Back in March the Congressional Budget Office published a bombshell report that got virtually no attention in media. Titled The 2021 Long-Term Budget Outlook, the report actually discusses the possibility of a U.S. debt default.
Their approach to the default scenario is not as blatant as it could be, but runs instead through the somewhat less dramatic term “fiscal crisis”. The choice of focus on “crisis” instead of “default” is intentional, of course, as the default term is basically an economic hand grenade with the pin taken out. However, the term “fiscal crisis” is only marginally less explosive, at least from an international viewpoint.
Americans generally do not understand either term, in particular when discussed in the context of sovereign debt. It is high time to change that, and the CBO report was a valiant but crude attempt at doing that. Having researched and published on fiscal crises for years, I find the CBO approach to the topic surprisingly shallow, given the wealth of literature and experience offered by both the academic and the public-policy community. Hopefully, though, this was only a very first take on the issue, with more to follow.
To the CBO’s credit, the very fact that they dare bring up the possibility of a debt default is a welcome change for the better. Despite scant interest in the matter from media, politics and think tanks, the fact that the question of a debt default is now out in the open as far as government is concerned, makes it possible for us independent analysts to make a broader outreach about it.
The report approaches the debt-default issue with care and caution. The term “default” is not mentioned at all; “fiscal crisis” gets its own section, called “Greater Risk of a Fiscal Crisis”. In this section the CBO attempts to define this term in such a way that it is comprehensible to the lay reader yet precise enough to inspire policy action. They succeed on the former but fail on the latter, one reason being – again – their lack of attention to existing literature.
High and rising federal debt increases the likelihood of a fiscal crisis. Such a crisis can occur as investors’ confidence in the U.S. government’s fiscal position erodes, undermining the value of Treasury securities and driving up interest rates on federal debt because investors would demand higher yields to purchase those securities. Concerns about the government’s fiscal position could lead to a sudden and potentially spiraling increase in people’s expectations of inflation, a large drop in the value of the dollar, or a loss of confidence in the government’s ability or commitment to repay its debt in full.
The starting point of the definition, namely the erosion of sovereign-debt investor confidence in the U.S. Treasury, is correct. The effect of confidence erosion is three-fold: first they shift demand from long-term debt to short-term debt; secondly they cease to buy more debt altogether; third, they start selling off Treasurys from their portfolios. For this reason, the signs of a looming fiscal crisis are detectible in the form of a slump in investor demand for U.S. debt, first and foremost for longer debt.
In my Tuesday updates I have tracked the rise in long-term Treasury interest rates and the simultaneous decline in rates on short-term debt. This is a classic first step toward a fiscal crisis. It does not necessarily lead to the other two steps, but it signals the distinct possibility thereof. So far, this first step appears to be the only one the market has taken, but the reason is by no means that investors have regained confidence in the market. On the contrary, it is more than likely caused by a rise in Federal Reserve purchases of U.S. debt, hinted at by the surge in money supply back in March. In other words, the central bank has concealed the first sign of a fiscal crisis, and in doing so postponed the second step.
But it has not eliminated it. The confidence-eroding circumstances on the debt market are still present.
Once the CBO has placed its finger on the starting point of a fiscal crisis, it moves on to explaining its immediate consequences. The mention of inflation is unfortunate: there is no immediate causality between fiscal crises and inflation. The only causal relationship between them is indirect and requires deficit monetization by the central bank. That can lead to an upward adjustment of inflation expectations, but it does not necessarily cause higher inflation in itself.
The real casualty for a fiscal crisis is the interest rate. It surges, often rapidly, as sovereign-debt investors turn their worries about debt default into portfolio action. This rapid and violent rise in interest rates is always disruptive for the economy, causing consumer spending and – even more so – business investments to plummet. In the Greek fiscal crisis surging interest rates and adverse fiscal policy measures caused a wipe-out of two thirds of all capital formation in the private sector.
