Between a Rock and a Hard Place: U.S. Fiscal Policy

By Rodrigo Valdés

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The United States faces two pressing challenges to fiscal policy: raise the debt ceiling, and begin the arduous process of reducing deficits and debt.

And, right now, this leaves U.S. fiscal policy between a rock and a hard place. How much savings should be found and in what form are crucial questions. So is when to put those savings in effect.

Simply unsustainable

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. That, quite simply, is not sustainable.

If left on automatic pilot, debt would continue to increase faster than the economy, until financial markets say “no more.” Credit rating agencies have issued their warnings and, as part of the debt ceiling discussions, the political system has been trying to decide where to find the savings.

Unemployment worries

At the same time, too much fiscal retrenchment in the short run could unduly weaken an economy that was recovering very gradually and has lately lost 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 just not enough to significantly reduce today’s very high unemployment.

Persistently weak conditions in the labor market can threaten the long run prospects of the economy. A person who is unemployed for too long can gradually lose his or her work skills and find it increasingly difficult to find a job. Another headwind to economic activity is certainly not welcome at this juncture.

Difficult balancing acts

The fiscal problem was center stage in the IMF’s 2011 annual assessment—or Article IV consultation—of the United States’ economy. Discussions centered on the need to balance long-term adjustment and short-term support for the recovery.

A loss of fiscal credibility in the United States is too dangerous a scenario to be tested. So, the top priority is reaching political agreement on a comprehensive adjustment plan that begins the consolidation process in FY 2012.

The plan should be an appropriate size. Ideally, the consolidation should be spread over several years to avoid overly tight policies in 2012-13. The plan has to be balanced to include cuts in discretionary spending, higher revenues—for example by closing tax loopholes—and entitlement reforms. The latter should focus on containing the rate of growth entitlements—namely, social security and health care—and the changes may kick in later, but they have to be agreed and legislated now. Curbing non-defense discretionary spending alone is not sufficient because this type of spending is simply not large enough to achieve the required deficit reduction.

No crash dieting, but the diet has to start now

A somewhat crude analogy is dieting and losing weight. An overweight person who urgently needs to shed pounds must start to diet immediately. A simple announcement that he or she will start soon is not credible. By the same token, slashing the calorie intake too quickly is dangerous, risking the proverbial yo-yo dieting or, worse still, long term damage to your health. A gradual and enduring process is better. And the appropriate balance also requires relying on more than one lever: the dieter should not only eat less, but exercise too.

Putting public debt on a sustainable path—say, stabilizing its ratio to the size of the economy by mid-decade and then lowering it gradually—requires a fiscal adjustment whose size and scope depends on two key variables: the pace at which the economy grows, and interest rates in the next several years.

If the economy expands, the benefits multiply. Not only do revenues grow more rapidly, but debt also represents a smaller part of the economy, which reduces the need for savings. On the other hand, higher interest rates increase the amount of adjustment required because the interest bill will eat more of the available revenue. And complicating matters, higher debt tends to lift interest rates, raising the interest bill, and so on.

So, where does all of that leave us? Active polices to lower the fiscal deficit of the order of 5 percent of GDP in the next several years would do the trick based on official U.S. projections. That amount is broadly equivalent to the $4 trillion savings over 10 years publicly discussed by policymakers during debt ceiling negotiations. Under our more conservative economic projections, the United States needs to find savings of approximately $6 trillion. That $4 trillion would be a very good first step.

If you want to crawl out from between a rock and a hard place, you have to start now.

2017-04-15T14:19:48-05:00July 25, 2011|


  1. Rodger Malcolm Mitchell July 25, 2011 at 12:02 pm

    Since 1940, pundits have been declaring the federal debt a “ticking time bomb” and “unsustainable.” See:

    I am reminded of Harold Camping who declared the end of the world. His mistake was to give a date. The debt-hawks are cleverer than that. They just make generalize predictions, based on nothing, providing no evidence — endlessly.

    What will it take for them finally to admit they are wrong?

    Rodger Malcolm Mitchell

  2. joebhed July 25, 2011 at 12:12 pm

    I don’t mean to insult another IMF parrothead, but things are getting serious and we need for people to know what’s going on. As a result, it’s time for the IMF to realize that its role has changed. Who’s working on the exit strategy?

