OPINION
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March 7, 2013, 7:09 p.m. ET
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The Federal Reserve's 'Fiscal Crunch' Trap
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High debt loads and rising deficits may force the central bank to pursue inflationary policies.
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By DAVID GREENLAW, JAMES D. HAMILTON, PETER HOOPER AND FREDERIC MISHKIN
Annual budget deficits have surged past $1 trillion and, according to the International Monetary Fund, gross U.S. government debt is currently at 107% of GDP. The good news: Congressional Budget Office estimates suggest that as a result of declining deficits, the level of debt relative to GDP will stabilize over the next several years. The bad news: Debt levels will then resume a relentless climb, with the debt-to-GDP ratio exceeding 150% in 25 years, assuming that long-term interest rates do not rise above 5.2%.
There is uglier news. Research we have recently presented at the U.S. Monetary Policy Forum leads us to conclude that, as debt grows relative to GDP, rising interest rates could bring the debt-to-GDP ratio up to 176% in 25 years, and even higher under less favorable assumptions about unemployment and the current-account deficit.
The reason? Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders about fiscal sustainability lead to higher government bond rates, which in turn make debt problems more severe. Using statistical methods, case studies and a wealth of recent data on fiscal crises, we have found that countries with gross debt above 80% of GDP and persistent current-account deficits—as is currently the case in the United States—face sharply increasing risk of escalating interest payments on their debt. This means even higher budget deficits and debt levels and could lead to a fiscal crunch—a point where government bond rates shoot up and a funding crisis ensues.
A fiscal crunch would force a central bank to pursue inflationary policies, a situation that's called fiscal dominance. If the Federal Reserve does not monetize the government debt (by purchasing it or, in other words, by printing money), then interest rates will rise sharply as private lenders demand a higher rate. These higher interest rates will cause the economy to contract.
Indeed, without monetization, the government could end up defaulting on its debt, which would lead to a financial crisis, producing an even more severe economic contraction. The central bank would be forced to purchase ever increasing quantities of government debt by printing money, eventually leading to a surge in inflation.
Given the Federal Reserve's greatly expanded balance sheet, which has ballooned from less than $1 trillion at the end of 2007 to more than $3 trillion today, there is an additional factor that could exacerbate inflation expectations—Fed remittances to the U.S. Treasury. If interest rates climb higher over the next few years, this could lead to substantial losses on the Fed's holdings of Treasurys and mortgage-backed securities, losses that could approach several times the size of Fed capital. The Fed would be unable for a number of years to make its usual payments to the Treasury of interest it earns minus its realized losses on its debt holdings. This could subject the institution to a loss of credibility in financial markets and to political attacks.
The grave scenarios we outline here do not have to happen. Since the debt-to-GDP ratio is likely to stabilize over the next few years, there is time to avoid the dire potential problems we have highlighted. But with the gross-debt-to-GDP ratio already well above the 80% threshold—and likely to resume a steady climb by the end of this decade—the clock is ticking.
With sufficient political will, the U.S. government can avoid fiscal dominance and achieve long-run budget sustainability by gradually reining in spending on entitlement programs such as Medicare, Medicaid and Social Security, while increasing tax revenue by broadening the base.
A number of plans, including those put forth by members of the Simpson-Bowles Commission and the Domenici-Rivlin Task Force, have already shown the way. The political will to put the fiscal house in order has not yet been summoned—but should be the highest priority of this country's elected officials.
Mr. Greenlaw is a managing director at Morgan Stanley. Mr. Hamilton is professor of economics at the University of California, San Diego. Mr. Hooper is a managing director at Deustche Bank Securities. Mr. Mishkin is a professor at Columbia University's Graduate School of Business and a former member of the Board of Governors of the Federal Reserve.
There is uglier news. Research we have recently presented at the U.S. Monetary Policy Forum leads us to conclude that, as debt grows relative to GDP, rising interest rates could bring the debt-to-GDP ratio up to 176% in 25 years, and even higher under less favorable assumptions about unemployment and the current-account deficit.
The reason? Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders about fiscal sustainability lead to higher government bond rates, which in turn make debt problems more severe. Using statistical methods, case studies and a wealth of recent data on fiscal crises, we have found that countries with gross debt above 80% of GDP and persistent current-account deficits—as is currently the case in the United States—face sharply increasing risk of escalating interest payments on their debt. This means even higher budget deficits and debt levels and could lead to a fiscal crunch—a point where government bond rates shoot up and a funding crisis ensues.
A fiscal crunch would force a central bank to pursue inflationary policies, a situation that's called fiscal dominance. If the Federal Reserve does not monetize the government debt (by purchasing it or, in other words, by printing money), then interest rates will rise sharply as private lenders demand a higher rate. These higher interest rates will cause the economy to contract.
Indeed, without monetization, the government could end up defaulting on its debt, which would lead to a financial crisis, producing an even more severe economic contraction. The central bank would be forced to purchase ever increasing quantities of government debt by printing money, eventually leading to a surge in inflation.
Given the Federal Reserve's greatly expanded balance sheet, which has ballooned from less than $1 trillion at the end of 2007 to more than $3 trillion today, there is an additional factor that could exacerbate inflation expectations—Fed remittances to the U.S. Treasury. If interest rates climb higher over the next few years, this could lead to substantial losses on the Fed's holdings of Treasurys and mortgage-backed securities, losses that could approach several times the size of Fed capital. The Fed would be unable for a number of years to make its usual payments to the Treasury of interest it earns minus its realized losses on its debt holdings. This could subject the institution to a loss of credibility in financial markets and to political attacks.
The grave scenarios we outline here do not have to happen. Since the debt-to-GDP ratio is likely to stabilize over the next few years, there is time to avoid the dire potential problems we have highlighted. But with the gross-debt-to-GDP ratio already well above the 80% threshold—and likely to resume a steady climb by the end of this decade—the clock is ticking.
With sufficient political will, the U.S. government can avoid fiscal dominance and achieve long-run budget sustainability by gradually reining in spending on entitlement programs such as Medicare, Medicaid and Social Security, while increasing tax revenue by broadening the base.
A number of plans, including those put forth by members of the Simpson-Bowles Commission and the Domenici-Rivlin Task Force, have already shown the way. The political will to put the fiscal house in order has not yet been summoned—but should be the highest priority of this country's elected officials.
Mr. Greenlaw is a managing director at Morgan Stanley. Mr. Hamilton is professor of economics at the University of California, San Diego. Mr. Hooper is a managing director at Deustche Bank Securities. Mr. Mishkin is a professor at Columbia University's Graduate School of Business and a former member of the Board of Governors of the Federal Reserve.
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