by Simon Johnson, Peterson Institute for International Economics
Congressional testimony submitted to the US House Ways and Means Committee hearing on "Tax Reform and Consumption-based Tax Systems"
July 26, 2011
This testimony draws on joint work with Peter Boone and James Kwak. Underlined text indicates links to supplementary material; please see also BaselineScenario.com, where we also provide daily updates and detailed policy assessments for the global economy.
Effects of Defaulting on US Government Debt
The consequences of any default on the US debt would, ironically, actually increase the size of government relative to the US economy.
The reason is simple: A government default would destroy the credit system as we know it. The fundamental benchmark interest rates in modern financial markets are the so-called "risk-free" rates on government bonds. Removing this from the picture—or creating a high degree of risk around US Treasuries—would disrupt many private contracts and all kinds of transactions.
In addition, many people and firms hold their "rainy day money" in the form of US Treasuries. The safest money market funds, for example, are those that hold only US government debt. At least, these are the funds perceived as safe—if the US government defaults, all of these funds will "break the buck," meaning that they will be unable to maintain the principal value of the money that has been placed with them.
The result would be a flight of capital—but to where? Banks will have a similar problem; many of their balance sheets will be destroyed by the collapse in US Treasury prices (the counterpart of an increase in interest rates on such debt, as bond prices and interest rates move in opposite directions).
There is no company in the United States that would be unaffected by a government default—and no bank or other financial institution that could provide a safe haven for savings.
There would be a massive run on cash, with everyone withdrawing as much as possible from their banks. Imagine the lines at ATM machines and teller windows—something we have not seen on a grand system since the Great Depression.
And private credit would disappear from our economic system, which then gives the Federal Reserve an unpleasant choice. Either it can step in and provide an enormous amount of credit directly to households and firms—very much as the central bank, Gosbank, did in the Soviet Union. Or the Fed can stand idly by while GDP falls 20 to 30 percent, the kinds of decline we have seen in modern economies when credit suddenly dries up.
With the private economy in free fall, consumption and investment would decline sharply. Our ability to export would also be down—foreign markets would likely be affected also and, in any case, if firms trying to export cannot get credit, then most likely they cannot produce.
Government spending would contract in real terms, without a doubt. But what would fall more—government spending or the size of the private sector? Almost certainly the answer is the private sector, because this is so dependent on credit to buy its inputs. Think about the contraction that happened in fall 2008 multiplied by 10.
The government, on the other hand, in the last resort has access to the Federal Reserve and can therefore get its hands on cash money to pay wages. With the debt ceiling not increased, this would require some legal sleight of hand. But the alternative would clearly be a collapse of US national security—the military and the border guards have to be paid; the transportation system needs to operate, and so on.
Issuing money in this situation would almost certainly be inflationary but, the Fed would reason, perhaps not—because we have never been in this situation before, credit is now imploding, and the desperate credit expansion measures in fall 2008 proved not to be as bad as the critics feared.
This is what a US debt default would look like. The private sector would collapse, unemployment would quickly exceed 20 percent and, while the government would shrink, it would also remain the employer of last resort.
Anyone who does not want to raise the debt ceiling is playing with fire. Some people expressing this position are also advocating a policy that would have dire effects—and do the exact opposite of what they want to the structure of our economy. The government would become more important, not less important.
Spending Cuts Would Be Contractionary
Immediate spending cuts would, by themselves, likely slow the economy. The IMF’s recent comprehensive review of cross-country evidence concludes: "A budget cut equal to 1 percent of GDP typically reduces domestic demand by about 1 percent and raises the unemployment rate by 0.3 percentage point."16
The contractionary effects of spending cuts can sometimes be offset by other changes in economic policy or conditions, but these are unlikely to apply in the United States today.
