The U.S. Fiscal Cliff is Not the Biggest Challenge

In connection with its annual meeting in Tokyo, the International Monetary Fund (IMF) released two book-sized reports. Had they not been written in dry economist language, they should be required reading for all. One is a twice-a year report entitled the “Global Financial Stability Report”. The second report is entitled “World Economic Outlook: Coping with High Debt and Sluggish Growth”. Both reports contain similar conclusions.

The IMF studied the level of sovereign debt that is sustainable without causing a drag on economic growth. The IMF concluded that debt exceeding 100 percent of GDP would cause meaningful growth reduction. The U.S. now exceeds this 100% of GDP debt level. Because of the higher debt and the taxes that the IMF says must occur to service this debt, the IMF forecasts that long-term economic growth will be roughly one percent below what would otherwise occur. Currently, the U.S. growth rate is around two percent, meaning that the policy changes necessary to address current debt levels will cut economic growth in half from the weak growth that we currently have.

These IMF baseline projections, and practically all forecasts published in the U.S., assume that interest rates will stay low. Low interest rates reduce the debt service costs for the U.S, and make balancing the budget easier. This low interest rate assumption is consistent with the U.S. Federal Reserve’s extremely accommodative monetary policy for the foreseeable future.

But, there is a limit to how much the Federal Reserve can control. Currently, the rest of the world is purchasing large amounts of U.S. Treasuries, largely because the alternative risk exposures for investing in Europe are currently viewed as being unacceptable. At some point, the current optimism for U.S. Treasuries relative to alternative “safe” investments will almost certainly change. Once this occurs, even modest interest rate increases brought about by less demand for U.S. Treasuries significantly increase the U.S. deficit, which in turn will aggravate the U.S. debt problem.

The IMF studied historical circumstances when any country had debt levels as high as what the U.S. currently carries. Historically, most debt reductions as large as what the U.S. now requires were significantly facilitated through inflation. The inflation allowed the debt to be repaid with lesser-valued currency relative to the original borrowings. Typically, monetary policy as easy as what the Federal Reserve is now employing has led to significant inflation. The IMF acknowledges that the opportunity to repay debt with cheaper money will be almost too much to resist.

Unless you believe you are clairvoyant enough to beat the rush to the exits, go as light as you can on Treasuries and other fixed income investments. Inflation will become the policy of the U.S. as a means of reducing its too-large debt load. Simply put, it will be easier to inflate the currency than to make hard decisions to cut entitlements, cut other spending, reduce popular tax breaks, or increase the tax base enough to actually make a difference on reducing the deficit.

Additional information and key quotes from the IMF reports are in this longer article.


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