Policy makers anticipate that interest rates will be near zero at least through the end of 2022. Given the commitments made by Chairman Powell there is little likelihood that the Fed will again be guided by the benchmarks set in the Taylor rule, and restore moderation in monetary policy, at least in the near future.


In his analysis of the ‘Great Moderation’, John Taylor poses a counterfactual hypothesis (Taylor 2009, 2010, 2014; Cogan, J., J. Taylor, V. Wieland, and M. Wolters. 2013a, 2013b). What if the rules base approach to monetary policy that emerged in the late 1980s and 1990s had continued over the past two decades? He and his coauthors




simulate the impact of a ‘Taylor Rule’ on monetary policy. They conclude that a Taylor Rule-based monetary policy could have avoided the destabilizing effects of the discretionary monetary policies pursued in this period. Taylor and others argue that we can no longer rely on the Federal Reserve to pursue discretionary monetary policies to approximate a rules-based policy, and that formal monetary rules, such as the Taylor rule, should guide monetary policy (Poulson and Baghestani 2012).


Subsequent research has explored different versions of the Taylor rule as the basis for explaining monetary policy over business cycles in the United States (Orphanides 2008; Poulson and Baghestani 2012; Davig and Leeper 2007).


In Search of a Fiscal Taylor Rule (FTR)


Taylor recognized that commitment to a monetary policy rule such as the Taylor Rule was not a sufficient condition for price stability. If fiscal expectations are inconsistent with a stable price level, this could preclude price stability, even with a Taylor Rule in place.4 He advocated a rules-based approach to fiscal policy (Taylor 1993, 2000). The Fiscal Taylor Rule (FTR) is a rule providing benchmarks to guide discretionary fiscal policy. The objective of the FTR is to promote economic stability over the business cycle, while maintaining debt sustainability in the long run.5


The FTR requires that a structural surplus is maintained over the business cycle. Application of the FTR means that fiscal policy is anchored in the sense that debt converges to a sustainable level in the long run. The nominal budget balance allows automatic stabilizers to support aggregate demand when actual output is below potential output, and for reductions in expenditures when actual output exceeds


  • As Sargent and Wallace argued, there might be inconsistency between monetary and fiscal policy, and this outcome is most likely to exist when the government pursues a discretionary fiscal policy (Sargent and Wallace 1975).



  • For a survey of this literature on rules base approaches to monetary and fiscal policy see Debrun and Jonung (2018).



potential output. Taylor maintains that this FTR provides a good fit for the fiscal balance in the U.S. in the long run. He fits the FTR to U.S. fiscal data for 1960 to 1999.


A number of studies have built upon the original Taylor design for a FTR (Carnot 2014; Debrun and Jonung. (2018); kleim and Kriwolusky 2013; Kumhof and Laxton 2013; Lukkezen and Teulings 2013). Debrun and Jonung (2018) recently generalized the Taylor FTR in a model that they also fit to U.S. data.6 Their model provides benchmarks for the nominal budget balance to provide for economic stabilization over the business cycle, and convergence of the debt/GDP ratio to a given target. They assume the 60% target for the debt/GDP ratio adopted by the European Union and the OECD. They fit the model to U.S. fiscal data for the period 1990 to 2017.


Debrun and Jonung (2018) find that in the U.S. the actual budget balance in the 1990s exceeded the benchmark budget balance. In other words, the fiscal policies pursued during the ‘Great Moderation’ were actually more prudent than that consistent with their FTR benchmarks. However, over the past two decades the actual budget balance was significantly below that consistent with the benchmarks. This suggests that over the past two decades fiscal policy no longer approximates the rules based fiscal policy pursued during the ‘Great Moderation’.



  • Debrun and Jonung. (2018) generalizes the FTR in the following model: bt = bt* + βyt



bt     is the nominal budget balance


bt* = -ø*t  d*FTR

1+ ø*t          is a long term objective defined as the nominal balance ensuring the


convergence of the public debt to GDP ratio to a given number if the output gap is always zero


ø*t   is the ten year moving average of nominal GDP growth


  • is the deficit allowance for cyclical stabilization


yt    is the output gap




Debrun and Jonung (2018) are somewhat sanguine regarding the prospects for a rules-based approach to fiscal policy in the U.S. They argue that while the actual budget balance has been below the benchmark budget balance over the past two decades, there is evidence of convergence toward the benchmark after the financial crisis. They conclude that as the output gap closes deficits will move back to levels consistent with long term debt objectives. They seem to suggest that we should expect a return to a rules-based fiscal policy similar to that pursued during the ‘Great Moderation’.


Debrun and Jonung (2018) are also supportive of discretionary fiscal policy to stabilize the economy over the business cycle. The benchmarks in their FTR model provide for discretionary fiscal policy as well as automatic stabilizers. Taylor and other monetary economists are more skeptical of the effectiveness of discretionary fiscal policy in stabilizing the economy over the business cycle.


As Debrun and Jonung (2018) note, the simulation of FTRs that they and Taylor conducted are sensitive to data vintage. They have both chosen time periods that include the fiscal policies pursued during the ‘Great Moderation’. The Debrun and Jonung (2018) simulations end in 2017, prior to the impact of fiscal policies pursued by the Trump Administration.


We question the sanguine view that Debrun and Jonung have of the prospects for U.S fiscal policy. After the 2008 recession, the U.S. attempted to reduce deficits for several years but quickly abandoned these fiscal austerity measures, incurring trillion dollar deficits, even in years of rapid economic growth. This is in contrast to Germany and other countries in northern Europe that were successful in balancing their budgets and reducing debt burdens over the past decade (Merrifield and Poulson 2016a, 2016b, 2016c, 2017a, 2017b, 2020a).


The long-term forecasts of the Congressional Budget Office (2020f) reveal that at least under current law the U.S. will incur greater deficits that will further deviate from benchmark budget balances required by a FTR. The debt/GDP level is projected to increase well above current levels and diverge even further from the 60% target for sustainable





level in their analysis. The U.S. does not appear to be returning to the rules based fiscal policies pursued during the ‘Great Moderation’.


We conclude that over the past two decades the U.S. has abandoned the rules based fiscal policies pursued during the “Great Moderation’. If elected officials had continued to pursue those more prudent fiscal policies, the country could have avoided a debt crisis. But, hoping that elected officials will again be guided by a FTR to stabilize the economy over the business cycle and reduce the debt/GDP ratio to a sustainable level is wishful thinking. Because the U.S. has abandoned a rules-based fiscal policy it will be even more difficult to solve the debt crisis.