    The “debt-crisis” of the U.S. referred to here is the result of the failure of the debt-based monetary system, the same model that the IMF has been forcing on the world for almost 70 years. Austerity is its draconian solution.

    The proof of the failure of debt-based money has been lain out explicitly clear for all to see in the historic works of German economist Dr. Prof Bernd Senf in his lecture titled On The Deeper Roots of the World Financial Crisis” (

    I would like to think there are folks in the back room at the IMF who actually care that we attack the roots to our global financial and monetary crisis, and not its manifesting symptoms of growing government deficits.which are necessary during private sector, debt-driven contractions.

    So, both the rock and the hard place are components of the debt-based money system. The solution of a movement towards continued prosperity is to put an end to the crisis’ root cause – the global system of debt-based money.

    Fortunately, the proof of the benefits of a move to end the private debt-money system and to replace it with a publicly-issued system of money, and a fully-reserved system of banking, lies in the works of noted Japanese economist Dr. Kaoru Yamaguchi in his very recent study titled: “On the Workings of a Public Money System in Open Macroeconomies” (

    So, we know that the real cause of the crisis is the debt-based money system, with its long-term accumulation of unfunded compounding interest costs, stealing labor’s wealth and replacing it with more debt.

    And we know that a viable solution is available, if we can only form a workable transition plan to make it happen.

    So the question for the IMF becomes – who is working on an exit-strategy?

  3. Per Kurowski July 25, 2011 at 1:07 pm

    Like Lilliputians tying Gulliver down, so have the regulatory gnomes in Basel tied down the USA and most other Western World economies.

    The moment bank regulators decided that banks were basically not required to have any capital at all when lending to a sovereign like the US, or very little capital when lending to those rated AAA and perceived as not risky, they placed the responsibility of shouldering most of the required bank capital of the whole bank system, on that part of the economy which is perceived as “risky”, and which includes the small businesses and the entrepreneurs. This translated into a very significant discriminatory and regressive, hidden tax on risk-taking…and this, in the home of the brave!

    Now, if you find yourself between a rock and a hard place, you must know there is no safe-risk-free way out and you absolutely need to put your most creative and dynamic forces to work… not the bureaucrats. And so, in this respect, the first thing the US should do is to considerably reduce the capital requirements for banks when lending to small businesses and entrepreneurs. And this they can safely do because there has never ever been a bank crisis caused by excessive lending to those perceived as “risky”.

    Does it mean that banks need not more capital? Of course not! They need a lot of capital to rebuild that capital they should have had when lending to what is perceived as not risky, but that they don’t have, because some naïve regulators decided to bet the whole bank system on some human fallible rating agencies always being right.

  4. Rodger Malcolm Mitchell July 26, 2011 at 8:42 am

    The fundamental problem remains the same, as witness the various comments to this post: America seems not to understand that federal finances are diametrically the opposite of personal finances.

    So we hear, “I have to balance my budget, so why doesn’t the federal government balance its budget?” And, “Too much debt is bad for me, so too much debt is bad for the federal government.” Both concepts are nonsense.

    To spend, you and I need a source of funds, whether income, savings or borrowing. By contrast, the federal government, which is Monetarily Sovereign, needs no source of funds. It pays its bills simply by crediting bank accounts. Even were federal taxes to fall to $0 or rise to $100 trillion, neither event would affect the federal government’s ability to credit bank accounts.

    The federal government creates money by paying bills. When the government pays a $1,000 bill it creates exactly $1,000, to the penny. Unfortunately, you and I cannot do the same. We create nothing by spending. So why all these home-spun comparisons between the federal government and us? Ignorance of economics.

    Concerns about the federal debt are nonsense:

    1. The federal government has not needed to borrow since 1971, the end of the gold standard, when we became Monetarily Sovereign. We could and should stop borrowing tomorrow (i.e stop issuing T-securities). No T-securities = no debt = no more debt-limit controversy.

    2. Federal deficit spending is necessary to grow the economy. The federal government is the private sector’s biggest customer. What happens to a business when its biggest customer cuts back? That is exactly what will happen if and when the federal deficit is cut.

    Today, Congress and the President recommend, in effect, applying leaches to cure anemia. Cutting federal spending and/or increasing taxes will remove the lifeblood of the economy: Money.

    If they succeed, we absolutely, positively will have a depression that will make the Great Depression look like a party.

    Rodger Malcolm Mitchell

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