Between a Rock and a Hard Place: U.S. Fiscal Policy
IMF Blog, July 25, 2011
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- Published: July 25, 2011
Overview
- The United States faces two pressing fiscal challenges: raise the debt ceiling, and begin reducing deficits and debt.
- The situation is characterized as “between a rock and a hard place,” with crucial questions on how much savings to find, in what form, and when to implement them.
- The fiscal problem was center stage in the IMF’s 2011 annual assessment—or Article IV consultation—of the United States’ economy.
Fiscal position and unsustainability
- By the end of this year, federal debt held by the public will represent 70 percent of the U.S. economy, almost double the 36 percent it was in 2007.
- The federal fiscal deficit will be 9.3 percent of GDP this year.
- If left on automatic pilot, debt would continue to increase faster than the economy until financial markets react; credit rating agencies have issued warnings.
- Active policies to lower the fiscal deficit of the order of 5 percent of GDP in the next several years would put debt on a sustainable path based on official U.S. projections.
- Under more conservative IMF projections, the United States needs to find savings of approximately $6 trillion.
- A $4 trillion savings over 10 years, as publicly discussed by policymakers during debt ceiling negotiations, is described as a very good first step.
Unemployment and short-term risks
- Too much fiscal retrenchment in the short run could unduly weaken an economy recovering very gradually and lately losing momentum.
- In the first half of 2011, output appears to have grown at an average annual rate of less than 2 percent.
- That pace is insufficient to significantly reduce very high unemployment.
- Persistently weak labor market conditions can damage long-run prospects by causing long-term unemployed workers to lose skills and find it increasingly difficult to find jobs.
Policy recommendations and sequencing
- Top priority: reach political agreement on a comprehensive adjustment plan that begins the consolidation process in FY 2012.
- The plan should be:
- Appropriate in size and spread over several years to avoid overly tight policies in 2012-13.
- Balanced to include cuts in discretionary spending, higher revenues (for example by closing tax loopholes), and entitlement reforms.
- Entitlement reforms should focus on containing the rate of growth of entitlements—namely, social security and health care—and can kick in later, but must be agreed and legislated now.
- Curbing non-defense discretionary spending alone is not sufficient because this type of spending is not large enough to achieve the required deficit reduction.
- Analogy: start now but avoid “crash dieting” — gradual and enduring adjustment is preferable, and the strategy should rely on more than one lever.
Mechanics and risks affecting required adjustment
- Putting public debt on a sustainable path—stabilizing its ratio to GDP by mid-decade and then lowering it gradually—depends on:
- The pace at which the economy grows: stronger growth increases revenues and reduces the debt-to-GDP ratio.
- Interest rates in the next several years: higher interest rates increase the adjustment required because the interest bill consumes more revenue.
- Higher debt tends to lift interest rates, which raises the interest bill and complicates consolidation efforts.
Source: Between a Rock and a Hard Place: U.S. Fiscal Policy (IMF blog, July 25, 2011).
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