"Federal Debt and the Risk of a Financial Crisis" - CBO

The likes of Larry Kudlow have been pushing happy talk of late that maybe, just maybe Congress and the Administration will act to extend the Bush tax cuts. This line of thinking is evolving as the evidence is mounting that a new round of economic weakness is in the offing. The official and blue chip economic forecasts are all calling for growth to subside a tad but to average about 3% for the balance of 2010 through 2012. That is most unlikely. Those forecasts will be coming down. And with it will come more talk of stimulus.

While the MSM and some in D.C. are starting the push against the tax increases it was interesting to see the CBO chime in on the topic. They rained all over the rosy thoughts about preserving the Bush tax cuts. They put out a paper yesterday titled, “Federal Debt and the Risk of a Financial Crisis”. Hopefully Mr. Kudlow will read it. I’m sure a number of folks in Washington will. They could choose to ignore this report. But at our collective peril, according to the CBO. The following graph was released a few weeks ago; it was used again in the July 27 report. This is what a doomsday scenario looks like:

The dark blue dotted line is how bad things will be even if we let the Bush tax cuts sunset. But the light blue line is the disaster that will befall us if we don’t let them expire. We will be over 200% debt to GDP in twenty years. This terrible chart still does not tell us how bad things are. This information excludes the intergovernmental debt which is every bit as “Due and Payable” as the debt held by the Chinese. When you add in the extra 4.5T of IG debt we will be north of 150% Debt/GDP before 2020.

We will never make it to 150%. We will blow up in a spectacular fashion before we even get close to that mark. Some snippets from the CBO report: (full report here)

Further increases in federal debt relative to the nation’s GDP almost certainly lie ahead if current policies remain in place.

Unless policymakers restrain the growth of spending/increase revenues as a share of GDP, budget deficits will cause debt to rise to unsupportable levels.

A growing level of federal debt would increase the probability of a sudden fiscal crisis, during which investors would lose confidence and the government would lose its ability to borrow at affordable rates.

Having a small amount of debt outstanding gives policymakers the ability to borrow to address significant unexpected events such as recessions, financial crises, and wars.

The government would need to undertake some combination of three actions:
-restructuring its debt;
-pursuing inflationary monetary policy;
-adopting an austerity program of spending cuts and tax increases.

Governments can attempt to change the terms of their existing debt—investors would demand a large interest premium on subsequent loans for many years.

Foreign investors would face substantial losses.

Higher inflation might appear to benefit the U.S. government. However, higher inflation would also increase the size of future budget deficits.

I am sure that Bernanke reads these reports. I wonder if he was struck by the comment, “higher inflation might appear to benefit the U.S. government”. He should be, that is his only policy at this point. Will he consider the CBO warning? I doubt it. Will Congress? It depends on the November elections.