Debt Fatigue: The Path Not Taken


Debrun et al (2018) conclude that we are left with the final explanation for unconstrained growth of debt in high debtor developed countries, lack of domestic support for fiscal discipline. The question is why domestic support for fiscal discipline has deteriorated in the U.S. in recent decades. The public choice literature identifies deficit bias of elected officials as the source of deficits and unsustainable debt. Combined with erosion in fiscal rules constraining rent seeking behavior, opportunities for rent seeking have expanded greatly over the past half century. The ability to finance expenditures with debt has increased the fiscal commons, and created more incentives to engage in rent seeking. That begs the question why citizens in countries such as Switzerland and Germany support fiscal discipline, while citizens in countries such as Japan and the U.S. have abandoned it (Merrifield and Poulson 2018).


Feld and Kirchgassner (2001, 2006) and Blankert (2000, 2011, 2015) explore the effectiveness of Swiss debt brakes. Blankert (2000, 2011, 2015) provides a nuanced explanation for Swiss citizen’s support for fiscal discipline using the concept of dynamic credence capital. The path chosen by Switzerland can be traced to a crucial court decision in 1998. In that year, the municipality of Leukerbad could not service its debt, and turned to the canton of Wallis for a bailout. The court ruled that the canton was not liable for the debt incurred by the municipality; leaving Credit Suisse First Boston and other creditors to absorb the loss.



Blankert argues that this ‘no-bailout’ rule has been the basis for the success of fiscal rules in constraining debt at all levels of government in Switzerland. Each level of government perceives that they are autonomous and independent in their fiscal affairs, and cannot depend on other governments to bail them out. To avoid default on their debt municipal and cantonal governments enacted ‘debt brakes’, fiscal rules limiting the ability of elected officials to spend and incur debt. A “debt brake’ was then enacted at the federal level through a referendum with overwhelming support from Swiss citizens. Blankert maintains that the fiscal discipline imposed by these ‘debt brakes’ has resulted in growing dynamic credence capital; over time Swiss citizens have gained greater confidence in the ability of their elected officials to pursue prudent fiscal policies within the framework of these fiscal rules.


Debrun and Jonung (2019), and Merrifield and Poulson (2016b, 2017a, 2018, 2020b) explore whether the fiscal rules enacted in Switzerland and other European nations are relevant for the U.S. Throughout most of U.S. history, governments operated with a ‘no-bailout’ rule. State as well as municipal governments went bankrupt in the 19th and early 20th centuries. The last state to declare bankruptcy was Arkansas during the Great Depression. In response to the fiscal stress experienced during the Great Depression Congress enact new federal laws providing for municipal bankruptcy. But no provisions were made for state bankruptcy, the federal government abandoned the unwritten ‘no-bailout’ rule for state governments. In periods of recession, the federal government now responds to fiscal stress providing state governments with funds to offset revenue shortfalls, and states then use this bailout money to rescue municipal and other local governments.


With the collapse of financial markets in 2008 the federal government introduced a new method for bailing out state and local governments. The federal government subsidized debt issued by state governments as Build America Bonds (BABs). States issuing these bonds received a direct federal subsidy of 35% of the interest cost, and more importantly what in effect was federal guarantees of these bonds. With this federal bailout money, state and local governments continued to expand their borrowing during that recession (Merrifield and Poulson 2018).





The federal government has responded to the coronavirus pandemic in 2020 with a more ambitious bailout of state and local governments (Wall Street Journal 2020d, A3). The initial coronavirus rescue package included billions in direct aid to state and local governments. The most recent rescue package includes massive aid for state and local government; a House measure proposes $3 trillion in aid, with $1 trillion earmarked for state and local governments.


For the first time, the Federal Reserve has been authorized to purchase state and local debt, with backing from the U.S. Treasury. Congress allocated $454 billion for the Treasury to offset losses in Fed lending programs, with $35 billion earmarked to backstop municipal debt. With these measures the federal government has eliminated the no-bailout rule for local as well as state government.


The federal government bailout of state and local governments has resulted in significant distortion and misallocation of capital markets. Over the past decade there has been little change in the bond ratings of the states. With the exception of Illinois, all states receive investment grade ratings for their bonds. Despite wide variations in total debt, and especially in unfunded liabilities in pension and OPEB plans, the states are able to issue debt at low interest rates, reflecting the investment grade rating. In recent years, with the Fed pushing the federal funds rate toward 0, state and local governments are able to issue debt at all-time low interest rates (Merrifield and Poulson 2020b).


The federal bailout of state and local governments creates all the wrong incentives. Elected officials have little incentive to enact effective fiscal rules or pursue prudent fiscal policies. Special interest have more incentive to engage in rent seeking to capture the benefits of these bailouts. Lenders do not have the incentive to practice due diligence in assessing the creditworthiness of these governments, anticipating that in periods of fiscal stress they will be bailed out by the federal government. Bond rating agencies have no incentive to distinguish between debt issues of different state governments because it is all guaranteed by the federal government.


The U.S. is experiencing deterioration in dynamic credence capital (Merrifield and Poulson 2018, 2020c). In each recession the federal




government incurs more debt to bail out the states, and each state issues more debt to bail out local governments. The absence of a ‘no bailout’ rule means that there is little incentive for elected officials to practice fiscal discipline. With the erosion of fiscal rules imposing fiscal discipline citizens have lost confidence in the ability of elected officials to pursue prudent fiscal policies.


The coronavirus pandemic has exacerbated a deep division between citizens in the states (Merrifield and Poulson 2020b, 2020c). Support for federal bailouts comes primarily from citizens in high debtor states, that have a high percentage of urban populations, and that stand to capture most of the rent from federal bailouts. Citizens in low debtor states, have a low percentage of the population in urban areas, and therefore do not capture as much rent from the federal bailouts. Citizens in states such as Utah that balance their budgets and limit debt are challenging the federal bailout of high debtor states. Citizens in Salt Lake City are asking the obvious questions about this bailout money. Why should their federal tax dollars be used to bailout elected officials in Illinois who have failed to balance their budget and where debt is growing at an unsustainable rate. Public employees in Utah, where reforms have significantly reduced unfunded liabilities in pension and OPEB plans are asking why their federal tax dollars are used to prop up pension and OPEB plans in Illinois with unfunded liabilities that cannot be paid off within a 30 year amortization period. When the federal government addressed similar problems in Puerto Rico it enacted legislation mandating that Puerto Rico declare bankruptcy in order to restructure its debt. If bankruptcy is the solution for Puerto Rico, why is it not the solution for unsustainable debt in Illinois and other high debtor states?


