Arguably, the true legacy of banking crises is greater public indebtedness.
That line, taken from the seminal work of economists Carmen M. Reinhart and Kenneth S. Rogoff, could not be truer of the fiscal challenges facing the U.S. as it recovers from the recent worldwide financial crisis. In This Time is Different, Reinhart and Rogoff show that government debt rises by an average of 86 percent in the three years following a banking crisis. That number is anything but far-fetched. From 2007 to 2012, U.S. debt as a share of GDP increased from 35 percent to 70 percent, at one point reaching 83.4 percent in 2009. This surge in government debt occurs as crises lead to sharp declines in tax revenue and substantial increases in government spending.
What, then, is the outlook for the U.S. as it emerges from the Great Recession saddled with greater government debt? In other words, how dangerous is its growing debt? Granted, the status of the U.S. as the world’s largest economy and issuer of the world’s reserve currency gives it the special privilege of borrowing in its own currency and at lower interest rates. Thus, debt is not as dangerous for the U.S. as it was for Asian emerging market economies of the late 1990s or Greece during the recent financial crisis. Yet the U.S. is not immune from other dangers posed by greater government debt, nor is the currency privilege of the dollar necessarily permanent. As the 2013 debt ceiling showdown evinced, greater government debt has increased the likelihood of a fiscal crisis. Moreover, higher borrowing costs could weaken long-term U.S. economic growth, leading to an eventual decline in U.S. power.
The Currency Privilege of the U.S. Dollar
Government debt is substantially less dangerous for the U.S. than for countries that cannot borrow in their own currencies. For one, if the U.S. had trouble meeting its loan obligations, it could always print money to pay off its debts. Floyd Norris of The New York Times argues that the ability of the U.S. to print dollars makes involuntary default impossible. That is, since U.S. debts are denominated in dollars, the government could always print enough money to pay off its debts, even though economists such as Reinhart and Rogoff consider such an inflationary strategy a de facto default. By contrast, countries that borrow in foreign currencies can only print money to inflate away domestic debt, not debt denominated in other currencies. Thus, these countries have much less control over their ability to meet foreign debt obligations in the event of a panic.
Korea during the Asian financial crisis is a prime example of a country for which debt, specifically foreign-denominated debt, posed a great danger. During the late 1990s, foreigners’ confidence in Asian emerging markets allowed banks and companies in countries such as Korea to finance long-term investments with short-term foreign debt. However, as Simon Johnson and James Kwak argue in 13 Bankers, reliance on foreigners “rolling over” short term loans exposed Asian countries to the vulnerability of a sudden crisis of confidence. Specifically, fears of debtors not meeting loan obligations could be self-fulfilling, as credit markets could suddenly dry up, triggering the very defaults that the markets feared. This is what the Argentine-American economist Guillermo Calvo refers to as a “sudden stop.” Thus, when anxiety about Southeast Asia spread through markets in the late 1990s, Korea and other emerging market economies suddenly could not obtain foreign financing. A crisis of confidence, fueled by credit rating downgrades on both Korean sovereign and corporate debt by Standard & Poor’s, caused the Korean won to depreciate sharply, making dollar debts nearly twice as expensive. The resulting downward spiral, in which the currency continued to fall and foreign financing became even harder to obtain, raised interest rates and led to a domestic credit collapse, harming Korean economic growth.
Due to its currency privilege, the U.S. has been able to avoid such devastating consequences of greater debt. As Reinhart and Rogoff assert, “Were the United States an emerging market, its exchange rate would have plummeted and its interest rates soared” during the Great Recession. Instead, the international response to the recent crisis was exactly the opposite. In the midst of the global financial crisis in 2007, the U.S. dollar actually appreciated and interest rates fell as international investors deemed U.S. Treasuries a relative safe haven. This is in sharp contrast to the experience of Greece, 98.2% of whose debt was denominated in euros in 2010. Unable to print money or borrow from jittery capital markets, Greece resorted to negotiating a bailout package with fellow euro-zone members and the International Monetary Fund (IMF). As Floyd Norris has also noted, some of Greece’s debt was issued under foreign law, meaning that Greece could not force foreign bondholders to accept debt restructurings. Clearly, since the U.S. is able to borrow money in its own currency and under its own laws, debt is less dangerous, though by no means harmless.