If there is high perceived sovereign default risk, fiscal contraction can potentially lower long-term interest rates. But the United States is currently one the lowest perceived risk countries in the world—hence the widespread use of the US dollar as a reserve asset. To the extent that there is pressure on long-term interest rates in the United States today due to fiscal concerns, these are mostly about the longer-term issues involving health care spending; if this spending were to be credibly constrained (e.g., in plausible projections for 2030 or 2050), long rates should fall. In contrast, cutting discretionary spending would have little impact on the market assessment of our longer-term fiscal stability.
It is also highly unlikely that short-term spending cuts would directly boost confidence among households or firms in the current US situation, particularly with employment still around 5 percent below its precrisis level. The United States still has a significant "output gap" between actual and potential GDP, so unemployment is significantly above the achievable rate. Fiscal contractions rarely inspire confidence in such a situation.
If monetary policy becomes more expansionary while fiscal policy contracts, this can offset the negative short-run effects of spending cuts on the economy to some degree. But in the United States today, short-term interest rates are as low as they can be, and the Federal Reserve has already engaged in a substantial amount of "quantitative easing" to bring down interest rates on longer-term debt. It is unclear that much more monetary policy expansion would be advisable or possible in the view of the Fed, even if unemployment increases again—for example because fiscal contraction involves laying off government workers.
Tighter fiscal policy and easier monetary policy can, in small open economies with flexible exchange rates, push down (depreciate) the relative value of the currency—thus increasing exports and making it easier for domestic producers to compete against imports. But this is unlikely to happen in the United States, in part because other industrialized countries are also undertaking fiscal policy contraction. Also, the preeminent reserve currency status of the dollar means that it rises and falls in response to world events outside our control—and at present political and economic instabilities elsewhere seem likely to keep the dollar relatively strong.
The available evidence, including international experience, suggests it is very unlikely that the United States could experience an "expansionary fiscal contraction" as a result of short-term cuts in discretionary federal government spending.
The Real Dangers and Costs of Fiscal Crisis
The advisable debt limit, relative to GDP, for the United States is subject to considerable debate and is not knowable with a high degree of precision. There is no precise debt-to-GDP level at which a crisis is triggered, but with net debt relative to GDP in or above the range of 90 to 100 percent, a country becomes much more vulnerable to external shocks—particularly if it is relying on foreign investors to buy a substantial part of its debt.
If any shock throws the economy into recession, fiscal policy in most industrialized countries will to some degree automatically counteract the effect—as spending increases (on unemployment benefits and other forms of social support) and taxation declines (as GDP falls). Such automatic stabilizers are generally helpful as they prevent the recession from becoming more serious—or from even some form of prolonged collapse, which was the pre-1945 experience of many countries.
It is important not to oversimplify fiscal concerns into precise cut-offs for "dangerous" debt levels. Recent European experience provides ample illustration that countries can run into trouble refinancing their debts at a wide range of debt-to-GDP values.
Greece ran into trouble in 2010 with a gross debt-to-GDP level of 142 percent; its debt levels in 2006 and 2007 were around 105 percent. This is a classic case of too much debt by any measure—although the full extent of the debt and underlying deficits were not completely clear until market perceptions shifted against Greece.
Portugal faces a fiscal crisis with gross debt at 90.6 percent of GDP in 2011, but its debt was only 62.7 percent in 2007. The issue for Portugal is low achieved and expected growth relative to fiscal deficits—the markets have become unwilling to support debt that continues to increase as a percent of GDP.
Ireland, the third euro area country that currently has an IMF program, is a different kind of fiscal disaster. In this case, the on–balance sheet government debt was low (25 percent of GDP in 2006–07 for gross debt), but there was a big buildup in off–balance sheet obligations—in the form of implicit support available to a banking system that was taking on large risks. Bailing out the banks in fall 2008 and supporting the economy during severe recession has pushed up gross debt to 114 percent of GDP in 2011, and debt levels will reach at least 125 percent (in our estimates, even higher) before stabilizing.