The U.S. at a Crossroad


In 2020 the U.S. has virtually abandoned rules based monetary and fiscal policy. The discretionary monetary and fiscal policies pursued in response to the coronavirus pandemic are unprecedented. The question is how to restore rules based monetary and fiscal policy when the economy has recovered from the pandemic.


There are now two competing approaches in addressing the debt crisis in the U.S. Debrun and Jonung argue that the U.S. should return to the



Fiscal Taylor Rules (FTR) that proved to be effective during the ‘Great Moderation’ of the 1980s and 1990s. These are referred to as indicative fiscal rules because they simply set benchmarks or objectives against which to measure the effectiveness of fiscal policies. This approach does not rely on formal fiscal rules or objectives that require sanctions and enforceability when the objectives are not met.


Debrun and Jonung maintain that this indicative fiscal rule approach is a more viable alternative than the formal fiscal rules enacted in many countries in recent decades. The fact that most countries have evaded or abandoned formal fiscal rules suggests that lack of enforceability is undermining the credibility and public support for rules based fiscal policy. They conclude that indicative fiscal rules, such as FTRs, combined with institutional reforms to provide greater transparency and accountability may be the only viable way to restore rules based fiscal policy in the long run. Further they argue that institutional innovations such as Fiscal Responsibility Councils may be required to boost reputational effects as well as provide for greater transparency and accountability.


There are several reasons why this indicative fiscal rules approach may fail in addressing the debt crisis in the U.S. The FTR rules that were effective in the 1980s and 1990s may prove to be ineffective in the 21st century. During the Great Moderation the U.S. experienced high rates of economic growth, with modest recessions.


Debt fatigue has put the U.S. on an unsustainable debt trajectory. Over the past two decades major economic shock have left the country with a greater debt burden, and with a greatly expanded role for the federal government in the economy. The economic impact of the coronavirus pandemic has been comparable to a war time economy; in responding to this recession the federal government has incurred unprecedented amounts of debt, and has all but abandoned rules based fiscal and monetary policy.


The long term forecast by the CBO is for a continuation of these trends over the next three decades. The federal government will account for a greatly expanded share of GDP, and much of this expanded role for the federal government will be financed by debt.




The literature on debt tolerance suggests that debt in the U.S. has increased to levels that negatively impact economic growth. For example, a study by the Bank for International Settlements (BIS, 2011) finds that


“At moderate levels, debt improves welfare and economic growth. But high levels are damaging”.


The BIS study found that when government debt exceeds 85% of GDP economic growth slows. The report also found that beyond this threshold a country is less able to respond to economic shocks.


The CBO (2020f) forecasts that higher debt levels in coming decades will be accompanied by retardation and stagnation in economic growth. Potential output is now growing at a significantly lower rate than it did during the ‘Great Moderation’. This means that even when the gap between actual output and potential output is reduced, the economy will grow more slowly than it did two decades ago. The climacteric in economic growth is making it more difficult to bend the debt/GDP curve downward.


From an historical perspective, the CBO long term forecast appears to be very optimistic. The CBO assumes that over the next three decades the U.S. will not experience a major recession. The CBO does assume that actual output will fall somewhat short of potential output over the forecast period, but that is not the same as assuming a major recession. In recent decades, after each major recession the U.S. has recovered more slowly, with long periods when actual output was significantly below potential output. Each major recession has left the federal government with higher debt levels and with less fiscal space to pursue countercyclical fiscal policy.


We conclude that the pursuit of indicative fiscal rules will fail in the U.S. for the same reason that they have failed in Japan. For three decades Japan has set benchmarks for inflation that it has failed to achieve. Inflation rates have remained stubbornly well below the 2% target rate over most of this period. Japan has also experienced retardation in the rate of growth in output and employment. Japan has failed to achieve benchmarks despite aggressive monetary and fiscal policies .The Bank of Japan has kept interest rates at or below 0%. The



Japanese government has pursued a series of fiscal stimulus packages over these years, with the Bank of Japan monetizing the debt. The outcome is the highest debt/GDP ratio among advanced economies.


The combination of debt fatigue and retardation in economic growth in Japan is the most likely path for the U.S. under current law. The question for the U.S. is whether there is an alternative path to the one projected in CBO long term forecasts, and if so how can citizens choose this alternative path. The experience in Switzerland and other European countries reveals that there is an alternative path, and that citizens in a democratic society are capable of choosing that path. In the remainder of the paper we explore both questions. The following section explores the potential impact of Swiss style fiscal rules on the budget and the economy over the next three decades. The dynamic simulation analysis reveals that with these fiscal rules in place it is possible for the U.S. to stabilize and reduce debt to sustainable levels over the forecast period. With these fiscal rules in place downsizing the federal government, the U.S. can restore long term economic growth. The empirical analysis also reveals how difficult this challenge will be, and why the U.S. is likely to continue to experience debt fatigue. The final section explores issues of political economy in enacting Swiss style fiscal rules in the U.S.


Designing New Fiscal Rules


The IMF and Second generation Fiscal Rules


There has been a dramatic increase in the number of countries enacting new fiscal rules. In 1990, only a handful of countries had enacted the new fiscal rules; by 2015 92 countries had the new rules in place (Budina et al 2012; Lledo et al 2017).


There is an extensive literature on the design of fiscal rules, and no other organization has been more influential in analyzing fiscal rules than the IMF.7 During the 2008 financial crisis many countries


  • For surveys of fiscal rules see Ayuso Casals 2012; Buduna et al 2012; Cordes et al 2015; Fall and Fourier 2015; Fall et al 2015; Casselli et al 2018; Debrun et al 2008; Eyraud et al 2018; Alesina and Drazen 1991; Persson and Tabelini 2000; Von Hagen 1991; Von Hagen and Harden 1995; Kopits and Syzmanski 1998; Kopits 2001; Kumar et al 2009; International Monetary Fund (IMF) 2009, 2015, 2018a, 2018b,



circumvented or abandoned their fiscal rules. However, following the financial crisis some of these countries enacted refinements in their rules to make them more effective in constraining fiscal policy. The IMF refers to these as second generation fiscal rules. The IMF maintains that there is now a consensus based on this experience that is the basis for optimal design of fiscal rules. In addition to its extensive research, the IMF has codified this optimal design in two publications “How to Select Fiscal Rules”, and How to Calibrate Fiscal Rules: A Primer” (International Monetary Fund, 2018a, 2018b).


