"The budget deficit has exceeded $1 trillion since 2009. Combined with a shrinking economy,
deficits increased the publicly held federal debt by over 30 percentage points of GDP between
2008 and 2012. Deficits of this size are NOT SUSTAINABLE in the long run because the federal debt
cannot indefinitely grow faster than output. Over time, a greater and greater share of national
income would be devoted to servicing the debt, until eventually the government would be forced
to finance the debt through money creation or default.
The current policy debate on the “fiscal cliff” occurring at the end of 2012 has raised the question
of whether a deficit of the current magnitude is manageable and what risks it poses to the
economy. Since deficit reduction could have a contractionary effect on the economy in the short
run at a time when the economy is still fragile, restoring fiscal sustainability poses another set of
risks that must be balanced against the risks of continuing an UNSUSTAINABLY large deficit. This
report will evaluate sustainability issues.
Although the debt cannot persistently rise relative to GDP, it can rise for a time. It is hard to
predict at what point bond holders would deem it to be unsustainable. A few other advanced
economies have debt-to-GDP ratios higher than that of the United States. Some of those countries
in Europe have recently seen their financing costs rise to the point that they are unable to finance
their deficits solely through private markets. But Japan has the highest debt-to-GDP ratio of any
advanced economy, and it has continued to be able to finance its debt at extremely low costs.
If investors on balance deemed the debt to be unsustainable, the yields and the cost of credit
default swaps on Treasury securities would be expected to rise. Instead, both are currently low.
This may seem surprising, given that the debt is currently growing more rapidly than output and
is projected to continue to do so under current policy. The willingness of bond holders to finance
the federal debt at low interest rates in light of these projections suggests that they believe that
policy changes will eventually be made to place the federal debt on a sustainable path. This belief
could change at any time; if it did, the experience of foreign countries suggests that the effects on
the economy and financial markets could be severe. A failure to raise the debt limit or a ratings
downgrade of U.S. debt by a credit rating agency are two events that have been seen as potential
catalysts for a change in investor sentiment, although the downgrade when the debt nearly
reached its statutory limit in 2011 did not result in higher yields.
According to standard macroeconomic theory, large deficits have temporarily boosted overall spending at a time when there is significant slack in the economy. Once private investment
demand recovers, a large deficit would be expected to “crowd out” private investment spending.
By accounting identity, domestic investment spending equals national saving plus net borrowing
from abroad. The budget deficit has been equal to about half of private saving over the last three
years. Even before the increase in the deficit, national saving was insufficient to finance domestic
investment spending, and the United States was borrowing from abroad at unprecedented rates,
peaking at about 6% of GDP. (Borrowing from abroad has since fallen by half, but remains
relatively high.) To sustain large deficits, the economy will require some combination of higher
private saving, lower investment, and higher borrowing from abroad. Some economists have
argued that borrowing much more than 6% of GDP from abroad is unrealistic, and the already
heavy U.S. reliance on borrowing from abroad makes the maintenance of a large budget deficit
even less sustainable."
--http://www.fas.org/sgp/crs/misc/R40770.pdf
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