The United States Has No Fiscal Space Left

Published July 12, 2017

The Great Recession and slower economic growth in recent years have been accompanied by a discontinuous increase in debt-to-GDP ratios in most countries in the Organisation for Economic Co-operation and Development (OECD), most notably the United States. This debt burden has raised significant questions about the ability of these countries to pursue discretionary fiscal policies — an issue that has become more important as countries have encountered the limits of accommodative monetary policy.

Some economists argue the current low interest rates have expanded the “fiscal space” for countries to pursue expansionary fiscal policies, using long-term bonds to lock in interest rates. Deficits in the medium term are justified as a stimulus to economic recovery and to finance investments for long-term economic growth. That view is challenged by economists who argue that high debt-to-GDP ratios have reduced — and in some cases eliminated — fiscal space, and that expansionary fiscal policies have exposed at least some countries to the risk of default.

The concept and measurement of “fiscal space” is a controversial issue in macroeconomic policy. Fiscal space is estimated as the distance between actual debt levels and their estimated limit. Debt limits are measured by the level of debt at which the government defaults and loses market access, with the result that it cannot continue to service the debt.

Further complicating this issue is the enactment of new fiscal rules. In recent years, many OECD countries responded to increased debt burdens by enacting fiscal rules designed to reduce debt-to-GDP ratios below tolerance levels. Among the most successful of these have been European countries relying on national as well as supranational fiscal rules that require budget constraints whenever deficits and debt exceed tolerance levels. To the extent that these new fiscal rules are effective, they expand fiscal space, improving the capacity to pursue countercyclical fiscal policies as well as policies to promote economic growth. To that extent, fiscal space cannot be separated from the fiscal rules that constrain fiscal policy.

In our forthcoming book Restoring America’s Fiscal Constitution (Lexington Press), we explore fiscal space and fiscal rules in the United States. We argue that if the United States had enacted fiscal rules to constrain deficits and debt over the past two decades — as some OECD countries have done — the national debt could have been reduced below tolerance levels by relying on orthodox fiscal policies. Thus a modest reduction in the rate of growth in spending and entitlement reform could have balanced the budget. In turn, a cyclically balanced budget would have resulted in sustainable fiscal policies, and the nation would not have had to respond to the Great Recession with a fiscal bailout that doubled the national debt.

Unfortunately, addressing the debt crisis today is a more formidable task, requiring unorthodox fiscal policies beyond anything proposed by Congress or the president. New fiscal rules are needed to constrain the growth in discretionary spending to less than 1 percent per year for the next two decades. These fiscal rules would require that any increase in deficits or debt above tolerance levels would trigger even more stringent limits on the growth in discretionary spending. Moreover, even with more effective fiscal rules in place, the federal government will have to generate about $600 billion in savings, earmarked for debt reduction each year for two decades. This will require substantial savings from entitlement reform and sale of federal assets, with the proceeds earmarked for debt reduction.

With a cyclically balanced budget, the federal government would have some discretion to pursue a countercyclical fiscal policy. If future recessions are mild, these fiscal policies could be maintained in the long run. However, this rosy scenario is predicated on the assumption that we avoid major headwinds, such as slower economic growth, higher interest rates, and higher health-care costs. If, however, the nation experiences another financial crisis comparable to the Great Recession, we may not be able to achieve a sustainable fiscal policy, even with effective fiscal rules and fiscal reform.

Keynesians like Paul Krugman argue that the United States has ample fiscal space and should pursue expansionary fiscal policies to stimulate economic growth. But our research reveals that we can no longer muddle along as we have for half a century, incurring deficits and accumulating debt. Expansionary fiscal policies, such as those pursued by the Obama administration, would trigger deficits and debt levels that would expose the country to default and loss of access to international capital markets.

In other words, our nation has no fiscal space. Our debt burdens are already beyond tolerance levels. Prudent fiscal rules and fiscal reforms must be enacted immediately and maintained for the foreseeable future to restore a sustainable fiscal policy. The era of Keynesian stimulus is over; we must return to our country’s historical tradition of enacting balanced budgets.

[Originally Published at RealClearPolicy]