Bacon's Rebellion

James A. Bacon

Imagine this scenario: Investors in U.S. Treasuries are so nervous about the country’s credit worthiness that they pile into notes with short-term maturities. Thirty percent of the national debt rolls over each year. To cover its routine borrowing, equal to 10% of the economy, and to keep the debt treadmill rolling, the federal government is finally forced to raise taxes or cut spending — not just talk about doing it. The anti-stimulus (I call it “suckulus”) threatens to tank the economy. Investors panic and no one wants to touch Treasuries. Abandoning its inflation targets, the Federal Reserve creates money as a short-term measure to purchase the bonds and keep government afloat. The prospect of fiscal austerity and runaway inflation proves even more ruinous to the economy. The political class starts discussing Greece-like scenarios. Should the U.S. continue printing money? Should it raise taxes? Should it force owners of U.S. debt to take a haircut?

All the choices are bad. If the U.S. tries closing a  budget gap equal to 10% of the economy, the resulting fall in output might approach 25% after the multiplier effect kicks in. The alternative is setting off Zimbabwe-style inflation that amounts to a 99% tax on financial wealth. Either way, a U.S. debt default triggers a global economic crisis far worse than the one we’ve just come through.

Sounds like a scenario ripped out of the pages of “Boomergeddon”? Indeed, those are precisely the kind of unthinkable thoughts that I wrote about, predicting a Great Depression-scale economic catastrophe if the United States does not quickly and dramatically correct course. But it comes from a new paper, “Catastrophic Budget Failure,” written by Leonard E. Burman, Jeffrey Rohaly, Joseph Rosenberg and Katherine C. Lim and published by the National Tax Association.

The thesis of “Boomergeddon” was an outlier when I published it more than a year ago. But the idea is going increasingly mainstream. The authors of “Catastrophic Budget Failure” are very worried about where the U.S. is heading, and for exactly the same reasons.

I’m particularly intrigued by their paper because the authors buttress an argument that I alluded to only briefly — how the Euro crisis would interact with U.S. debt crisis: first masking the symptoms of our malaise and then accentuating it. The argument goes like this: The euro crisis has driven billions of dollars worth of investment into U.S. Treasuries as investors seek a safe haven for their money. While Treasuries are perceived to have long-term risk, that’s better than the short-term risks of European sovereign debt. The flight to safety keeps U.S. interest rates low, convincing the big spenders that there is little risk to their reckless fiscal policy.Write Burman et al.:

This has been convenient in short-term because it enabled a huge amount of Treasury borrowing to fund economic recovery programs at miniscule interest rates, but it raises the threat of an explosion in interest rates in the future. Suppose that U.S. finances continue to deteriorate and that the European Union works out its policy coordination and monitoring problems. At some point (presumably in the distant future), investors could decide that the European Union, which is twice the size of the U.S. economy, is a better investment and Treasury interest rates could increase very suddenly. That shock could produce a tangible risk of default.

Even if such a shift in investment sentiment doesn’t trigger a default, it will drive up the cost of carrying the national debt, now $15 trillion and heading to $22 trillion or so in another decade assuming that the Obama administration’s  happy-face budget forecasts pan out. But rising interest rates would push annual interest on the debt from roughly $230 billion this year to well over $1 billion a year a decade from now. Treasury would borrow more money to pay the interest, swelling the debt and future interest payments. Crash. Boom.

Since my book was published last summer, my every fear has been confirmed. Democrats and Republicans have utterly failed to make a serious dent in the budget gap. If government remains divided between the Ds and Rs, that’s it. Game over. Abandon hope. If the Rs sweep the presidency and both houses of Congress, the end of political gridlock might make progress possible on spending cuts… except in the defense arena… and most entitlements… The fear of electoral backlash and losing the next election to the Ds will restrain them from taking the bold measures that are necessary.  I hold out some hope that the Rs can do a better job of getting the economy moving again, but the economy faces bigger problems than Obama. There is no magic-wand solution.

So, what’s a middle-class American to do? Buy that cabin in the woods and load up on shotgun shells and concertina wire. There’s still time. Boomergeddon should take 10 more years to get here. But it’s gonna get ugly when it comes.