Martin A. Sullivan (Tax Analysts) has published Fiscal Crisis, Part 2: Catastrophe, 129 Tax Notes 647 (Nov. 8, 2010):

Last week we talked about the first stage of the U.S. fiscal crisis: the slow erosion of long-term growth because of mounting government debt. [Fiscal Crisis, Part 1: The Slow Descent to Second-Class Status, 129 Tax Notes 499 (Nov. 1, 2010).] This phenomenon arises from a straightforward application of conventional supply-side economics. Government borrowing absorbs private saving that would otherwise be used for capital formation. The diminished capital stock reduces productivity, growth, and competitiveness.

This week we look at stage two: a rapid economic meltdown precipitated by an untamable accumulation of government debt. …  We are in uncharted economic territory. We cannot be sure of what danger lies ahead or how fast it may arrive at our doorstep. But at least economists are providing some useful ideas to help us better conceptualize the problem.

With their help we can see that we absolutely want to be vigilant about any risk premium creeping into the government’s interest rate. It surely will precede any bond market meltdown. But that is not enough. The dynamics are such that we may not have much warning before uncertainty suddenly develops into a catastrophe.

Figure 2. The Supply and Demand for Deficit Reduction

 

We can also see that when government debt levels are high, any unexpected spike in interest rates is a threat to solvency, irrespective of the cause of that increase. The shock could be generated by the government itself taking on too much debt (as discussed above), or it can come from outside events that are not directly related to government policy.

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