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.