IMF studies use econometric models to measure the impact of fiscal rules on budgets and aggregate economic activity. The econometric models are used to simulate the impact of economic shocks. The simulation analysis incorporates fiscal multipliers designed to capture the impact of fiscal policies in the short run. The assumption is that fiscal rules impose a tighter fiscal stance that has a negative impact on output in the short run.


There are two basic problems with the IMF methodology for analyzing the impact of fiscal rules. The assumption of Keynesian fiscal multipliers is challenged in recent studies (Taylor 2009, 2010, 2014; and Cogan et al2013a, 2013b). With Keynesian multipliers the IMF studies simulate a negative impact on output when fiscal rules impose a tighter fiscal stance. If the Keynesian assumptions are faulty then this assumption should not be the basis for fiscal rule design. This controversy has focused on the impact of fiscal rules and fiscal policy over the business cycle, but we must also question this assumption in designing fiscal rules for long term fiscal sustainability.


The second problem with IMF methodology is static scoring in measuring the impact of fiscal rules and fiscal policy. As the IMF notes, their approach may miss valuable information on how the economy would behave over a forecast period. In particular, using IMF methodology “there is no feedback from fiscal policy changes to macroeconomic variables, in particular GDP”. The IMF notes that their


2018c, 2018d, 2018e; Schick 2010; Schaechter et al 2012; and Wyploz 2005, 2012,






analysis assumes that growth is constant over the long run, but “in reality growth and the interest-growth differential vary with the level of debt” (IMF 2018, 2010, 2013c).


The IMF surveys alternative methodologies in measuring the impact of fiscal rules and fiscal policies on aggregate economic activity (IMF 2018a, 2018b). An alternative to Keynesian modeling are political economy models first introduced in the work of Alesina and Tabellini (1990a). That study was the first to find evidence that fiscal consolidation policies could have a positive impact on economic growth in the long term. Several features of these political economy models capture the supply side effects of fiscal policies. The models capture the feedback from fiscal policy changes on macroeconomic variables, most importantly GDP. Fiscal consolidation policies that constrain the growth of government spending are accompanied by higher rates of economic growth, which over a long period of time results in significantly higher levels of GDP. In contrast to the Keynesian models, the political economy models utilize dynamic scoring rather than static scoring to capture these feedback effects.




A Political Economy Model for the U.S.



In this study, a political economy model is designed to measure the impact of fiscal rules and fiscal policy on budgets and aggregate economic activity in the U.S. The study uses scenario analysis first introduced by Debrun et al (2008) to simulate the impact of fiscal rules in Israel, and then expanded in other IMF studies (IMF 2009). Scenario analysis is forward looking in simulating the impact of fiscal rules over a forecasting horizon. The simulated outcome with fiscal rules is compared to a baseline, which in the IMF studies is the World Economic Outlook. In this study the baseline used for comparative purposes is the CBO Long Term Budget Outlook. Debt dynamics are compared with and without new fiscal rules and fiscal policies in place.


In contrast to IMF studies this analysis uses dynamic rather than static scoring to capture feedback effects on macroeconomic variables. The




dynamic simulation analysis assumes an opportunity cost when resources are shifted from the private to the public sector. Fiscal consolidation policies that constrain the growth of government spending are accompanied by higher rates of economic growth. The dynamic simulation model also captures the supply side effects of changes in taxes in the long term. The feedback effects of changes in fiscal rules and fiscal policies that result in fiscal consolidation is captured in this dynamic simulation analysis. A combination of fiscal rules and fiscal policies that downsizes the federal government and boosts economic growth is most likely to achieve sustainable debt in the long term. As Alesina and Tabelllini (1990a) argue, fiscal consolidation may or may not negatively impact output in the short run, but the primary objective of fiscal consolidation policies is achieving sustainable debt levels in the long term.


A fundamental tradeoff is that between commitment and flexibility in rule design. Rules may commit elected officials to follow a constrained fiscal policy in order to achieve a specific target, such as a spending limit or revenue limit designed to achieve a desired debt or deficit target. But the more stringent the rule the, less flexibility elected officials have in responding to economic shocks from recessions or emergencies.8 The fiscal rules that we propose, the Merrifield-Poulson (MP) rules, incorporate features that are viewed as optimal from the standpoint of fiscal rules design (Merrifield and Poulson 2014, 2016a, 2016b, 2016c, 2017a, 2017b, 2018, 2020).


The theoretical and empirical literature on second generation fiscal rules supports a hybrid approach to rule design. In a hybrid approach, a threshold is set for target levels of debt/GDP and deficit/GDP that trigger fiscal policy responses. The optimal target thresholds must be tight enough to achieve a sustainable fiscal policy, but not so tight that policy makers cannot respond to economic shocks. This hybrid approach can resolve the tradeoff between commitment and flexibility in fiscal rule design.





  • For a discussion of this tradeoff see Azzimonti et al 2016; Halac and Yared 2014, 2016, 2017, 2018a, 2018b; Amador et al 2006; and Yared 2018.



The Merrifield/Poulson (MP) Fiscal Rules


We propose second generation fiscal rules for the U.S. A detailed description of the proposed Merrifield/Poulson (MP) rules is provided in the Appendix, the following summarizes the main features of the rules.


Flexibility is introduced in our proposed (MP) rules in a number of ways. For example, if the policy instrument is an expenditure limit, elected officials have discretion in determining how stringently to apply the limit. In the long term, a spending limit is gradually increased to meet the increased demand for government services, such as pension and health benefits for an aging population. Elected officials can set a spending limit multiplier set at unity in the medium term, and then adjust the multiplier upward in the long term.


Flexibility is also introduced in the form of debt and deficit brakes. Debt and deficit brakes are designed to give elected officials flexibility in constraining fiscal policy in the medium term. When debt and deficits reach threshold levels this triggers debt and deficit brakes that impose a more stringent spending limit. The debt and deficit brakes provide flexibility to elected officials in the form of multipliers. A multiplier set at unity would apply a debt brake or deficit brake gradually at threshold levels. A multiplier greater than unity would apply the debt brake and deficit brake more stringently above the threshold levels.


Our proposed deficit/debt brake is complemented by other fiscal rules. An emergency fund provides for emergencies such as natural disasters and military conflict.9 The MP rules allow for deficits in the emergency fund in periods of financial crisis and recession (International Monetary Fund 2017, 2018a). The MP rules address countercyclical government services demand growth with a higher spending cap equal to half the amount of revenue declines. However, like the Swiss debt brake, these deficits in the emergency fund must be offset by surpluses in the primary budget in the near term. As in the Swiss case, deficits in



  • One of the reasons for the success of fiscal rules in other OECD countries is the provision for emergency funds and escape clauses (Halac and Yared 2016; Coate and Milton 2017; Lledo et al 2017).



the emergency fund must be balanced by surpluses within a fixed time frame. The emergency fund is similar to the notional account used in Switzerland to achieve budget balance in the near term. The rules constraining the emergency fund could be suspended in the case of a war (Blanchard et al 2010; Delong and Summers 2012).


