If the federal government had not abandoned the unwritten fiscal constitution of balanced budgets the debt could have been reduced, and perhaps eliminated over the past half century. Unfortunately the government has pursued Keynesian fiscal policies that are biased toward deficits and debt accumulation in the long term. Keynesians question whether or not the U.S. faces a fiscal crisis.
They argue that creditors, including foreign investors continue to buy U.S. debt at low interest rates compared to historical average rates. The dollar continues to dominate as the major reserve currency in international financial transactions. But with current fiscal policies the federal government will continue to incur deficits and accumulate debt at an unsustainable rate.
It is important to understand the limitations of traditional Keynesian policies in the context of the current debt crisis. Historically the country could rely on some combination of spending cuts and tax increases to close the fiscal gap. But the country is now on the horns of a dilemma that is best described as a debt trap. The draconian spending cuts and tax increases now required to close the fiscal gap would trigger retardation in economic growth, which is self-defeating. The growth inducing impact of tax cuts could generate economic growth, and increased revenues, but not by a magnitude sufficient to close the fiscal gap (Congressional Budget Office 2017).
After years of monetary stimulus, the limitations of monetary policy are also clear. Maintaining interest rates close to zero combined with quantitative easing has facilitated borrowing by the federal government, but this monetary stimulus has been accompanied by the slowest recovery from a recession in the post-World War II period. A continuation of such monetary stimulus would at some point trigger inflation similar to that experienced during the 1970s, a period of low savings and investment and retardation in economic growth. The volatility of prices in such periods of inflation creates political pressure for wage and price controls, resulting in even greater misallocation of resources (Poulson 1981).
The country now faces a debt trap in which it can no longer rely on traditional tools of fiscal policy to reduce the debt/GDP ratio below tolerance levels. The draconian increases in taxes and/or reductions in spending required to close the fiscal gap would result in economic stagnation. Escaping this debt trap will require more fundamental reforms to eliminate deficits and reverse the accumulation of debt.
To escape this debt trap we must recognize the magnitude of the task. The most recent long term forecasts by the Congressional Budget Office (2017) project that over the next 30 years debt held by the public will increase from 77% of GDP to 150% of GDP. Interest on that debt as a share of GDP will increase from 1.4% to 4% (30.5% of General Fund Revenue).
In addressing this debt crisis the country will also face new headwinds. The Congressional Budget Office (2017) projects that interest rates on the public debt will increase significantly above interest rates paid in recent years, resulting in higher costs to service the debt. The interest rate on the public debt could exceed the rate of economic growth, which is the classic definition of an unsustainable debt. The economy has recovered slowly from the Great Recession, and the Congressional Budget Office (2017) projects a continuation of this retardation in economic growth in coming decades. Finally, the Congressional Budget Office (2017) projects that expenditures for entitlement programs will increase more rapidly than national income, and will account for a significantly higher share of the federal budget.
The fiscal gap literature reveals that the longer the U.S. fails to address this debt crisis, the more difficult it will be to close the fiscal gap. The recent financial crisis revealed that high levels of debt have exposed the country to financial market instability, and reduced the capacity of the government to respond to these shocks with prudent fiscal and monetary policies. It is certainly significant that in the midst of that financial crisis credit rating agencies downgraded U.S. debt (Goldfarb 2011). We should expect that when the U.S. experiences another recession the country will be exposed to even greater financial market instability.
Failure to escape this debt trap would be catastrophic for the U.S. We should expect a flight of capital as investors sell off dollars and U.S. securities. This would lead to a collapse of financial institutions, similar to that experienced during the Great Depression. The outcome of such a financial crises would be economic stagnation, falling incomes, rising unemployment, and pervasive poverty.
Default on a scheduled debt payment would lead to the kind of financial crisis experienced in Greece, and other countries that have defaulted on their debt. Greece recently rejected the austerity measures recommended by the European Union, and continues to experience economic stagnation. Greece remains trapped by their debt burdens. When a country defaults on its debt this can lead to erosion in democratic institutions. Following default on its debt, Argentina also rejected austerity measures, and pursued dirigiste policies not seen since the Juan and Evita Peron era.
The challenge is to design and implement new fiscal rules that will allow the country to avoid bankruptcy and escape the debt trap. In this study we propose a new path for fiscal policy that requires new fiscal rules, and a new Homestead Act.