Do You Trust Congress to Act?

I want to recommend that you read a short Economic Brief, titled “Unsustainable Fiscal Policy: Implications for Monetary Policy.”  It’s written by Renee Haltom and John A. Weinberg of the Richmond Fed.  It’s a great summary of where we’re headed.  Here’s the link.

Here’s the short version of their thoughts…

Our debt has hit its highest point since WWII.  The debt held by the public is approximately 70%.  (Our total debt is approximately 100%.)

There will be huge fiscal demands in the future due to the retirement of the baby boomers.

The nonpartisan CBO has two forecasts: (A) the baseline scenario, which is their more optimistic scenario (tax revenues reach higher levels than in recent history and expenditures reach low relative levels); and (B) the alternative scenario, which the CBO thinks is more likely.  See figure 1.

If you believe that we’re going to face the alternative scenario, you believe that our debt will explode.  It would exceed 250% of GDP after 2042.  See Figure 2.

The sustainability of government finances hinges crucially on financial markets expecting that the government can and will raise adequate future surpluses given its debt.

A budget that is widely out of balance – the expected path for debt is much larger than the likely path of future surpluses – is described as unsustainable.  This reflects the expectation that financial markets will force an adjustment in fiscal policy before such debt levels could be reached.   An example of the financial markets forcing an adjustment would be if they would require higher interest rates.

We don’t know when the markets will turn on us.  But, as our debt becomes larger and the likelihood of us getting our house in order gets smaller, this event becomes more likely.

Once we get to the fiscal limit (the debt level at which point the financial markets refuse to loan further to the government), the government must either default or the central bank must take action to reduce its real debt level.

The primary way that the central bank can take action is to create surprise inflation.  In fact, it may not even take central bank action to create inflation.  If the markets start to believe that the government can’t handle its debt, the currency will become worth less.

Currently, markets appear willing to believe that the government can handle its debt.  Investors are purchasing our debt and requiring low yields.  But, we cannot be certain that the market’s view won’t change.

Of course, even inflation might not solve our problem (in a crisis).  Our debt is relatively short-term.  The result is that we would have to refinance our debt and we would do this at higher rates.  As a result, “the solution to current fiscal imbalances must ultimately come from fiscal authorities.  Making these difficult decisions in a planned manner before a crisis arises almost certainly would entail fewer costs than if the decisions were forced by financial markets or by other events.”

My Summary Thought

Apparently, the markets still believe that Congress will do the right thing.  But, the existing debt combined with our demographics mean that fixing our debt problem becomes more difficult as each day passes.  Ultimately, you have to ask yourself whether you believe that Congress can do the right thing.  Doing the “right thing” is neither simple nor is it even clear.  If you don’t believe they can, the question is when the market’s opinion will turn and we will face the market’s wrath.  That time is probably still far off…but that doesn’t give me any comfort.

Have a great week.

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