Is the U.S. on a certain path toward a debt crisis? And if so, at what point will it strike? Economists disagree on the details, but the best answers we have to these questions right now are: “It sure looks that way,” and “sooner or later...probably.” Some countries, like Japan, manage to survive with extremely high debt to GDP ratios. Others, like the Russian Federation, which defaulted in 1991 with a debt load equal to just 12.5 percent of its GDP, crash under far less debt pressure. The wide variation has allowed folks like Paul Krugman to argue that our current debt trajectory is, if not ideal, perfectly manageable.
In a new paper, the Mercatus Center’s Arnold Kling attempts to describe just how uncertain the workings of debt markets—sovereign and otherwise—actually are:
The trigger point for a debt crisis is not quantifiable. This is often true even in the case of private debt, such as a credit card balance. What should be the trigger point at which your bank disallows use of your credit card? If the limit were based solely on your theoretical ability to pay, then the upper limit on your credit card balance would equal the present value of all of your future earnings. However, you clearly are not going to work solely for the purpose of paying the outstanding balance on your credit card. Your willingness to pay is much less than your ability to pay. This presents the bank with a problem in psychological guesswork. The bank has to estimate the maximum amount that you can borrow and still be willing to repay.
If you are a credit card borrower with a large outstanding loan balance, your decision to default depends on the costs and benefits of default. The costs might include various legal penalties as well as reduced access to credit in the future. The benefits of default would include the ability to devote more of your future earnings to consumption, rather than to repaying the debt. If your perception is that the costs of default are less than the benefits, then you will choose to default.
However, another borrower in similar circumstances might evaluate the costs and benefits differently and choose to repay the debt.
The fact that different people may respond differently under similar circumstances poses an analytical challenge for the bank. In addition to assessing the borrower’s financial characteristics, the bank must guess how they are likely to behave under financial distress. The circumstances surrounding sovereign debt are, if anything, even murkier. The holder of sovereign debt has little or no legal redress available in the event of default. For the sovereign borrower, the cost of default is pretty much limited to (temporary) loss of reputation in credit markets.
Kling admits up front that there’s no way to preemptively pinpoint the exact trigger point for a debt crisis. But after laying out a number of the important factors, concludes that if one accepts the Congressional Budget Office’s alternative fiscal scenario as the most likely fiscal path going forward, the U.S. will likely experience a debt crisis within the next two decades. No surprises there; the CBO has described the country’s fiscal path as unsustainable, Moody’s recently cautioned that the U.S. had inched closer to losing its platinum credit rating, and earlier this year, the International Monetary Fund told the U.S. that it needed to generate a “credible, medium-term” plan for bringing down its debt level.
Yet despite the warnings, Kling notes that “international capital markets continue to treat U.S. Treasury debt as a fairly safe asset.” Why? In his paper, Kling suggests that it may be that “investors expect the United States to take steps to get its fiscal house in order,” an assumption, he says, is “based more on hope than on recent experience.” In other words, investors simply presume that the U.S. will eventually get its fiscal house in order. But given the political disincentives to making the sort of policy moves necessary to stabilize our debt, it’s not the safest assumption.
Yet the folks on the pro-spending side of the equation—in particular, those who wanted to see a bigger stimulus last year and those who want to enact more stimulus measures now—are using the signals from international capital markets as a sign that all is basically well, and that increasing our debt load may not be all that big a problem. But that’s like seeing smoke rise up from the floorboards of your house and responding that, “Well, if there’s anything dangerous going on, the fire department will show up.” Well, yes, eventually the fire department will roll in, sirens flashing—but often enough by that point, the house is already burning. As Kling puts it, if we continue forward without seriously addressing our national debt load, “investor expectations will change at some point. That change in market perception is likely to be swift and severe.” So sure: In theory it’s possible that we could coast along for decades without a debt crisis. But just because all the emergency sirens aren’t blaring quite yet doesn’t mean we shouldn’t worry.