The US faces a rather easy to manage short run fiscal crisis, and very challenging long-term fiscal and growth problems. The short-term crisis is due to the rapid growth of federal debt outstanding that will soon hit the ceiling set by Congress. I have no doubt that Congress will, and should, vote to raise the ceiling. The only major uncertainty about this is whether that will be tied to presidential and congressional actions to try to reduce the long-term fiscal crisis.
That Congress will have to raise the debt limit this summer is a no-brainer since revenues are not anywhere near large enough to cover government spending. Without a boost in the ceiling, the federal government will be unable to pay its bills, including pay to federal employees. Since both Republicans and Democrats know that, and since Republicans are likely to be blamed if the ceiling is not raised and the federal government “shuts down”, congressional Republicans cannot credibly threaten not to agree to raising the ceiling. This is true even if they do not receive major concession on government spending from President Obama and congressional Democrats. Since many House Republicans oppose voting for substantial new taxes in order to gain Democratic support for spending reductions, prospects for an agreement before the debt-ceiling deadline on spending cuts and revenue increases are not good. Therefore, the best approach at present for Democrats and Republicans is to agree to an increase in the ceiling, and then afterwards try to work on a serious plan to meet the long-term spending-taxes-growth challenge.
However, contrary to much that is written, the US is not in any long-run real danger of explicitly defaulting on the federal debt, assuming debt limits are raised. If revenue is needed to pay Medicare and Medicaid expenses, purchase military equipment, pay interest on federal debt in the hands of the public, or finance other spending, the federal government can always resort in effect to printing money. To do this the government need not actually print dollar bills, for the federal government can issue enough new debt to cover its expenses that are not met by tax revenues. This is how the federal government financed its rapid increase in spending during the past several years.
If there were not enough demand by private investors and foreign governments like China for the new federal debt, the Fed would help out, to avoid explicit federal default, by buying government debt. In this way, the government could always get additional revenue to pay its bills. Of course, this approach carries major risks because banks get reserves when the government receives the “high-powered” money supplied by the Fed as it absorbs debt. Under normal economic conditions, the banks would spend most of their new reserves by extending loans to businesses and households, and by increasing their demand for assets paying higher returns than reserves do. The banks’ spending increases the money supply in the form of additional currency, demand deposits, and other highly liquid assets. In effect, the Fed would “monetize” the debt issued by the federal government to finance the government's shortfall in tax revenue.
This growth in the money supply would increase inflation in the United States, and reduce the value of the dollar in international transactions. Inflation also reduces the real, as opposed to nominal, value of the US debt in the hands of the public. In effect, the US could avoid bankruptcy and a default on its debt by inflating away some or most of the real value of its debt. The government has the power to inflate away its debt because the debt is denominated in a currency that it controls, namely dollars, as opposed to gold or another currency.
This option to use inflation to reduce the real value of its debt is not available to states like California because the Fed will not purchase their debt. Nor is it available to countries like Greece, Portugal, and Italy because their debt is denominated in Euros. These countries cannot print Euros, nor do they have unlimited capacity to issue government debt that would be bought by the European Central Bank.
However, the impact of rapid inflation on the American economy, and America’s reputation for fiscal responsibility, could be disastrous. Moreover, the government might be forced to increase the money supply, and hence inflation, at faster and faster rates in order to finance growing federal spending. So while default on government debt is not a likely prospect, avoiding the cost of growing rates of inflation does require resolution of America’s long-term fiscal situation. This is why the looming fiscal problems are a potential crisis of the first order.
The components of a solution to this crisis are clear. One major needed reform is a significant slowdown in the long-term growth of entitlements, especially Medicare and Medicaid, because entitlement growth is the main component of the long-term spending problem. A resolution of the long-term crisis also requires tax reforms that would broaden the tax base by reducing various subsidies and exemptions from the base, but would also lower marginal tax rates on most corporations and households. A broader and much flatter tax structure would raise taxes on some families and businesses, but it would bring in more revenue while causing much less harm to the economy.
What matters for the wellbeing of future generations is the long-term growth rate of the economy. The growth of the economy also determines the real burden of the debt since it is the ratio of debt to GDP that determines whether a fiscal crisis develops. In an earlier post (see “An Economic Growth and Deficit Reduction Agenda for Congress and the President”, 11/07/10) I spelled out some steps to allow America to regain its long-term growth rate of GDP of 3% per year. I hope the country can even do better than that. These steps include radically slowing the long-term growth of federal spending on entitlements, tax reform of the kind mentioned in the previous paragraph, more open immigration, especially of skilled individuals, free trade agreements, improved K-12 school systems, and a sensible and reduced regulatory structure.
All these and other reforms are feasible, but whether they will be implemented depends on whether both Republicans and Democrats put aside some of their partisan differences over spending, taxes, immigration, trade, and other policies. The present loud squabbling in Congress and by the president does not boost one’s confidence in this happening.