Some countries have enacted fiscal rules with a ‘golden rule’ that exempts government capital expenditures from the spending limits (Bassetto and Sargent 2006). We propose a version of the golden rule that would retain the integrity of the fiscal rule. Investment spending spurs economic growth, so some countries exempt it from spending caps, and also allow debt financing. But even with a clear formal definition of investment, an exemption creates a loophole we want to avoid. So, the MP rule creates regular saving to fund investment beyond what the ex-ante fiscal limits allow.


The capital investment fund proposed in the MP rules is patterned after the Swiss model (Geier 2011; Andersen 2013; Bodmer 2006; Beljean and Geier 2013). The capital investment fund is designed to fund infrastructure investments. In periods when economic growth is above the long- term average rate of economic growth a portion of revenue is set aside in the capital investment fund. In periods of slower economic growth money is transferred from the capital fund to help finance infrastructure investments. This method of allocating the capital funds based on the rate of economic growth assures a steady growth in infrastructure investment in the long run.


Our deficit/debt brake is designed for the unique institutions in the U.S. economy. The proposed fiscal rules are simulated for the U.S. over the forecast period 2019-2042, based on parameters unique to the U.S. economy over this time period.


It is important to contrast the proposed MP fiscal rules, with other fiscal rules proposed for the U.S. We propose a combination of interrelated fiscal rules designed to achieve multiple targets, including a deficit/GDP ratio, and a debt/GDP ratio. The long-term goal is a sustainable debt/GDP ratio. Once a sustainable debt level is reached the proposed rules approximate a cyclically balanced budget, with surpluses in periods of economic expansion offsetting deficits in periods of economic contraction.





The flaw in current U.S. fiscal policy is the failure to set long term goals and to incorporate those goals in the budget process. Some have argued that it is unrealistic to set long term goals and impose fiscal rules to achieve those goals. They argue that Congress already struggles with short term budgets, and that Congress is not able to hold to long term goals. But this is an argument for continuing a budget process relying on discretionary fiscal policies that created the debt crisis. Continuing to muddle along with current discretionary fiscal policies is no longer a viable option in the long run.


Critics will argue that such a complex set of rules will be difficult to enact and to implement. We simulate the proposed fiscal rules to show how they can be implemented to achieve the multiple targets. We maintain that a combination of fiscal rules is a prerequisite for fiscal stabilization in the U.S. over the long term.



A Dynamic Simulation of the Model


We used dynamic simulation analysis to measure the impact of the proposed rules on the budget and on the U.S. economy over the forecast period 2019-2042.10 The simulation results provide insight into the role that fiscal rules can play in achieving debt sustainability.11


We use the national income accounting methodology adopted by the OECD.12 Our GDP, personal Income, population, inflation, and fiscal data are from standard sources, including the Congressional Budget Office, Office of Management and Budget, Department of Commerce, and Department of Labor. The National Bureau of Economic Research produced our income elasticity of federal revenue data. Lacking an official source for ‘emergency spending’ and inability to cobble together reliably complete annual emergency spending estimates from separate sources, we estimated emergency spending data, as the TARP revenue-adjusted difference between the planned deficit, or surplus,


  • The dynamic simulation model and the simulation analysis are discussed in detail at the web site, and in (Merrifield and Poulson 2017a).


  • A similar methodology is used in Geier 2012)


  • For a discussion of this methodology see Organization for Economic Cooperation


and Development 2013.



and the typically much larger change in the national debt. Simulation

results and sensitivity analysis of the major parameters on the model


are available at the web site



The design of fiscal rules must take into account the unique fiscal institutions of each country, and that is especially true for the U.S. Budget process rules in the U.S. Congress are unlike that in any other country. The rules assume that changes in tax rates are binding over a ten year forecast period. At the end of the ten year period the tax rates are assumed to revert to the tax rates prior to this policy change. Congress can propose that the new tax rates become permanent, but the assumption is that the tax rules are non-binding on a future Congress. Some provisions of the 2017 tax law (Tax Cuts and Jobs Act) are temporary while others are permanent.13 The dynamic simulations in this study are based on the Congressional Budget Office forecast, and incorporate these assumptions.


The following discussion summarizes the results of the simulation analysis. The analysis includes two forecast scenarios. The first scenario is the long term forecast by the CBO. This CBO long term forecast is used a baseline for comparison with the alternative scenario with the MP fiscal rules in place. That simulation assumes the CBO baseline scenario combined with the fiscal rules, and measures the impact of fiscal rules on the economy over the forecast period. The coronavirus pandemic recession has an impact on economic growth over the entire forecast period. The second scenario captures the impact of this economic shock in the long term with the fiscal rules in place.




The following graphs compare the debt forecast by the CBO, with debt simulations with the fiscal rules in place. The CBO forecasts an increase in debt from $20 trillion to $71 trillion over the next two decades. As a share of GDP the CBO forecasts an increase from 98% to 151%.



  • For a discussion of how this legislation impacts the budget see Congressional Budget Office, 2017.



Figure 2. Debt


dollars 70000000
0 FY2022 FY2028 FY2033 FY2039
FY2020 FY2021 FY2023 FY2024 FY2025 FY2026 FY2027 FY2029 FY2030 FY2031 FY2032 FY2034 FY2035 FY2036 FY2037 FY2038 FY2040 FY2041 FY2042
National Debt Actual National Debt MP Rules





Figure 3. Debt/Gross Domestic Product


Debt/ Gross Domestic Product
percent 150
0 FY2023 FY2030 FY2036 FY2037
FY2020 FY2021 FY2022 FY2024 FY2025 FY2026 FY2027 FY2028 FY2029 FY2031 FY2032 FY2033 FY2034 FY2035 FY2038 FY2039 FY2040 FY2041 FY2042
National Debt Actual/Gross Domestic Product Actual
National Debt Revised/Gross Domestic Product MP rules










The fiscal rules significantly reduce the growth in debt compared to the CBO forecast. With the fiscal rules in place debt increases to $57 trillion by the end of the forecast period. As a share of GDP debt increases to 132% by the end of the period.


It is important to note that the impact of the coronavirus pandemic recession makes it impossible to close the fiscal gap by the end of the period, even with the fiscal rules in place. While the trajectory of the debt/GDP ratio is downward by the end of the period, with debt at these levels the U.S. is exposed to a high risk of default over the entire period.
















