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The loss in ‘dynamic credence capital’ in the U.S. has magnified the difficulties in solving the debt crisis. The expectation is that in a financial crisis the federal government will again suspend the fiscal rules now in place. The precedent set during the recent financial crisis is massive bailout of corporations and financial institutions. We should expect the federal government to continue the ‘silent bailout’ of state and local governments. Citizen loss of confidence in the ability of the federal government to constrain debt may now be the biggest hurdle in bringing debt below the debt tolerance level (Congressional Budget Office 2016a, 2016b).

Loss of ‘dynamic credence capital’ in the U.S. raises questions regarding the effectiveness of any fiscal rules to address the debt crisis. Clearly the fiscal rules now in place have proven to be ineffective, and are not likely to be effective in future years. But the question is whether new fiscal rules, such as those enacted in the Eurozone countries could be effective.

Critics of the debt brakes enacted in the Eurozone countries questioned whether these fiscal rules were credible solutions to their debt crises. They pointed to design flaws in the early debt brakes enacted in Germany and other countries. More importantly they questioned whether these fiscal rules could be effective without fundamental institutional reforms. Given the success that some Eurozone countries have had in using debt brakes to achieve fiscal stabilization, the critics were probably too pessimistic.

Effective implementation of the proposed new fiscal rules would require fundamental reform in institutions, and that would be quite challenging in the U.S. context. Historically, fiscal policies in the U.S. were pursued within a strong federalist system, with substantial taxation/expenditure autonomy for state and local government. Erosion of this federalist system, with growing dependence of state and local governments on the federal government, has contributed to the debt crisis. Restoring a strong federalist system by shifting taxation/expenditure control back to state and local governments is a prerequisite to the success of the proposed fiscal rules at the national level.

We conclude that debt brakes proposed for the U.S. are not credible without fundamental institutional reforms. This assessment of the credibility of proposed fiscal rules to solve the debt crisis in the U.S. absent fundamental institutional reforms may be discouraging to citizens supportive of these rules. But failure to enact these institutional reforms would expose the country to even greater risks in coming years. The heavy debt burden now imposed on U.S. citizens exposes the government to risk of default. With an effective debt brake in place the government would be better able to respond to recession, military conflict, natural disaster, terrorism, or other emergency. The government would be able to respond to a mild recession; but, if the U.S. were to experience a major recession, comparable to the recent financial crisis, it is not clear that fiscal stabilization could be achieved, even with a debt brake in place.

Today, it is much more difficult for the U.S. to enact effective fiscal rules to address the debt crisis. The U.S. is behind the learning curve in enacting fiscal rules compared to the Eurozone countries. As U.S. citizens perceive the failed attempts to enact effective fiscal rules, they lose confidence in the ability of the government to solve the debt crisis. These pessimistic expectations are rational, and they won’t be changed overnight. Because of the loss of ‘dynamic credence capital’, the U.S. will continue to pay a substantial risk premium on long term debt, compared to that for Eurozone countries with effective debt brakes and no-bailout rules.

DOWNLOAD: Summary Institutional Reform as a Prerequisite to New Fiscal Rules in the U.S.

Summary: Institutional Change as a Prerequisite to New Fiscal Rules in the U.S.

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