It’s difficult to forget the drama—including riots, fires, and even deaths—that unfolded during Greece’s recent fiscal crisis. But what would happen if bad budget policy led to a financial crisis in the United States?
A recent report from the Congressional Budget Office (CBO) points out the economic casualties of a fiscal crisis in the US would be devastating.
- First, fiscal crises trigger significant spikes in interest rates, which devastated business investment and consumer spending alike.
- Second, such a surge in interest rates would dramatically worsen an already dismal budget picture. According to CBO, a 4 percent increase in interest rates would raise interest payments by $100 billion—a 40 percent leap above CBO’s current baseline projection. If that trend continued, net interest would reach $460 billion in the year 2015 alone.
- Third, a jump in interest rates would cause the value of existing government debt to drop precipitously, which would result in losses through mutual funds and pension funds and for other debt holders. CBO warns those losses “might be large enough to cause some financial institutions to fail.” Similar losses for banks would collapse their capital base, forcing a dramatic drop in lending.
- Finally, with the federal government cut off from credit markets, the Federal Reserve could be forced to print money to pay for ongoing deficit spending. Not only would inflation effectively make citizens poorer while the purchasing power of their earnings and savings tried to catch up, but it would increase interest rates further to reflect both the higher inflation and the resurrection of the inflation uncertainty premium in interest rates.
Unfortunately, unless America reforms its fiscal policies, it will be a question of when rather than if a crisis will ensue. As CBO notes, a government already heavily in debt and with a bleak long-term budget outlook has an increased probability of experiencing a financial crisis.
Sound familiar? In the U.S., debt currently stands at a peacetime record high of 62 percent of the gross domestic product (GDP). By 2020 debt will reach nearly 90 percent of GDP, and the International Monetary Fund has recently pointed out that the U.S. long-term debt situation is one of the world’s worst.
The easiest way to stop the debt from growing out of control is to stop adding to it by cutting spending, particularly on entitlements. CBO calculates that stabilizing the debt-to-GDP ratio for 25 years would require an immediate spending cut equal to 5 percent of GDP. If we wait for a fiscal crisis, the level of austerity required would be even more severe—not to mention economically devastating.
This report should serve as a wake-up call about how risky a financial crisis would be for the U.S. economy.