Compared with other industrialized countries, Japan stands out as an extreme. Government debt relative to GDP is expected to reach 229.1 percent in 2011 (on a gross basis) and rise to 250.5 percent in 2016. On a net basis—taking out government debt held by other parts of the public sector—the equivalent figures are 127.8 percent in 2011 and 163.9 percent for 2016. But nearly 95 percent of Japanese government debt is held by residents—and, at least for the time being, Japanese household and business savings remain high. Countries with greater reliance on foreign savers, such as the United States (where nonresidents held over 30 percent of general government debt in 2010) and the United Kingdom (nonresidents held 26.7 percent of general government debt in 2010) need to be much more careful. Within the euro area, as a result of greater financial integration combined with the mispricing of risk, foreigners typically hold 40 to 90 percent of all outstanding government debt (mostly held by other euro area financial institutions).
The increase in debt relative to GDP in industrialized countries from 2007 to 2011 was about 28 percent of GDP (unweighted average across countries, as calculated by the IMF)—most of which was due to automatic stabilizers, i.e., the increase in spending and fall in taxation that occurs whenever a country goes into recession.
Seen in that context, the increase in the US gross debt—from 62.2 percent of GDP in 2006 to 91.6 percent at the end of 2010—was very much in line with experience in other countries. But the current trajectory of debt now, rising to 111.9 percent in 2016, is on the high end (the average debt-to-GDP level for industrialized countries is projected to rise by about 5 percent over this period).
In terms of net general government debt held by the private sector, at the end of 2011, the United States is expected to have around 72.4 percent of GDP—up from 42.6 in 2007. This is not yet at a dangerous level, but projections for the future are not encouraging—this number will rise to 85.7 percent in 2016, according to the IMF. And in the CBO’s longer-term projections, the future costs of health care cause a rise in debt to Japanese levels or beyond by 2030 or 2050.
The role of the US dollar as the world’s preeminent reserve currency means there is a strong demand for our government securities in the foreseeable future. But it is not clear how far this will carry us—particularly as alternative reserve assets typically develop in a diverse world economy with competing national interests. It would be wise to undertake medium-term fiscal consolidation. Rising healthcare costs and a weak tax base could well undermine our long-term potential growth.
In addition, the United States continues to face very large implicit liabilities in the form of implicit support available to the financial sector, both directly—if "too-big-to-fail" global banks get into trouble—and indirectly, in the form of automatic stabilizers that will always kick in when the economy declines sharply due to a banking crisis.
If a financial crisis due to the mispricing of risk causes a fiscal crisis, including immediate spending cuts and tax increases, this has major distributional consequences. The financial sector executives and traders who do well during a financial boom are highly paid; typically this is on a return-on-equity basis without appropriate adjustment for risk, so they take on too much debt. When the downside risks materialize, the costs of the crisis are borne by those who lose jobs and suffer other collateral damage. If sharp spending cuts follow that reduce public services (e.g., government-funded education), this effectively transfers the costs of dangerous compensation schemes for the financial elite onto the middle class and relatively poor people.
There is nothing pro-market or pro-private sector about an inefficient redistribution scheme that allows a few people to become richer due to implicit government subsidies for "too-big-to-fail" global financial institutions. Such firms are likely to damage themselves with some regularity—their executives have little incentive to be sufficiently cautious. If the consequent crises undermine public goods, such as access to effective education and quality health care, this is likely to permanently lower growth rates through undermining the human capital of the US workforce.
Simon Johnson is a senior fellow at the Peterson Institute for International Economics and a professor at MIT.
4. Scrapping the existing tax system would not make sense, for example under the so-called "Fair Tax" proposal—this would be a huge undertaking with big downside risks. The benefits of such a system have been greatly exaggerated by some of its proponents. See Bruce Bartlett, "Why the Fair Tax Won’t Work," Tax Notes, December 24, 2007, pp.1241–54, and chapter 9 [pdf] in the President’s Advisory Panel on Tax Reform, a report prepared during the administration of President George W. Bush.
