WASHINGTON (MNI) – The following is an excerpt from a Congressional
Budget Office issue brief on “Federal Debt and the Risk of Fiscal
Crisis,” published Tuesday:

How Might a Fiscal Crisis Affect the United States?

WASHINGTON (MNI) – The following is an excerpt from a Congressional
Budget Office issue brief on “Federal Debt and the Risk of Fiscal
Crisis,” published Tuesday:

How Might a Fiscal Crisis Affect the United States?

In all three of those fiscal crises in other countries, sharp
increases in interest rates on government debt forced the affected
governments to make difficult choices. The U.S. government would also
face difficult choices if interest rates on its debt spiked. For
example, a 4-percentagepoint across-the-board increase in interest rates
would raise federal interest payments next year by about $100 billion
relative to CBO’s baseline projection-a jump of more than 40 percent. As
longer-term debt matured and was refinanced at such higher rates, the
difference in the annual interest burden would mount; by 2015, if such
higher-than-anticipated rates persisted, net interest would be nearly
double the roughly $460 billion that CBO currently projects for that
year.11 Moreover, if debt grew over time relative to GDP, the effect of
a spike in interest rates would become increasingly pronounced.

A sudden increase in interest rates would also reduce the market
value of outstanding government bonds, inflicting losses on investors
who hold them. That decline could precipitate a broader financial crisis
by causing losses for mutual funds, pension funds, insurance companies,
banks, and other holders of federal debt-losses that might be large
enough to cause some financial institutions to fail.12 Foreign
investors, who owned nearly half of U.S. debt held by the public in May
2010 (or about $4.0 trillion, $1.7 trillion of which was held by Japan
and China alone), would also face substantial losses.

If a fiscal crisis occurred in the United States, policy options
for responding to it would be limited and unattractive. In particular,
the government would need to undertake some combination of three
actions: restructuring its debt (that is, seeking to modify the
contractual terms of existing obligations); pursuing inflationary
monetary policy (that is, increasing the supply of money); and adopting
an austerity program of spending cuts and tax increases.

Restructuring Debt

Governments can attempt to change the terms of their existing
debt-for example, by changing the payment schedule-but that approach
tends to be very costly for countries that try it.14 Any discussions or
actions by U.S. policymakers that raised the perceived likelihood of
that outcome would cause investors to demand higher interest rates
immediately, if they were willing to extend additional credit at all.15
Furthermore, investors would demand a large interest premium on
subsequent loans for many years.

Inflationary Monetary Policy

An alternative approach is to increase the supply of money in the
economy. But as governments create money to finance their activities or
pay creditors during fiscal crises, they raise inflation. Higher
inflation has negative consequences for the economy, especially if
inflation moves above the moderate rates seen in most developed
countries in recent years.16 Higher inflation might appear to benefit
the U.S. government financially because the value of the outstanding
debt (which is mostly fixed in dollar terms) would be lowered relative
to the size of the economy (which would increase when measured in dollar
terms).17 However, higher inflation would also increase the size of
future budget deficits.

Specifically, if inflation was 1 percentage point higher over the
next decade than the rate CBO has projected, budget deficits during
those years would be roughly $700 billion larger.18 Several factors
contribute to that estimate. Investors, after having their investments
devalued by the rise in prices in the economy, would demand higher
interest rates in the future, even if inflation was eventually reduced;
thus, as debt matured, it would be refinanced at higher rates. Indeed,
even raising the perceived likelihood of higher inflation during a
fiscal crisis would trigger immediate further increases in interest
rates. Moreover, the amounts of many government benefits rise when
prices rise, and much of the income tax system is indexed to inflation.
On balance, the increase in tax revenues resulting from higher inflation
would be more than offset by higher payments for benefit programs and
higher interest payments as the outstanding debt rolled over and ongoing
deficits required the issuance of more debt.19

Increasing Taxes and Reducing Spending Austerity programs generally
include both tax increases and spending reductions. When fiscal crises
occur during recessions, as they often do, such policy changes can
exacerbate the economic downturns-although some studies suggest that
certain types of fiscal austerity programs tend, at least in some
circumstances, to stimulate economic growth.21

The later that actions are taken to address persistent budget
imbalances, the more severe they will have to be. CBO’s long-term
projections for the federal budget indicate that an immediate, permanent
cut in spending or increase in revenues equal to about 1 percent of GDP
(relative to the policies assumed for the extended-baseline scenario) or
about 5 percent of GDP (relative to the policies assumed for the
alternative fiscal scenario) would prevent a net increase in the U.S.
debt-to-GDP ratio over the next 25 years. The latter would be equivalent
to roughly 20 percent of all of the government’s noninterest spending
this year. Actions taken later, particularly if there was a fiscal
crisis, would need to be significantly greater to achieve that same
objective. Larger and more abrupt changes in fiscal policy, such as
substantial cuts in government benefit programs, would be more difficult
for people to adjust to than smaller and more gradual changes.

11. See Congressional Budget Office, An Analysis of the President’s
Budgetary Proposals for Fiscal Year 2011 (March 2010).

12. U.S. banks, insurance companies, and mutual funds held
approximately $1 trillion worth of U.S. debt as of the first quarter
of 2010. See Department of the Treasury, Financial Management
Service, “Ownership of Federal Securities,” Treasury Bulletin
(June 2010), Table OFS-2.

13. Department of the Treasury, Major Foreign Holders of Treasury
Securities, May 2010, available at www.ustreas.gov/tic/mfh.txt.

14. See Borensztein and Panizza, The Costs of Sovereign Default.

15. See Carmen M. Reinhart, Kenneth S. Rogoff, and Miguel A.
Savastano, “Debt Intolerance,” Brookings Papers on Economic
Activity, no. 1 (2003).

16. For a discussion of the issues, see N. Gregory Mankiw,
Macroeconomics, 5th ed. (New York: Worth Publishers, 2003),
pp. 95-107.

17. Higher inflation would not enhance the U.S. government’qs ability
to redeem Treasury inflation-protected securities, which are
indexed to inflation; however, such debt constitutes only about
7 percent of publicly held U.S. debt.

18. See Congressional Budget Office, The Budget and Economic
Outlook: Fiscal Years 2010 to 2020, Appendix C.

19. Historically, the long-term effects of countries’ inflating away part
of their debt — very high borrowing costs and reduced economic
output — have been similar to the effects of explicit debt
restructurings. See Reinhart, Rogoff, and Savastano, “Debt
Intolerance”

20. There is no 20th footnote.

21. See, for example, Alberto Alesina, “Fiscal Adjustments: Lessons
from Recent History” (paper presented at a meeting of Ecofin,
Madrid, April 15, 2010); Alberto Alesina and Silvia Ardagna,
Large Changes in Fiscal Policy: Taxes Versus Spending, Working
Paper No. 15438 (Cambridge, Mass.: National Bureau of
Economic Research, October 2009); Roberto Perotti, “Fiscal
Policy in Good Times and Bad,” Quarterly Journal of Economics,
vol. 114, no. 4 (November 1999), pp. 1399-1436; and Alberto
Alesina and Silvia Ardagna, “Tales of Fiscal Adjustment,”
Economic Policy, vol. 13, no. 27 (October 1998), pp. 487-545.

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