The US could be closer to a debt crisis than some observers realize, according to four prominent economists.
The economists—David Greenlaw, chief US fixed income economist at Morgan Stanley; James Hamilton of the University of California, San Diego; Peter Hooper, chief economist at Deutsche Bank Securities in New York and co-head of Deutsche Bank's Global Economics team; and Frederic Mishkin, a former Federal Reserve governor and now a professor at Columbia University made their case at the annual US Monetary Policy Forum (USMPF). The conference in New York City on February 22, organized by Chicago Booth’s Initiative on Global Markets, included 130 invited policymakers, academics, market participants, and journalists.
As they later summarized in a Wall Street Journal op-ed, and as was noted in New York Times, Wall Street Journal, CNN, and other media reports, the four economists argue in a paper, “Crunch Time: Fiscal Crises and the Role of Monetary Policy,” that “countries with high debt loads are vulnerable to an adverse feedback loop.” In such a loop, wary investors demand risk premiums for owning sovereign debt, which in turn can increase worries about inflation and default and possibly lead to a tipping point—which is followed by runaway interest rates and a funding crisis.
The authors say that the US may face such a loop, although they don’t predict when the country could hit a tipping point. “We should be scared,” Mishkin told the attendees.
The authors in their paper compile a wealth of data about fiscal crises in Greece and Ireland, among other countries, and conclude that a country that has a gross debt load above 80 percent of GDP and persistent current-account deficits is vulnerable to such a loop. The US has a projected gross debt load, by 2014, of 107 percent of GDP.
Should investors in US bonds start demanding a risk premium, this could complicate matters for the Federal Reserve as it plans to exit its economic stimulus programs, the authors continue. As the Fed sells securities it has purchased, it is likely to record billions of dollars in losses. The authors note that the duration of the Fed’s portfolio peaks at nearly 11 years in 2013, and this long average maturity means that potential losses could grow.
Moreover while the Fed typically sends annual profits to the US Treasury Department, the authors calculate that the Fed will have to skip some of those payments as it takes losses. And the authors suggest that this could become a political issue. The Fed could feel pressure to hold the securities longer, but that could fuel inflation fears. “In brief, the combination of a massively expanded central bank balance sheet and an unsustainable public debt trajectory is a mix that has the potential to substantially reduce the flexibility of monetary policy,” the authors write.
Not all speakers at the conference agreed. Eric Rosengren, president of the Federal Reserve Bank of Boston, questioned whether conclusions drawn by looking at other countries should apply to the US. “The tipping point is pretty difficult to actually pinpoint in any particular country,” he said. He also defended the Fed’s policy of large-scale asset purchases, saying that purchases this year could create 400,000 new jobs.
Meanwhile Jerome Powell, a governor of the Federal Reserve System, said that while he “would not want to sound complacent,” he does not believe the US is in imminent danger of a hitting an adverse feedback loop in the near term. He called that possibility “unlikely and premature.”
And panelists at the forum’s afternoon session, Harvard’s Martin Feldstein and the Brookings Institution’s Alice Rivlin, offered suggestions for how to address the country’s fiscal challenges. Feldstein, the George F. Baker Professor of Economics at Harvard, was chairman of the Council of Economic Advisers from 1982 to 1984 as well as President Reagan’s chief economic adviser. Rivlin, senior fellow in the Economic Studies Program at the Brookings Institution and a visiting professor at the Georgetown Public Policy Institute, was the founder and first director of the Congressional Budget Office from 1975 to 1983.
Feldstein said one way to raise revenue is to cut tax expenditures, including deductions such as the mortgage interest deduction. Cutting expenditures has widespread support from economists, as a previous Economic Experts Panel from the Initiative on Global Markets has shown, but is a difficult political matter, he noted. Feldstein proposed capping tax deductions at 2 percent of adjusted growth income as a way to gain political support. He said that such a cap would reduce the deficit by $140 billion this year and reduce the national debt by $2 trillion in a decade.
Feldstein and Rivlin agreed that spending on entitlements such as social security and Medicare would need to slow. “Everybody in this room expects to live longer, and maybe you already have,” joked Rivlin, who is 82. They discussed how to possibly raise the enrollment age for some but not all of the population, perhaps by raising the enrollment age only for people who make $100,000 or more.
Zanny Minton Beddoes, economics editor of the Economist, who moderated the discussion, coined their suggestions the “Feldstein-Rivlin plan.” But both Feldstein and Rivlin said that while politicians in Washington DC have been divided in the past, it is particularly difficult in the current political environment to reach consensus in Congress. “The problem now is nobody’s cutting the deal,” Rivlin said. —Emily Lambert