Which brings us to the crisis response in the CBO report. Here, it becomes clear that the CBO report authors have not done their homework. They claim that policy makers – Congress and the President – “would have several options to respond to a fiscal crisis”. This is patently false: a fiscal crisis deprives policy makers of virtually all policy options, leaving them with only two: harsh fiscal austerity or debt default.
In fairness, the report does mention austerity as one “option”. They don’t use the term “austerity”, the reason being ostensibly that they are unfamiliar with it (again due to laziness on the homework front). They also mention deficit monetization as a so-called policy option, not realizing that austerity is only possible if combined with monetization. In other words, these two measures are in reality one, as evidenced by how the European Union, the European Central Bank and the International Monetary Fund responded to the fiscal crisis in several euro-zone countries a decade ago.
After having mentioned contractionary fiscal and expansionary monetary policies, they point to the the elephant in the room:
A third option would be to restructure the debt (that is, modify the contractual terms of existing obligations) so that repayment was feasible. (Restructuring the debt is generally viewed as less likely because it would undermine investors’ confidence in the government’s commitment to repay its debt in full.) Coordinating fiscal and monetary policies in times of crisis could also present significant challenges.
Again using the Greek crisis as an example – which I have written about primarily in this book from 2014 and this two-part white paper from 2018 – a debt default means that government goes to its creditors and unilaterally tells them that it will only repay a portion of what it owes them. In the Greek case the default amounted to 25 percent of the total debt.
In practice, you cannot do that without risking a complete meltdown of the market for your debt. The Greek government was able to “convince” commercial banks to take a debt haircut because the European Central Bank had made a pledge to buy up any sovereign debt that was denominated in euros, regardless of its credit status, for a prime-rate price that would protect investors from losing money. This, of course, led to a huge expansion of the euro-zone money supply and a complete elimination of the ECB’s last pretenses of monetary conservatism.
A similar default scenario in the United States would have to come with a very close coordination of Treasury and Federal Reserve policies, where the former absolves itself of part of its own debt and the latter promising to cushion the market when the market wants to dispose itself of all U.S. debt. While good in theory, this scenario is almost unimaginable from a practical viewpoint, as it could require a monetary expansion far beyond what we have seen to date.
It is unfortunate that the CBO report only scratches the surface of the debt-default issue, and that in doing so it lacks foundation in existing literature (needless to say, I am far from the only one who has written about this). That said, it is good that they have now allowed the subject out in the open. It is, in a sense, the economic equivalent of what UFO disclosure is to national defense.
As a further point to their credit, the CBO also tries to explain the difficulties in predicting when a fiscal crisis will start. They center in on the ratio of national debt to GDP as the metric that investors will use when deciding whether or not to trust the Treasury with their money:
In CBO’s assessment, the debt-to-GDP ratio has no set tipping point at which a crisis becomes likely or imminent; nor is there an identifiable set point at which interest costs as a percentage of GDP become unsustainable. Indeed, the agency cannot reliably quantify the probability that a fiscal crisis might occur. Thus, the distribution of possible outcomes that CBO considered in preparing its baseline projections does not include the potential budgetary and economic outcomes of a fiscal crisis.
They don’t need to. My book Industrial Poverty accounts in detail for those budgetary and economic outcomes, from Sweden in the 1990s through a number of countries in Europe during the Great Recession a decade ago.
It is good that the CBO recognizes the major difficulties in pinpointing the crisis trigger point. There are simply too few crises to make for a statistically relevant analysis of such trigger points. In addition, the institutional differences between the crisis-ridden countries are prohibitively large. However, experience gives us two important indicators to look out for:
- The aforementioned behavioral change among sovereign-debt investors, where they prefer short-term debt to long-term debt and then begin scaling down purchase altogether.
- The macroeconomic performance of a country: when there is no outlook predicting any meaningful growth in GDP and therefor in the tax base, while demand for tax-paid entitlements continues to grow, there is a significant risk for the crisis-triggering change in investor portfolios.
This last crisis trigger point is to some degree quantifiable, more so than the debt-to-GDP ratio. We will return to it in a separate article.