Greater Government Debt and the Threat of a Fiscal Crisis
As the 2013 government standoff demonstrated, Congress could bring a fiscal crisis upon itself if debt ceiling debates become overly politicized. The fiscal impasse in Congress tested the limits of investor confidence, as Republicans attempted to package a debt ceiling agreement with a defunding of Obama’s signature health care law. The reaction of markets to the fiscal standoff was stark, as investors shifted $1.7 trillion out of the market for short-term Treasury bills. On October 8, 2013, Treasury bills maturing in one month sold at an interest rate of 0.355 percent, triple the rate of the previous week. Normally, these rates drop as the date of repayment for a Treasury bill draws closer, since the government is less likely to default on its debt obligations. Instead, the U.S. government was paying rates higher than those of an average highly rated American company. Clearly, the higher yields on U.S. Treasuries showed that investors were losing confidence in the ability of the U.S. government to meet its short-term debt obligations. If confidence declined even further, the yields on long-term government debt could also increase; these developments could create a self-reinforcing, downward cycle in which investors, seeing higher yields, are scared away from Treasury bonds, thus increasing the chance of a fiscal crisis.
Granted, the last time Congress faced an impasse over debt limits in 2011, investors actually flocked to Treasury bonds as a safe haven. This happened despite Standard & Poor’s downgrading the U.S. from its golden AAA credit rating. However, it would be unwise to extrapolate from the 2011 experience that another credit downgrade would not bring widespread panic to the U.S. bond market. This is especially the case as the U.S. continues to post sizeable budget deficits. In its 2013 Long-Term Budget Outlook, the Congressional Budget Office (CBO) projects that the debt to GDP ratio will rise to 73 percent by the end of 2013. These figures compare with a debt to GDP ratio of around 39 percent in the several decades preceding the financial crisis. Clearly, the Great Recession has dramatically altered the fiscal position of the U.S., possibly damaging investors’ faith in U.S. Treasury bonds.
In fact, some business executives believe the U.S. came close to a fiscal crisis in 2009. Maurice R. Greenberg, honorary vice chairman of the Council on Foreign Relations and former chairman and CEO of American International Group, argues that ever-increasing amounts of government debt, expectations of the Federal Reserve’s expansionary policy ending, and an increase in inflation expectations caused the ten-year Treasury yield to increase by fifty basis points from 3.25 percent to 3.75 percent. Greenberg describes the U.S. situation in 2009 as a harbinger of Triffen’s Paradox, which asserts that the country at the center of the international monetary system becomes unsustainably burdened as other countries buy its seemingly risk-free bonds. The system ultimately breaks down with a wholesale dumping of the “safe” asset, severely damaging the “center country” with high interest rates and slow economic growth.
Greenberg says that in late 2009, Triffen’s paradox almost came true. In particular, markets were bullish about Europe’s prospects and nervous about the U.S. Prominent economists even argued that the euro would replace the U.S. dollar as the world’s reserve currency as early as 2015. With the dollar falling relative to the euro, it seemed as if faith in the U.S. dollar was quickly deteriorating. But then Europe entered its own phase of the financial crisis, diverting the trajectory of the U.S. away from a fiscal crisis, or what Greenberg calls Triffen’s endgame.
This doomsday scenario seems plausible. Using Greenberg’s logic, if another country (or union of countries, in the case of the euro-zone) possessed sufficiently liquid and stable bond markets and was in a better fiscal condition than the U.S., countries might altogether abandon the dollar, severely damaging the U.S. economy. Under such a scenario, the U.S. would no longer enjoy special currency privileges. In fact, it would have just experienced its first sudden stop and quite possibly could start borrowing (at least partially) in foreign-denominated currencies.
