By John Merrifield and Barry Poulson
Ever since the financial crisis, elected officials have debated the efficacy of financial market stress tests. Consequently, the bank stress tests incorporated in the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 are more controversial than ever.
Despite the massive accumulation of debt at all levels of government, however, there has been little debate regarding fiscal stress tests for the federal government. Fiscal stress tests have been conducted by the Federal Reserve and by the International Monetary Fund.[i] The Federal Reserve study, using simulation analysis of fiscal policy, reveals that in a major recession the federal government could experience even greater fiscal instability than that during the recent financial crisis.
The International Monetary Fund study estimates that in a major recession the federal government’s net asset position could deteriorate by 26 percent of GDP. In short, these stress tests suggest that the greatest threat to fiscal, and financial market, stability is not weakness in the balance sheets of private financial institutions, but rather in the growing debt burden and balance sheet of the federal government.
Other developed countries have enacted fiscal rules to constrain spending and deficits, and have reduced public debt to sustainable levels. An important part of the fiscal rules enacted in these countries is the incorporation of fiscal stress tests on a continuous basis, using deficit and debt brakes.
These countries set a target level for debt consistent with a sustainable fiscal policy in the long run. Spending limits are imposed to achieve the debt targets within a reasonable time frame. Tolerance levels are set for deficits and debt that can trigger more stringent spending constraints in the short term.
In other words, the deficit and debt brakes are continuous stress tests, or guardrails, designed to keep fiscal policy from going off track. With these fiscal rules in place, countries can not only achieve debt targets in the long run, but also pursue fiscal stabilization policies in response to financial crisis and other economic shocks.
In our research we simulate similar fiscal rules to estimate their potential impact on deficits and debt in the United States over the next two decades.[ii] We find that over this period, with these fiscal rules in place, the United States could balance the budget and reduce debt to sustainable levels.
But, this would require stringent spending limits that significantly reduce the rate of growth in total spending, and virtually freeze discretionary spending. Furthermore, the United States would have to generate an additional $800 billion each year to pay down the debt. In short, there is no way that the United States could achieve a sustainable fiscal policy without fundamental reform in entitlement programs, and downsizing the federal government through privatization and assets sales with the proceeds earmarked for debt reduction.
Our simulation analysis with these rules in place estimates the impact of a minor recession on revenue and spending. This stress test reveals that the United States has the fiscal space to pursue fiscal stabilization in response to a minor recession, and still reduce debt to a sustainable level by the end of the period. However, this would require more stringent spending constraints and additional savings earmarked for debt reduction. The United States now has little fiscal space to respond to a major recession.
These stress tests reveal why the federal government has failed to address the debt crisis. Over the past half century the federal government has continuously incurred deficits, accumulating a debt that now totals more than $21 trillion. Addressing this massive public sector failure will require fundamental reform of our fiscal rules and policies. It will take decades for the federal government to balance the budget and restore a sustainable fiscal policy.
Despite this growing body of evidence from stress tests, there is little debate on the fiscal reforms required to address the crisis. The debate in Congress between Republicans and Democrats is whether to cut defense spending or domestic programs. After the failed attempt to reform entitlement programs during the George W. Bush administration, the parties no longer even debate this fundamental driver of the debt. Fiscal stress tests reveal that solving the debt crisis will require all of the above, i.e. effective constraints on all spending, including entitlement programs.
If Congress can’t even agree on a budget resolution for the next fiscal year, it is not surprising that they won’t discuss the essential reforms in fiscal rules and policies required to solve the debt crisis. Perhaps we have passed a tipping point, such that Congress is now incapable of solving the debt crisis.
John Merrifield is Professor of Economics at the University of Texas San Antonio
Barry Poulson is Emeritus Professor of Economics at the University of Colorado Boulder
[i] International Monetary Fund, Fiscal Monitor: Managing Public Wealth, October 2018pp 11-13.
[ii] John Merrifield and Barry Poulson, Restoring America’s Fiscal Constitution, Lexington Press 2018.
John Merrifield is Professor of Economics at the University of Texas San AntonioDOWNLOAD