Academic journal article ABA Banking Journal

How the Fiscal Chickens Might Come Home to Roost

Academic journal article ABA Banking Journal

How the Fiscal Chickens Might Come Home to Roost

Article excerpt

In their recent paper, Crunch Time: Fiscal Crises and the Role of Monetary Policy (U.S. Monetary Policy Forum), David Greenlaw, James Hamilton, Peter Hooper, and Frederic Mishkin analyze the potential risks facing countries with high debt loads. In a nutshell, high debt loads reduce the maneuvering room that countries have in implementing fiscal and monetary policy when facing severe economic conditions. The authors conclude that countries with national debt above 80% of GDP and persistent current account deficits (primarily trade deficits) are "vulnerable to a rapid fiscal deterioration as a result of ... 'tipping point dynamics.'"

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The tipping point works like this: High debt loads lead to a reduced demand by debt holders as they become increasingly risk averse. This leads to higher interest rates, which lead to higher interest payments on debt, which lead to more borrowing, which feeds back into higher interest rates. The fiscal crunch can result in rapidly rising interest rates posing a severe headwind for a weak economy.

One implication of the adverse fiscal feedback loop is that the long-term budget projections of the Congressional Budget Office (CBO) may be optimistic--in at least one respect. In the CBO projections, interest rates are somewhat tame. For example, the CBO assumes in its baseline projection an average rate on 10-year Treasury bonds of 4.5% from 2015 through 2018, and an average rate of 5. …

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