In the CBO forecast deficits decrease over the next decade, and the increase significantly in the following decades. Deficits are estimated at 1.7 trillion dollars in 2021, and are projected to decrease to 1.1 trillion dollars in 20206. Deficits then increase to 4.5 trillion dollars by the end of the period. The CBO estimates deficits as a share of gross domestic product about 8% in 2021, and 10% at the end of the period.


















Figure 4. Deficit


0 FY2020 FY2021 FY2022 FY2023 FY2024 FY2025 FY2026 FY2027 FY2028 FY2029 FY2030 FY2031 FY2032 FY2033 FY2034 FY2035 FY2036 FY2037 FY2038 FY2039 FY2040 FY2041 FY2042
dollars -1000
million -3000
-5000 year
Deficit Actual Deficit MP Rules





Figure 5. Deficit/Gross Domestic Product




Deficit/Gross Domestic Product
0.00 FY2020 FY2021 FY2022 FY2023 FY2024 FY2025 FY2026 FY2027 FY2028 FY2029 FY2030 FY2031 FY2032 FY2033 FY2034 FY2035 FY2036 FY2037 FY2038 FY2039 FY2040 FY2041 FY2042
pecent -10.00
-20.00 year
Deficit Actual/ Gross Domestic Product Actual
Deficit MP rules/ Gross Domestic Product MP rules


With the fiscal rules in place deficits are reduced, but not eliminated. By the end of the period deficits are reduced to roughly $2.3 trillion, or 5% of GDP. The fiscal rules put the country on a trajectory to reduce deficits as a share of gross domestic product.


Government Spending


The following graphs compare the government spending forecast by the CBO with spending simulated with the fiscal rules in place. The CBO forecasts that discretionary spending will grow from 3 trillion dollars in 2021 to 5 trillion dollars at the end of the period. As a share of gross domestic product, discretionary spending is projected to fall from 14% to 11% over that period.


The fiscal rules in effect freeze discretionary spending at 3 trillion dollars over the period. As a share of gross domestic product, discretionary spending falls from 14% to 6%.




Figure 6. Discretionary Spending


Discretionary Spending
dollars 5000
0 FY2024 FY2025 FY2033 FY2041 FY2042
FY2020 FY2021 FY2022 FY2023 FY2026 FY2027 FY2028 FY2029 FY2030 FY2031 FY2032 FY2034 FY2035 FY2036 FY2037 FY2038 FY2039 FY2040
Discretionary Spending Actual Discretionary Spending MP rules











Figure 7. Discretionary Spending/Gross Domestic Product


Discretionary Spending/ Gross Domestic
percent 20
0 FY2021 FY2026 FY2033 FY2038
FY2020 FY2022 FY2023 FY2024 FY2025 FY2027 FY2028 FY2029 FY2030 FY2031 FY2032 FY2034 FY2035 FY2036 FY2037 FY2039 FY2040 FY2041 FY2042
Discretionary Spending Actual/Gross Domestic Product Actual
Discretionary Spending MP rules/ Gross Domestic Product MP rules







Total Spending



The CBO projects that total government spending will more than double, from 5 trillion dollars in 2021 to $13 trillion dollars at the end of the period. As a share of GDP total spending will grow from 24% in 2021 to 28%.


With the fiscal rules in place simulated total government spending grows from 6 trillion dollars in 2021 to 11 trillion dollars at the end of the period. As a share of GDP total spending falls from 27% to 23%.


The simulations reveal how difficult it will be to reduce government spending in coming decades, even with fiscal rules in place. Some have argued that government spending should be reduced relative to the private sector, by setting a cap of 20% or less on total government spending as a share of GDP. Note that simulated total government spending as a share of GDP exceeds that cap throughout out the forecast period. The impact of the coronavirus pandemic recession has




been to push that target for government spending even further out of reach.
























































Figure 8. Total Spending


Total Spending
dollars 12000
billion 6000
0 FY2024 FY2029 FY2037 FY2042
FY2020 FY2021 FY2022 FY2023 FY2025 FY2026 FY2027 FY2028 FY2030 FY2031 FY2032 FY2033 FY2034 FY2035 FY2036 FY2038 FY2039 FY2040 FY2041
Total Spending Actual Total Spending MP rules







Figure 9. Total Spending/Gross Domestic Product


Total Spending/ Gross Domestic Product
percent 25
0 FY2021 FY2026 FY2033 FY2038
FY2020 FY2022 FY2023 FY2024 FY2025 FY2027 FY2028 FY2029 FY2030 FY2031 FY2032 FY2034 FY2035 FY2036 FY2037 FY2039 FY2040 FY2041 FY2042
Total Spending Actual/Gross Domestic Product Actual
Total Spending MP rules/Gross Domestic Product MP rules


Economic Growth


The CBO forecasts that economic growth will be significantly lower over the forecast period, compared to growth over the past half century. In its most recent long term forecast the CBO projects that real potential GDP will increase at an average annual rate of 1.6 percent. The average annual rate of economic growth in the second half of the 20th century was 2.8%.


As shown in the following graphs the growth of GDP with the fiscal rules in place tracks closely the growth in GDP projected by the CBO.












































Figure 10. Gross Domestic Product


Gross Domestic Product
dollars 30000
0 FY2024 FY2029 FY2037 FY2042
FY2020 FY2021 FY2022 FY2023 FY2025 FY2026 FY2027 FY2028 FY2030 FY2031 FY2032 FY2033 FY2034 FY2035 FY2036 FY2038 FY2039 FY2040 FY2041
Gross Domestic Product Actual Gross Domestic Product MP rules





The economic shocks that the U.S has experienced in recent decades have clearly contributed to the climacteric or retardation in economic growth. As the CBO notes, actual GDP has been about half a percent below potential GDP and this is projected to continue in the long run.


During and after each economic shock actual output has fallen short of potential output to a greater extent and for longer time periods than actual output has exceeded potential output during economic booms. Retardation in economic growth is especially evident in the aftermath of the coronavirus pandemic recession.





The risk of another economic shock is not incorporated in the CBO long term forecast. If the economy experiences another economic shock comparable to the financial crisis in 2008, or the coronavirus pandemic in 2020, we should anticipate further retardation in economic growth in coming decades. The rising debt burden will make it even more difficult for the government to respond to these economic shocks.


