Gradual steps should be taken to avert an abrupt crisis
Viral Acharya our guest wrote on Feb 11th 2011, 15:35 GMT
IT IS clear that America cannot just "count on" growth going forward. While growth-enhancing strategies may work, and corporations may invest more as jobs and demand pick up, creating a virtual cycle, the scale of efforts and mixed results over the past two years suggest that any counting on growth must also prudentially count on associated risks. The risk of a fiscal stimulus that does not deliver on growth is an added government debt burden. While there is perhaps no immediate fiscal crisis and the woes of European countries only strengthen the role of the dollar as international reserve currency, there are three issue to worry about:
1. An American debt crisis is unlikely to be a smooth outcome; it will more likely be a trigger strategy at which its risks start looking worse than another group of countries and investors switch to a more diversified base of international currencies for their reserve holdings. This will likely erode the liquidity premiums built into different ends of the Treasury curve and raise the borrowing costs steeply and abruptly.
2. When an American debt crisis looms large, any current government would hate to be the one that takes tough measures to rein them in as the end game approaches. They would all want to borrow, even at exorbitant costs, to roll on the debt and pass on the cost to the next cycle of politicians. This political economy consideration implies that there is a prudential need to manage fiscal issues ahead of time, rather than by reacting at the end. It is quite possible that some of what we are seeing now is in fact an outcome of such political economy considerations—borrow now to "count on" growth and pass on risks to the future.
3. Spending cuts, tax increases and lengthening of debt maturity in spite of greater borrowing costs may all be needed to achieve lower liabilities, a better asset base and reduced rollover risk. These policies, if implemented abruptly, would also be dangerous, both from a triggering-a-debt-crisis standpoint as well as from the political instability or stalemate they may bring about. Again, a prudential strategy would be to work on these gradually. Of course, tax increases may be needed to affect the transfers essential for better provision of safety net employment insurance and health care.
Given these risks but also the emerging signs of a fledgling recovery, a slow but definitive fiscal policy commitment would be the best road forward. Policy uncertainty could exacerbate any risks the American economy faces in case growth does not pick up.