Committee for a Responsible Federal Budget

Eurozone Challenges Should Give Pause to U.S. Lawmakers

Dec 6, 2011

Europe's worsening debt crisis--notably Italy's--should serve as a warning to the United States of what can happen to an otherwise steady, solvent economy whose debt is too high. In short, when debt gets so precariously high that interest payments become a very large budget line, debt markets can expand a slight decrease of confidence into a significant increase in interest rates. From there, the crisis can quickly descend into a national failure to refinance expiring bonds, and then possibly into national bankruptcy and default. S&P recently warned of possible downgrades to 15 counties in the eurozone.

Italy’s fiscal situation is not like Greece’s, and this fact should give pause to U.S. lawmakers. In early 2011, Italy’s fiscal situation looked quite stable -- except for starting the year with public debt at 118 percent of GDP. Debt at that level has already been shown to be associated with slower economic growth by economists Carmen Reinhart and Ken Rogoff. GDP was forecast to grow at a meager one-half to one percent (real), but the national budget was expected to produce a primary surplus of 0.8 percent. As late as August, interest on Italy’s debt was forecast to cost a whopping 4.8 percent of GDP, leaving the net annual deficit at 4.0 percent--not good, but much less than 8.5 percent for the U.S. in FY 2011. In the first months of 2011, interest rates on Italian debt were stable at about 4.8 percent, while annual inflation was forecast at 2.2 percent. Today, by contrast, Italian-debt interest rates over 7 percent are pushing Italy toward default and a possible exit from the euro, catastrophic consequences for the Italian economy, terrible consequences for many European banks and economies, and very bad consequences for the world economy.

The timing of such a reckoning cannot be predicted. Obviously the U.S. is not Italy, and our economy arguably has more fiscal room to maneuver given the overall size of our economy and that the dollar is the world's reserve currency. However, our fiscal situation is nonetheless grave. Today’s U.S. national debt is 68 percent of GDP, forecast to increase to about 81 percent by 2021 and higher after that. In 2011, interest on the debt cost 1.5 percent of GDP at historically low rates (in part due to troubles in the euro zone). By 2018, however, interest on the debt is forecast to cost 3 percent of GDP and to rise steadily from there.

It’s also important to remember that Italy’s crisis of market confidence falls on a country that had a fiscal plan under average historical interest rates to muddle through some of the challenges. Some of the other Euro countries in trouble, however, did not have such a plan, or at least not one adequate for a major shock like the current recession. Ireland is struggling to put such a plan in place; Greek political forces are not yet resolved enough in favor of such a plan to reverse their crisis; and Spanish and Portuguese political actors have not yet determined a path toward fiscal sustainability. On this last element, U.S. lawmakers have too much in common with some European counterparts, and they need to agree on and pass a big, comprehensive plan for fiscal sustainability in this country.

The higher the national debt, the less wiggle-room for constant financing and refinancing of the debt, and the greater the vulnerability to a tipping-point and crisis of confidence--whose timing cannot be predicted. In Herbert Stein’s famous words, “If something cannot go on forever, it will stop.” The growth of U.S. national debt cannot go on forever at current rates, and it will stop. It’s up to lawmakers to stop it earlier and less painfully now, in order to avoid an abrupt, involuntary, and very painful halt later on. It's always better to act in advance.