The MP rules provide that a portion of federal revenues be earmarked for an emergency fund. With this emergency fund the government would have resources to address an economic shock, such as the financial crisis in 2008, and the coronavirus pandemic in 2019. In other words these fiscal rules would provide the federal government with more fiscal space to respond to economic shocks. Whether or not the government would have the fiscal space to avoid defaulting on the debt is an open question.



Scenario Analysis



Rules based fiscal and monetary policy is designed to close the fiscal gap and reduce debt to sustainable levels. In this scenario analysis the simulation model is used to identify policy options required to close the fiscal gap in the U.S. The following matrix reveals the impact of alternative policy options on the ratio of debt to gross domestic product in 2042. All of the scenarios assume that the MP fiscal rules are in place over the entire period. Closing the fiscal gap in the U.S. requires a debt/GDP ratio less than 100% by the end of the period. The scenarios with policy options that achieve this goal are identified in bold.















Table 1: 2042 Debt/Gross Domestic Product (Scenario Analysis)





Pct Point Annual Savings
Growth $0 $200 $400 $600 $800 $1,000
0.0 132.4% 122.3% 114.3% 106.3% 98.1% 89.3%
0.5 121.1% 113.7% 106.5% 99.1% 91.5% 83.4%
1.0 112.2% 105.4% 98.8% 92.0% 85.0% 77.5%
1.5 103.8% 97.5% 91.4% 85.1% 78.7% 71.7%
2.0 95.7% 90.0% 84.4% 78.6% 72.6% 66.1%
2.5 88.1% 82.9% 77.7% 72.3% 66.8% 60.8%





Economic Growth



The simulation analysis with the MP rules in place assumes the average annual rate of growth incorporated in the CBO long term forecast,


1.6%. Ceteris paribus, higher rates of economic growth will of course reduce the ratio of debt to gross domestic product. In this scenario analysis we assume higher rates of economic growth as shown in the first column of the matrix. Closing the fiscal gap with policies to promote economic growth would require additional growth of 2% or more, more than double the growth rate assumed in the CBO forecast.


It is not reasonable to expect the U.S. to close the fiscal gap solely through policies promoting higher rates of economic growth. This would require rates of economic growth more than double that projected in the CBO long term forecast. It would require significantly rates of growth higher than the historic average annual rates of economic growth in the U.S. extending back to the 19th and 20th centuries.


Downsizing the Federal Government




Closing the fiscal gap in the U.S. will require downsizing the federal government, and earmarking the saving to reduce the federal debt. There are two potential sources of saving of sufficient magnitude to reduce the debt and close the fiscal gap, entitlement reform, and federal asset sales. Row one of the matrix estimates the impact of different levels of savings on the ratio of debt to gross domestic product. Assuming no additional economic growth, closing the fiscal gap would require average annual savings of 800-1000 billion dollars over the forecast period.


The matrix reveals the impact of alternative scenarios combining economic growth with downsizing the federal government required to close the fiscal gap. The scenarios that close the fiscal gap are identified in bold. For example, boosting economic growth by .5% annually, and increasing annual savings by 500 billion dollars over the forecast period, would close the fiscal gap.


The CBO also explores the magnitude of savings from entitlement reform and other reforms required to close the fiscal gap. The estimates from this scenario analysis are in general consistent with the CBO estimates. The CBO also emphasizes what a formidable challenge it would be to generate savings from these reforms required to close the fiscal gap.


In the current political climate it is highly unlikely that the federal government would enact the reforms required to close the fiscal gap. The last time that the federal government generated significant savings from entitlement reform was during the Reagan administration. Neither political party now supports reform of entitlement programs sufficient to generate annual savings of 500 billion dollars.


There is a precedent for generating savings of this magnitude through federal asset sales and leasing in the 18th and 19th centuries. Massive amounts of land and other resources were transferred from the federal government to the private domain. But the closing of the frontier in the late 19th century ended this era of privatization. There has been some privatization of federal assets under recent administrations, but these policies generated modest savings, and the savings were not earmarked to reduce debt.




The Japan Disease



The scenario analysis reveals how challenging it will be for the U.S. to close the fiscal gap. Enacting the MP rules combined with policies to promote higher rates of economic growth and downsizing of the federal government could close the fiscal gap, but these policy reforms do not appear to be feasible in the current political climate.


The most likely scenario is for the U.S. to continue to experience debt fatigue over the next few decades. This is the scenario forecast by the CBO under current law. The explanation for debt fatigue in the U.S. is that suggested by Xavier Debrun, “Lack of domestic support for fiscal discipline, which leads to destabilizing budget cycles when fiscal fatigue sets in.” (Debrun et. al. 2018:16).


We refer to this scenario as the ‘Japan disease’. Japan has experienced debt fatigue for three decades, accruing one of the highest debt/GDP ratios ever recorded. Each economic shock in this period has been accompanied by a sharp increase in the debt/GDP ratio. The Japanese government responded to these economic shocks with a series of fiscal stimulus packages. The Bank of Japan monetized this debt, and with fiscal dominance is now required to keep interest rates at or below 0%. Over most of this period Japan has failed to achieve the benchmarks set for fiscal and monetary policy. Inflation rates have remained stubbornly below the target rate. Japan has experienced retardation and stagnation in the rate of growth in output and employment, and is projected to continue to experience debt fatigue in coming decades.




There is clearly an alternative path for the U.S. to pursue that would restore sustainable levels of debt. Following the precedent set in European countries, the U.S. could enact effective fiscal rules to constrain the growth in government spending, and reduce deficits in the long term. However, the simulation analysis reveals that after two decades of debt fatigue in response to major economic shocks, this will be a formidable task indeed.





Imposing effective fiscal rules would require a major downsizing of the federal government compared to that forecast by the CBO. Discretionary spending would have to be frozen at current levels. Total federal spending would have to be reduced far below that forecast by the CBO. This would require fundamental reforms to constrain the cost of entitlement programs, which are the major source of increased federal spending.


This simulation of fiscal rules for the U.S. will surely disappoint those searching for a solution to the debt crisis in the near term. Even with these stringent fiscal rules, the U.S. cannot achieve sustainable debt levels within the next two decades. The goal of downsizing the federal government relative to the private economy, and closing the fiscal gap, could not be achieved until the second half of the 21st century. Given the debt fatigue that has occurred over the past two decades, the U.S. is not likely to pursue this difficult alternative path.


Deterioration in dynamic credence capital in the U.S. means that the most likely scenario is that forecast by the CBO. The federal government will continue to expand relative to the private sector, with much of the growth in government spending financed by borrowing. By mid-21st century, federal debt in the U.S. will increase relative to GDP to levels comparable to that in Japan.


