July 27, 2011
In less than a week, according to projections from the Treasury Department, the U.S. government will begin defaulting on some of its obligations unless the Congress and the President increase the statutory ceiling on federal debt. (CBO doesnt analyze the Treasurys daily cash management, so we have no independent projection of the date.) The continuing debate about alternative approaches to raising the debt ceiling is taking place against a backdrop of serious ongoing problems with the federal budget and the economy that raise the stakes for decisions about the debt ceiling and budget policy. As CBO provides objective, nonpartisan information and analysis to assist the Congress during this crucial period, I'd like to highlight some of CBOs work that bears on the various issues at hand.
To begin, the federal government has ongoing obligations under current law to pay money to various people and organizations: the holders of Treasury debt, Social Security beneficiaries, hospitals providing care through Medicare, states expecting matching payments for Medicaid, large and small firms that have provided goods or services to the federal government, federal workers, and many others. (As Ive discussed earlier, in calendar year 2010, nearly half of federal spending was in the form of transfer payments, with grants to state and local governments and purchases for defense accounting for another one-third between them; the remaining one-fifth was a combination of interest payments and purchases of nondefense goods and services.)
In response to a question in June, I said that defaulting on those obligations of the federal government would be a dangerous gamble. Heres why:
- It is difficult to know exactly what would happen if the federal government were to default on its obligations to debt holders because we have no recent experience of doing so. However, a government that owes as much as ours does, and will need to borrow as much as ours will need to borrow, cannot take the views of its creditors lightly. Even a slight increase in the perceived risk of U.S. government securities would probably raise interest payments by a lot for years to come. If Treasury rates were pushed up by just one-tenth of a percentage point, the government would pay $130 billion more in interest over the next decade (given CBOs projected path of revenues and non-interest spending under current law, as explained in our January Budget and Economic Outlook). If, instead, Treasury rates rose by four-tenths of a percentage point, the government would pay more than half-a-trillion dollars in additional interest over the next decade.
- Moreover, public statements by many financial-market participants and experts have made clear that default by the federal government on obligations to debt holders would be a significant shock to the global financial system and economy. That shock could trigger large swings in stock prices, private interest rates, and the value of the dollar relative to other currencies; it might also generate massive disruptions and damage to the payments system and the flow of credit; and it would probably weaken the economy and reduce output and employment relative to what they would otherwise be. Indeed, the lack of a plan for increasing the debt ceiling may already be hurting household and business confidence, and default would reduce confidence further and increase uncertainty about future government policies, which would lower spending even apart from the effects of changes in asset prices and interest rates.
- It is also unclear what would happen if the federal government were to default on obligations other than Treasury debt. As I said in June, debt holders might be unconcerned because the payments due to them would not be directly affected; however, debt holders might conclude instead that if the government is willing to default on some obligations, it could default on its obligation to them next. In any event, the individuals, businesses, and state governments that are owed money under current law and are counting on receiving it would clearly need to deal with sudden and unexpected shortfalls in their own finances.
The debate about the best approach to raising the debt ceiling is occurring while the country faces serious ongoing budgetary and economic problems. CBO is currently preparing its summer update to the Budget and Economic Outlook; pending further economic developments and possible changes in federal laws and policies, the budgetary and economic picture looks broadly similar to what we portrayed in our latest economic projections in January and our latest budget projections in March:
- The budget is on an unsustainable path. Debt held by the public is already higher relative to GDP than it has been in more than half-a-century, and CBO projects that it will exceed its all-time high in about a dozen years under current policies.
Putting the budget on a sustainable trajectory in the face of an aging population and rising health costs cannot be achieved by repeating policies that may have been acceptable in the past; rather, we will need to make significant changes relative to the experience of the past several decades in popular programs, peoples tax payments, or both. (For background on the difficult and unavoidable tradeoffs, see CBOs Budget and Economic Outlook and Long-Term Budget Outlook, with the key points highlighted in recent blog postings here, here, and here.)
Delaying the decisions needed to put the budget on such a trajectory poses clear dangers. Following the intensive public discussions of the past few months, a failure to agree on credible, specific policy changes would increase doubts about the ability of the government to manage its budget. That could, in turn, raise the perceived risk of U.S. government securities, which would lead to higher Treasury interest rates, higher government interest costs, and the possibility of dislocations in financial markets. On the other hand, the adoption of a credible plan for deficit reduction could reduce Treasury interest rates and raise output and income over the medium term and long term. (For discussion of the risk of a fiscal crisis, see this CBO issue brief; for analysis of the effects of deficit reduction on the economy and thereby the federal budget, see this letter that CBO published earlier this month.)
- Moreover, and with a larger immediate impact on most Americans, the economy remains mired in a severe slump.
Three-and-a-half years after the recession started, roughly 10 million fewer Americans have jobs than if employment had continued to expand at its pre-recession pace. Total output of the economy this year will be about $700 billion less than would occur with high use of our labor and capital resources. In addition, 44 percent of the workers who were unemployed in the first half of this year had been out of work for more than 26 weeksan unprecedented share in the period since World War II. CBO expects that the lingering difficulties of the long-term unemployed in finding jobs, as well as the loss in business investment during the slump, will weigh on the nations output for years to come. (CBOs recent Outlooks and Updates have discussed the lasting effects of the downturn on future output and income; for a summary of the consequences of losing a job during a recession, see this CBO issue brief.)
Addressing the nations long-term fiscal challenges during a period of economic weakness poses particularly difficult policy choices. Reductions in tax rates or increases in government spending during the next few years would probably boost economic activity and employment in the short term, but the added debt would weaken the medium-term and longer-term outlookunless such policies were accompanied by credible changes in policy that would reduce budget deficits over time. (CBO has analyzed the economic effects of alternative paths for fiscal policy in testimony to the Senate Budget Committee, last weeks letter to the Senate Budget Committee, and other reports.) Based on CBOs analysis in a report last January and a letter that followed, certain short-term tax and spending policies would probably be much more effective at spurring output and employment than others.
With the federal budget and the economy both facing such serious problems, the additional problems that would probably be caused by a default on the federal governments obligations could be especially damaging. We are on the brink of harming the budget and the economy, possibly undermining the international financial system, and doing significant damage to the credibility of legal commitments made by the U.S. government. At the same time, an increase in the debt ceiling that was accompanied by enactment of an effective plan for significantly reducing future deficits could have substantial positive effects on the budget and the economy over time.