5. See table 6 [pdf] in the IMF’s May 2010 Fiscal Monitor for budget deficit financing needs across advanced countries. The United States has relatively short maturity debt (4.4 years by this measure), but it is broadly comparable with other industrialized nations on this and other deficit measures. Table 11 in the same report provides estimates of effects from raising revenue in various sources across the advanced G-20 economies. Again, the United States is in the middle of the pack—there is nothing unusually difficult (on paper) about the adjustment required. However, our projected increase in healthcare costs as a percent of GDP through 2030 is on the high side relative to comparable countries. See also "From Stimulus to Consolidation: Revenue and Expenditure Policies in Advanced and Emerging Economies," International Monetary Fund, Fiscal Affairs Department, April 30, 2010.
6. Statistical table 5 in the IMF’s May 2010 Fiscal Monitor has general government revenue as a percent of GDP since 2000 and forecast through 2015; in the April 2011 edition of the Fiscal Monitor, the series starts in 2006, and the forecasts run through 2016 (statistical table 6).
7. International Monetary Fund, Fiscal Monitor, April 2011, statistical table 6, p.126.
8. Most European VAT systems are less attractive as design models; we should particularly avoid systems that have different VAT rates for different kinds of goods and services. See Ian Crawford, Michael Keen, and Stephen Smith, "Value Added Tax and Excises," chapter 4 in the Mirrlees Review: Dimensions of Tax Design, published in 2010. For more background on how VAT systems operate around the world, see "The Value Added Tax: Experiences and Issues," [pdf] paper prepared for the International Tax Dialogue Conference on the VAT, Rome, March 15–16, 2005.
9. The cross-country evidence suggests that "the VAT has proved to be a particularly effective form of taxation" and it has also been used, to some extent, to reduce the use of less effective tax instruments (Michael Keen and Ben Lockwood, "Is the VAT a Money Machine?" National Tax Journal, vol. LIX, no. 4, December 2006, p. 925). Similar conclusions were reached during the George W. Bush administration by the President’s Advisory Panel on Federal Tax Reform (chapter 8: Value-Added Tax [pdf]).
10. For more discussion, see William G. Gale and Benjamin H. Harris, "A Value-Added Tax for the United States: Part of the Solution," Brookings Institution and Tax Policy Center, July 2010.
11. For more details and discussion of what accounts for the increase in inequality, see David Autor and Daron Acemoglu, "Skills, Tasks and Technologies: Implications for Employment and Earnings."
12. Over the past decade, foreign wars also contributed to increased government spending. But the negative fiscal effect of the financial crisis was much larger than the cost of the Iraq and Afghanistan wars combined.
13. See also the May 2010 edition of the IMF’s cross-country fiscal monitor [pdf] for comparable data from other industrialized countries. The box on debt dynamics shows that mostly these are due to the recession; fiscal stimulus only accounts for one tenth of the increase in debt in advanced G-20 countries. Table 4 in that report compares support by the government for the financial sector across leading countries; the United States provided more capital injection (as a percent of GDP) but lower guarantees relative to Europe.
14. See Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown, Pantheon, 2010.
15. See Anat Admati, Peter DeMarzo, Martin Hellwig, and Paul Pfleiderer, "Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive," [pdf] Stanford University, March 2011 (revised).
16. World Economic Outlook, October 2010, chapter 3, "Will It Hurt? Macroeconomic Effects of Fiscal Consolidation," p. 113. This study has important methodological advantages, in particular because it focuses on policy intentions and attempts to implement spending cuts and revenue increases.
Policy Brief 11-16: US Tax Discrimination Against Large Corporations Should Be Discarded October 2011
Policy Brief 11-2: Corporate Tax Reform for a New Century April 2011
Policy Brief 10-10: Higher Taxes on Multinationals Would Hurt US Workers and Exports May 2010
Testimony: Tax Reform and the Tax Treatment of Debt and Equity July 13, 2011
Book: US Taxation of Foreign Income October 2007
Book: Reforming the US Corporate Tax September 2005
Op-ed: America Badly Needs a Value Added Tax April 21, 2005
Paper: Tax Policy in a Global Economy Revised February 2000