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What Would a Genuine Budget Crisis Look Like?

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Most Americans probably would say that we already have a budget crisis. They have heard crisis talk long and often -- like the little boy crying "wolf." They have seen stories of riots and belt-tightening from Greece and elsewhere in Europe, but those countries are far away and very different -- America is "exceptional," after all. The current dislocation in the U.S. economy -- very high unemployment and very low interest rates and inflation, not typical of budget crises -- arose in 2007, before budget deficits spiked. It is not surprising that many citizens have come to conclude that "deficits don't matter."

I am far more concerned, for three reasons. Past warnings were intended not to announce then-impending disaster, but rather to keep the country from ever straying as close to a true budget crisis as it now has. A crisis well beyond today's apparent public understanding can happen here. However, most Americans have no conception of the serious, even dire, potential consequences of a true budget and debt meltdown.

No one knows precisely what will happen if our nation continues to accumulate massive amounts of public debt, because our situation is truly unprecedented. World War II is not a valid model; then, the nation accepted extreme measures -- rationing, forced saving, income tax rates rising above 90 percent, and price controls among them -- to limit the growth of the public debt. There are no signs of such public tolerance today. Moreover, at the end of the war, demand for American products from flattened foreign nations and demobilized troops swelling our labor force were the exact opposite of today's intense trade competition and population aging. We will not "grow out of" today's debt as we did World War II's.

As to the size and the immediacy of the problem: The best measure of our budget woes -- the size of the public debt relative to our collective income (to economists, the "debt-to-GDP ratio") -- is now at a level not seen since 1953; almost triple its low point of the middle 1970s; almost double the level of ten years ago; and higher than the level that triggered the 1990 bipartisan budget summit. Moreover, it is rising by the day, much faster than at any time since World War II. By reasonable projections, the debt could reach its highest levels in history within this decade, and still be rising at a rate nearly as fast as that during World War II. Over the last 25 years, in effect, the little boy was crying "wolf" to call his neighbors' eyes to the horizon; now, the wolf is almost to the door.

America is exceptional; and our accumulated public debt is becoming exceptional as well. Our debt-to-GDP ratio is the twenty first highest of the 28 OECD-member developed countries, and the nations with larger debt -- Japan, Italy, Iceland, Greece, Belgium, Hungary, and France -- are not the best role models. The status of these nations ranges from crisis to struggling to fend off the worst. The troubles of the euro and the yen, and the peg of the Chinese renminbi to our dollar, have left the dollar to this date in the role of a safe haven, the world's reserve currency. However, continued mounting debt will shake that status, sooner or later, as some alternative investment is perceived safer. The more debt we accumulate, the greater the ultimate risk that overseas holders of dollars will panic, and the harder our nation's eventual fall.

The path to a crisis is clear enough today. Our elected policymakers continue to follow a course that is politically -- though certainly not economically or financially -- risk averse: refusing to raise taxes, and refusing to consider spending savings in Social Security, Medicare, and defense -- or to specify precise savings anywhere else in the budget. If the financial markets conclude that our two political parties will continue this game of chicken no matter how large and fast-growing the debt, the wide range of possible consequences is uniformly dire.

A new report from CED, This Way Down to a Debt Crisis, describes several alternative plausible ways in which the nation might blunder into a full-blown debt meltdown, and what the chilling consequences could be:

  • A surprise "lender's strike" -- a sudden reluctance of the financial markets to buy at a Treasury auction -- could leave the federal government on short notice unable to meet its obligations. The markets would be most likely to question the Treasury's reliability as a borrower at such a vulnerable time: on the eve of federal government refunding, interest coupon and Social Security obligations, and weeks before the next major tax payment due date. A collision with the federal government's statutory debt limit could precipitate or facilitate such a crisis. To conserve cash to pay its many creditors, the government could be forced to postpone benefit and salary payments -- even to the military -- and delay payments to small-business contractors.
  • An outright federal government default -- likely because an undersubscribed auction prevents redemption of maturing debt obligations - could gridlock the financial markets, spike interest rates across the board, and send households and small businesses to the brink of disaster. Realization that Treasury securities may not be redeemed when due would threaten the operations of all manner of financial institutions, here and abroad. The federal government could scramble to redeem and service its public debt only at the cost of public services that Americans need, and take for granted today. Any auction failure or near-failure would tarnish the reputation and standing of the United States, perhaps beyond repair.
  • The Federal Reserve could implicitly head off a public auction failure by buying Treasury securities to make the auction manageable. However, the cost of Fed intervention would be lender uncertainty and a rise in interest rates, and more-rapid inflation as well. Again, higher interest rates would especially threaten credit-dependent small businesses, and many households as well.
  • Economic growth will be hobbled if the Federal Reserve is forced to intervene, or if our elected policymakers take the minimum action necessary to muddle through the budget problem. Growth requires strong business investment, and businesses will not invest if the federal government crowds the credit markets, interest rates are high and inflation threatens. Continued large budget deficits will not crowd out only private investment; important public investment in education and transportation, for example, will be curtailed as well, as tax revenues are diverted to paying rising interest on the public debt. We saw such "stagflation" in the 1970s, and the result of frustrated aspirations for rising incomes was both anger and despair.

The nation can wait until the financial markets revolt, and then respond in a panic and rush through a weak budget agreement -- essentially at the barrel of an economic gun -- or elected policymakers from both political parties could put statesmanship and stewardship ahead of political gamesmanship. The two sides could agree not to argue over who deserves the credit, which certainly would be better than pre-scheduling an argument over who deserves the blame for an inevitable economic and financial catastrophe.

If the American people understand the stakes, surely they will demand action.