“Federal debt and the risk of a fiscal crisis” – important takeaway

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This post is a guest contribution by Asha Bangalore, vice president and economist of The Northern Trust  Company.

Public debt of many countries has ballooned in the last three years as the financial crisis has unfolded.  In particular, U.S. government debt held by the public is entering a phase not seen since World War II (see chart 1). Chart 1 includes the latest Congressional Budget Office (CBO) estimates of federal debt as a percentage of GDP for the next decade. There are consequences to the projected elevated level of public debt not related to economic downswings and wars. In addition to the well known outcome of higher interest rates and crowding out of private investment as deficits persist, at the extreme, it could trigger a sovereign debt crisis such as the recent case of the European debt crisis.

With regard to the U.S., there is a simple question that needs an answer: Do we know what would trigger a debt crisis in the United States? The Congressional Budget Office’s recent publication, “Congressional Budget Office – Federal Debt and the Risk of a Fiscal Crisis,” answers this question. In their opinion, “the exact point at which a crisis might occur for the United Sates is unknown, in part because the ratio of federal debt to GDP is climbing into unfamiliar territory and in part because the risk of a crisis is influenced by a number o factors, including the government’s long-term budget outlook, its near term borrowing needs, and the health of the economy.”

The CBO also indicates that the “tipping point” for a crisis does not depend on debt-to-GDP ratio per se by citing the examples of Argentina (see chart 2), Ireland and Greece (see chart 3).

Including other nations, Japan’s debt-to-GDP ratio is the highest among the G-7 (see chart 4).  Spain, Italy, and Portugal (see chart 5) also belong to the club of highly indebted nations.  These charts highlight the position of the CBO which stresses the importance of long-term budget outlook, near-term borrowing needs, and health of the economy as playing a role in addition to the debt-to-GDP ratio.

The main takeaway is that markets will focus on these three aspects in evaluating the U.S. situation with the debt-to-GDP ratio.  The “safe-haven” status of the U.S. economy is a privilege to be protected.  The manner in which the aging population issues and rising health care costs are addressed holds the key to how the markets will view debt of the United Status.

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, August 23, 2010.

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