Over the next few decades the increase in federal debt burdens in the U.S. will expose the country to increased risk of debt default, especially if the country experiences another major economic shock. The U.S. will not likely default on federal debt in the near term, the most likely outcome is that the U.S. will continue along the current path, with more debt fatigue and continued retardation in economic growth.


However, in the long term there is another outcome suggested by the climacteric in economic growth experienced by the U.S. in the early


20th century. The major economic shocks of that era culminated in the decade long Great Depression, in which virtually every country devalued their currency, and many countries defaulted on their debt. Such a collapse of the international economy is increasingly possible as





more countries experience debt fatigue and retardation in economic growth.



























































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Feld, L., and G. Kirchgassner, 2006, “On the Effectiveness of Debt Brakes: The Swiss Experience”, Center for Research in Economics Management and the Arts, Working Paper No. 2006-21.


International Monetary Fund, 2013, Staff Guidance Note for Public Debt Sustainability Analysis in Market-Access Countries, May.


Merrifield, J., and B. Poulson, 2016a, Can the Debt Growth be Stopped? Rules Based Policy Options for Addressing the Federal Fiscal Crisis, (New York, NY: Lexington Books).


Merrifield, J., and B. Poulson, 2016b, “The Swedish and Swiss Fiscal Rule Outcomes Contain Key Lessons for the U.S.,” Independent Review, Vol. 21, No. 2, pp. 251–275.


Merrifield, J., and B. Poulson, 2016c, “Stopping the National Debt Spiral: A Better Rules for Solving the Federal Fiscal Crisis,” Policy Brief, The Heartland Institute.


Merrifield, J., and B. Poulson, 2017a, “New Constitutional Debt Brakes for Euroland Revisited,” Journal of Applied Business and Economics, Vol. 19, Issue 8, pp. 110–132.


Merrifield J., and B. Poulson, 2017b, Restoring America’s Fiscal Constitution, (New York, NY: Lexington Books, 2017b).


Merrifield, J., and B. Poulson, 2018, “Fiscal Federalism and Dynamic Credence Capital in the U.S.”, ERN Institutional and Transition Economics Policy and Paper Series, Vol.10 No. 16. November 28.


Merrifield J. and B. Poulson, 2020a, Perspectives on the Federal Debt Crisis, Cato Institute, forthcoming




Merrifield J. and B. Poulson, 2020b, “How to Solve America’s Debt Crisis in the Wake of the Coronavirus Pandemic”, Heartland Institute, Policy Brief, April.


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Appendix: The Dynamic Simulation Model


This appendix summarizes the main components of the dynamic simulation model (more detailed equations are available at the web site


The central element of the MP rules is an ex ante cap on discretionary spending growth. The two best approximations of a general basis for increased demand for discretionary federal spending are personal income growth and population plus inflation. Since our studies of state fiscal stress indicated that personal income growth is too volatile a basis for capping spending growth, the MP rules cap spending growth at a multiple of the sum of population growth and inflation.


A discretionary spending limit (DSP) rises, annually, at a multiple of population growth plus inflation (AFAF) unless the




proximity of the deficit or debt to the MP rules’ designated deficit and debt threshold levels triggers braking. Countercyclical supplementary spending occurs when revenue declines from one year to the next.


DSPt = IF((1 + ((1 – DEBTBADJt – DEFBADJt) x AFAFt)) > 1, ((DSPt-1 – CCYCSPt-1) x (1 + ((1 – DEBTBADJt – DEFBADJt)


  • AFAFt))) + CCYCSPt, DSPt-1)



Where: DSP = Simulation-revised discretionary spending AFAF = Allowed Fiscal Adjustment Factor,



CCYCSP = Countercyclical General Fund



DEBTBADJ = Debt Brake-based Adjustment of







Where: DEBTGDP = National Debt


divided by GDP

DEBTTOL = ‘Tolerance’ level


for Debt/GDP Ratio



adjustment factor/rate




(DEFGDPt-1 – (DEFTOL x 0.8))) x DEFBRATE)


Where: DEFBADJ = Deficit Brake-


based Adjustment of FAF



DEFGDP = Deficit divided by GDP


DEFTOL = ‘Tolerance’ level

for Deficit/GDP Ratio



adjustment factor/rate





The ‘0.8’ in some of the equations above is there to initiate braking, gradually, as the debt or deficit approaches the threshold levels (80% x .60=.48 for debt); (80% x .03=.024 for the deficit). The not-shown other part of the ‘IF’ in equation (1) bars spending reduction so that zero is the lowest possible growth rate; a constraint not present in each simulation. The braking criteria – capping spending growth below AFAF – are the debt and deficit measures that arise from comparing all revenue to all spending, including interest payments, entitlements, emergency fund and capital fund deposits, and countercyclical spending.



+ NEDEPt (2)


Where: RTOTSP = Simulation-revised total spending INT = Simulation-revised interest on the national



SSSP = Social Security Spending MEDSPA = Medicare Part A spending KDEP = Deposit into Investment Fund NEDEP = IF((EDEPRt x DSPt) + EBALt-1 –




CAPt – EBALt + EMERGt – EINTt, (EDEPRt x DSPt) + EINTt))


EDEPR = Cap on Emergency Fund Deposit Rate EDEPR = Emergency Fund Deposit Rate (% of

General Fund Spending)


EMERG = Emergency Fund Spending


ECAP = Emergency Fund Account Balance Cap EINT = Interest paid to/by Emergency Fund


RGDPt = ((RGDPt-1 + GDPAt – GDPAt-1) x (RMTR x


(FEDTBURDt-1 – FEDTBURDt-2))) + (OCR x (RREVt-1 – TOTSPt-1)) (3)


Where: RGDP = Simulation-revised GDP GDPA = Actual GDP


RMTR = Growth Acceleration Coefficient for Federal Tax Burden




FEDTBURD = federal tax burden, measured as revenue/GDP.


OCR = growth opportunity cost rate for diversion of


resources from private sector to public sector use.


RREV = RGFREVt + RSSMEDREVt RGFREV = Simulation-revised

General Fund Revenue



Medicare Part A

RSSMEDREV = Simulation-revised





In the sensitivity analysis we recognize that even widely-accepted parameter choices are still somewhat arbitrary. So, for the simulations that create a counterfactual to compare to CBO projections, we analyze an OLS regression-augmented, Monte Carlo sensitivity analysis of the parameter value choices (a mixture of behavioral factors and policy choices) used in the equations above. That regression yields an estimate of the average marginal effect of each parameter. Results of this sensitivity analysis are available at the web site































Debt Fatigue and the Climacteric in U.S. Economic Growth

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