Granted, there are many forces preventing such as scenario from occurring. China, whose news agency recently called for the building of a “de-Americanized world,” could actually be one of the biggest losers of a run on the dollar. An estimated 60 percent of China’s $3.66 trillion in foreign reserves is dollar-denominated, meaning a shift to a new world reserve currency would impart massive losses on the country. However, if countries such as China stopped adding to their foreign reserves, the losses associated with a switch to a new reserve currency could be reduced. Thus, Triffen’s endgame is not completely far-fetched. In 13 Bankers, Johnson and Kwak also suggest that in the event of another financial crisis, the U.S. government might have to raise money in foreign currencies.
This analysis seems to imply that the true danger of debt, a full-scale fiscal crisis, only becomes manifest when other countries appear to be stronger than the center country. During worldwide financial crises, the economic slowdown of other countries (such as the EU in 2009) causes the center country’s slowdown to appear relatively less severe. Thus, the U.S. may face the biggest risk of a fiscal crisis if it experiences a domestic, or even regional, crisis, one in which other strong countries are effectively shielded from economic contractions in the U.S. One implication of this analysis is that the U.S. must improve its fiscal balance during boom years so that it can better handle the unavoidable increases in debt that Reinhart and Rogoff have shown to accompany financial crises. Another implication is that the U.S. must maintain a steady level of inflation to maintain the stability of its bond market.
Other Dangers of Increased Government Debt
While I have mainly focused on the possibility of a government debt-driven fiscal crisis, there are other dangers associated with greater federal debt. As the CBO reported in its annual budget outlook last year, greater government borrowing could crowd out private investment as the government taps a larger share of the savings potentially available for private investment. Granted, as Martin Wolf argued in a July 2012 Financial Times column, the private sector responded to the Great Recession by going into surplus; thus, it would seem that greater government borrowing might not crowd out investment, since the private sector was not investing anyway. However, the debt accumulated during the financial crisis would have lingering effects on future growth, especially as private investment rebounds; the government and private sector would then be competing for the same pool of foreign savings, raising the interest rate.
Lastly, this analysis has seemingly assumed the existence of large quantities of foreign savings. It is worth mentioning that the U.S. is currently benefitting from a global savings glut. As Martin Wolf has argued in Fixing Global Finance, the scars of the Asian financial crisis and fears of borrowing in foreign currencies have caused countries such as China to sustain strong current account positions, accumulate official reserves, and keep exchange rates down. The result has been low interest rates for debtor countries like the U.S., which are benefitting from this concentrated “savings glut.” However, these global imbalances could eventually disappear, for instance if China allowed its citizens to hold foreign assets, or if China stopped its quasi-pegging to the U.S. dollar (which economists have termed Bretton Woods II). It is clear that the worldwide savings glut has made U.S. government debt somewhat more sustainable, though these conditions may not last into the future.
Legacy of the Great Recession
The Great Recession has raised many questions about “too-big-to-fail” institutions, the coziness of Wall Street and Washington, and the rise in unemployment in the U.S., but greater government debt is arguably the true legacy of the recession. While a fiscal crisis is one of the more extreme potential outcomes of greater government debt, there are many other consequences of greater debt, such as the decline in America’s ability to respond to unexpected crises. As the CBO has argued, a lingering debt problem will make it harder for lawmakers to respond to unexpected events such as financial crises, wars, and recessions. What this suggests is a mutually reinforcing relationship between fiscal health and national power, balanced budgets and international leadership. Conversely, this suggests a downward spiral of fiscal imbalance and geopolitical decline. These are the risks confronting the U.S. as it emerges from the Great Recession saddled with higher levels of government debt.
At the same time, however, a strategy of fiscal consolidation during the financial crisis would have brought its own set of risks. As IMF chief economist Olivier Blanchard has argued in an influential paper, fiscal multipliers are large when output is falling and interest rates are low, precisely the conditions that defined the U.S. experience. From December 2007 to June 2009, U.S. output contracted, and in early 2008, the Federal Open Market Committee voted to cut the federal funds rate by three-quarters of a point, the largest rate cut in 24 years. Subsequent Federal Reserve interventions brought the yield on short-term Treasuries close to their zero lower bound, creating what economists call a “liquidity trap.” Thus, while the U.S. now faces risks associated with higher levels of debt, the country may have averted the even greater dangers of fiscal consolidation, as cuts to government spending may have caused even larger declines in output.