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Econ Journal Watch & Mercatus Center at George Mason University Symposium on:

U.S. Sovereign Debt Crisis: Tipping-Point Scenarios and Crash Dynamics

Summary of Articles

Some PossibleConsequences ofa U.S. GovernmentDefault

By Jeffrey Rogers

Hummel

The Bond MarketWins

By Garett Jones

How a DefaultMight Play Out

By Arnold Kling

Courting anAvoidableFinancial Crisis

By Joseph J.Minarik

How and Why aU.S. SovereignDebt Crisis CouldOccur

By Peter J.

Wallison

Likelihood ofDefault

A crisis is boundto occur, and a

Treasury defaultis most likely.

A default isunlikely. Chronic

fiscal contritionis much morelikely.

A negotiateddefault is more

likely than aunilateraldefault.

Congressionaldeadlock will

make defaultmore likely,especially if itcauses interestrates to rise.

Default isunlikely, but a

political/financialcrisis is likely ifCongress failsto addressgrowingentitlementprograms.

Key Points A crisis iscertainly boundto occur

becausepromised futureoutlays vastlyexceedprojected futurerevenue.Without a crisis,a political fix isunimaginable.

Unless itseriously affectsthe currency,

Currently, lowinterest rates inthe long-term

U.S. bondmarket signalinvestors areconfident thatthe governmentwill repay itsdebt.

If it becameobvious thegovernment

wanted to inflateaway the debt,

Current debt isa relativelysmall part of the

problem; theaccumulation ofdebt in thefuture is highlyproblematic.Inflating awaythe debt is notan option.

Real reformmust be made

to SocialSecurity and

The structure ofpolitics hasdulled policy

makersawareness ofour dangerousU.S. fiscalsituation,resulting inpolitical inaction.

To help staveoff drasticeconomic

turmoil, bothpolitical parties

Political inactionwill causecreditors to lose

confidence inthe ability of theU.S. to meet itsdebt obligationswithout inflatingits currency.

Without politicalconsensus onhow to addressentitlements,

their costs willdrive the

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inflation cannotremedy thefiscal shortfall.

Todayssituation is notnovel.Numerous state

governmentsdefaulted ontheir debts inthe early 1840s.States mademajor fiscalreforms thatresulted inlastingconstitutionalchanges and a

period ofsustainedeconomicgrowth.

the cost ofrefinancing agovernmentloan (whichlasts 5 years onaverage) wouldcripple its abilityto do so.

Continuallynegotiated taxincreases andspending cutshave the abilityto stave off afuture financialcrisis.

Medicare. Oncespendingoutpaces taxrevenues inthese programs,the UnitedStates will haveto begin

borrowing. Onceinterest rates onborrowingbecome toohigh, the UnitedStates will haveto stop meetingits obligations.

must worktogether to forma viablecompromise.

The businesscommunitycould help stave

off default, butdistrust of bigbusiness islikely to harmthe chance ofreform. If bigbusinessesbegin to fail,smallbusinesses willtoo.

national debt to82% of GDP by2021.

Democrats andRepublicans aresplit on taxincreases and

entitlement cuts.This stalematewill continueuntil some crisisoccurs.

Possible TippingPoints or Triggers

When theHospitalInsurance andSocial Securitytrust funds areexhausted, theywill have to be

financed bygeneralrevenue, andinvestors coulddemand a riskpremium onTreasurysecurities.

Total federalexpenditures

are estimated tobe 75% of GDP

To avoiddefault,politicians willprefer to raisetaxes instead ofcuttingentitlements, but

the lack ofpolitical will toraise taxes willweaken investorconfidence inthe U.S.s abilityto service itsdebts.

Once creditorssee default asrealistic, theywill demandhigher riskpremiums fortheir

investments.This will triggera rapiddownwardeconomic spiralas high interestrates will makeit difficult forborrowers tomeetobligations.

OPEC choosingto abandon thedollar or furtherU.S. creditratingdowngradescould seriously

shake investorconfidence.

Higher interestrates wouldcause investorsto demandhigher riskpremiums.Economicactivity would

slow, and fear ofdefault would

At someunpredictablepoint, the bondmarkets will nolonger believethat the U.S.government will

be able to meetboth itsentitlementobligations andits contracteddebts, unless itinflates itscurrency.

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by 2083, with40% of GDPgoing to interestpayments.

cause the cycleto repeat.

Possible

Outcomes U.S.

governmentdebt repudiation

would cause $4trillion in direct,private sectorlossesthelargest in mutualfunds, state andlocalgovernmentsand theirretirementfunds, and

privatepensions.

Investors wouldlikely begin todumpTreasuries, andthe preferredassets willinfluence thedynamics of the

impendingcrisis.

Default wouldreduce futuretaxes. In a fullrepudiation, thedebtor gainswhat thecreditor loses.

As bondholdersget paid fromthe gap

betweengovernmentrevenues andspending, abattle againsttax increasesmay herald acrash.

Republicanslosing power

from time totime, therebyallowing theDemocrats toraise taxes isthe bestoutcome forbondholders.

Demand forgovernment can

increase aftertax cuts.

In a negotiateddefault, anoutside agency

would enforceausteritymeasures, andlenders andborrowers wouldagree to writedown orrescheduledebt.

Debt

restructuringmay result if theU.S. negotiatingposition isstronger than itscreditors.

The U.S. wouldhave to give upsomesovereignty and

abide by theIMF to continueborrowing ininternationalcredit markets.

Higher interestrates wouldcrush small

businesses,therebydisrupting thesupply chains oflargerbusinesses andthrusting thenation intodouble-digitunemploymentas businesses

fail.

Servicing thedebt will causeprivate andpublicinvestment ininfrastructureand humancapital to dropsignificantly.

Uncertaintyabout the futurewill causeprivateinvestment todry up further.

This will be acrisis but not asovereign debt

crisis. Inflationpolitical/financialwill triggerhigher interestcosts, highercommodityprices, a lowerstandard ofliving, and aseriousrecession.

The U.S. mustdecide betweenmeeting its debtobligations witha stable dollarand fulfillingpoliticalpromisesimplied by theentitlement

system.