A Wake-Up Call for U.S. Fiscal Policy

Moody’s downgrades United States ratings to Aa1 from Aaa

The statement:

We do not believe that material multi-year reductions in mandatory spending and deficits will result from current fiscal proposals under consideration. Over the next decade, we expect larger deficits as entitlement spending rises while government revenue remains broadly flat. In turn, persistent, large fiscal deficits will drive the government’s debt and interest burden higher. The US’ fiscal performance is likely to deteriorate relative to its own past and compared to other highly-rated sovereigns.

5 year CDS on US Treasurys (from worldgovernmentbonds.com)

Downgrades and CDS
By: Menzie Chinn – University of Wisconsin–Madison

Rising U.S. debt: gradual risks, not immediate crisis

In this Brookings commentary Wendy Edelberg, Ben Harris, and Louise Sheiner find that while the US federal debt is on an unsustainable long-term path-projected to rise from 98% of GDP in 2024 to 166% by 2054-an acute fiscal crisis is unlikely in the next few decades if current institutions and fiscal norms are maintained.

The authors identify four main risks that could trigger a fiscal crisis, such as a sudden loss of demand for Treasuries, political brinkmanship leading to missed payments, loss of inflation control by the Federal Reserve, or a sharp deterioration in the fiscal outlook prompting investors to fear default. However, they conclude that most of these risks are manageable and that crises are more likely to stem from political missteps than from debt levels alone.

Assessing the risks and costs of the rising US federal debt
Authors: Wendy Edelberg, Ben Harris, Louise Sheiner
From: Brookings

Congressional inaction and the quest for U.S. debt stability

In this paper, Alan J. Auerbach, Danny Yagan examine the historical and prospective dynamics of U.S. fiscal policy, focusing on Congress’s responsiveness to deficit projections and the conditions required to stabilize the debt-to-GDP ratio over the long term. By combining empirical analysis of legislative behavior with forward-looking simulations, the authors identify a critical shift in fiscal responsibility since the early 2000s and quantify the policy adjustments needed to avoid unsustainable debt trajectories. The research employs a dual approach:

Historical Analysis of Legislative Behavior
– Data source: Congressional Budget Office (CBO) records spanning 1984–2024, tracking legislated changes to deficits.
– Regression models: Investigated how Congress adjusted primary surpluses in response to projected deficits and economic conditions. Key variables included CBO’s five-year deficit forecasts and lagged output gaps (economic slack).

Forward-looking simulations
The authors simulated debt trajectories under varying fiscal feedback rules, incorporating:

1. Debt accumulation mechanisms: Driven by interest-growth differentials and primary deficits.
2. Economic shocks: Large, infrequent deficit shocks (e.g., recessions, pandemics) and persistent interest-rate fluctuations.
3. Feedback scenarios:
   – Gradual adjustments: Deficit- or debt-targeted responses.
   – Sudden adjustments: Large deficit reductions triggered by rising debt-service costs.

Findings

Disappearance of fiscal feedback post-2003

• 1984–2003 era: Congress systematically reduced deficits when projections worsened, demonstrating statistically significant responsiveness. Legislative changes offset a substantial portion of projected deficit increases, with revenue and spending adjustments contributing to stabilization.
• 2004–2024 era: Fiscal feedback vanished. Deficits increased regardless of projections, with no statistically meaningful relationship between legislative actions and fiscal forecasts. This shift persisted even after excluding recessionary periods and controlling for economic conditions.

Stabilization requirements under uncertainty

• Gradual feedback:
  – Modest ongoing adjustments could stabilize debt under stable conditions. However, accounting for shocks (e.g., recessions, interest-rate volatility) necessitates stronger responses-approximately half the magnitude observed historically.
  – Debt-targeted rules (linking surplus adjustments to debt levels) proved more robust to shocks than deficit-targeted rules.
• Sudden feedback:  Infrequent large deficit reductions (e.g., 1.5% of GDP) could stabilize debt but require rapid implementation during crises. For example, two major adjustments within a 12-year period might be needed in adverse scenarios, challenging “wait-and-see” approaches.

Counterfactual insights: Had pre-2003 feedback patterns persisted, current debt levels would be significantly lower. Debt-targeted rules would have particularly mitigated post-2008 and post-2020 debt surges.

Policy implications for the next decade: To stabilize debt below 250% of GDP over 100 years with 95% confidence:

• Gradual adjustments:
  – Deficit-focused: Average annual deficit reduction of 1.1% of GDP over the next decade, intensifying to 1.9% by 2034.
  – Debt-focused: More moderate reductions (0.5% annually), leveraging automatic responses to debt accumulation.
• Sudden adjustments: Require political capacity to enact large, sustained deficit cuts during crises, with minimal delay between interventions.

Conclusion
The erosion of fiscal feedback since 2003 has heightened U.S. debt sustainability risks. While historical responsiveness sufficed to stabilize debt, current inaction necessitates either a return to structured deficit reduction or reliance on high-stakes, crisis-driven adjustments. The analysis underscores that gradual, rules-based responses-even at half historical strength-are preferable to infrequent shocks, which risk compounding debt dynamics during periods of economic stress. Policymakers must prioritize institutional mechanisms that enforce fiscal discipline, particularly in the face of rising entitlement spending and potential interest-rate pressures.

Robust Fiscal Stabilization
Authors: Alan J. Auerbach, Danny Yagan
From: University of California, Berkeley