Martin A. Sullivan (Tax Analysts) has published Fiscal Crisis, Part 1: The Slow Descent to Second-Class Status, 129 Tax Notes 499 (Nov. 1, 2010):

It is undeniable that we are on the path to fiscal collapse. This decline will occur in two stages. First there is the decay as the swelling national debt wears away the economy’s foundations and commits more and more future income to foreign creditors. We are already in stage one.

In stage two a lethal combination of phenomena arises in quick succession: greater default risk, looming inflation, higher interest rates, declining growth, financial market instability, and an acceleration of government borrowing. They feed on each other. The economy heads on a downward spiral. Between stage one and stage two there is a tipping point. Experts know it will come, but nobody wants to predict when. … This article is about the slow economic decline of stage one. Next week part 2 will describe the hell of a full-blown fiscal collapse.

There is no question economics has failed us. The old paradigms have been made obsolete by the hard reality of the 2007-2009 financial crisis and soaring government debt. But some ideas can be salvaged from the wreckage. And one that will be particularly useful in coming years is the standard supply-side analysis of the impact of government debt on long-term economic growth. When government issues debt, it uses private savings that otherwise could be used for productive new capital and technology. This results in reduced capital formation (both tangible and intangible), which in turn reduces productivity, wages, competitiveness, and economic growth. …

[O]ne way or the other — through reduced domestic capital formation or through reduced ownership of domestic capital — the future well-being of Americans is hobbled by debt. …

The negative economic effects of debt — higher interest rates and lower growth — increase the numerator and decrease the denominator of the debt-to-GDP ratio. These effects are illustrated in Figure 2. The bottom line in the chart is what the CBO typically reports. It assumes that rising government debt does not raise interest rates or adversely affect growth. As bad as the bottom line looks, the top line — showing what the CBO actually thinks will happen — is considerably worse. By 2020 the projected debt-to-GDP ratio is 97 percent, taking into account higher interest rates and lower growth instead of the 87 percent in the standard CBO projection. Figure 2 is remarkable because it shows matters are worse than usually advertised.

Figure 2. From Bad to Worse: Adjusting Standard CBO Debt-to-GDP
Projection to Include Economic Effects of Higher Debt

 

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