United Liberty

Given the debt situation our country is in, long-term debt projections present serious cause for concern, the International Monetary Fund has analyzed whether or not lenders will stop supplying our habit:

[E]conomists at the International Monetary Fund are paid to ponder the improbable, and in papers published on Wednesday fund staff examined where the U.S. and other developed countries fit on a continuum between easy living and disaster.

We’re farther along than you might think.

Using a concept known as “fiscal space” - basically how much latitude a country has to borrow before markets will shut off the spigot by demanding unsustainable interest rates - the IMF staff drew a bright red line through five nations it considers to be running out of room: Greece, Iceland, Italy, Japan and Portugal. Of the 23 developed nations it analyzed, four others, including the U.S., received a yellow caution flag.

Does it mean default is imminent or inevitable? Hardly - and in companion articles the fund discussed the steps being taken to control public debt, and broadly discounted the chance of an outright sovereign default among any of the advanced countries.

But consider the U.S. The IMF estimated a series of probabilities regarding the amount of increased debt a country might be able to sustain without hitting its projected point of no return.

In the case of the U.S., the fund said the odds were roughly three out of four that the country could increase its total debt to some degree without being penalized by investors — logical considering that the debt is steadily increasing and interest rates remain low and steady.

However that probability falls to an even 50-50 if the amount of new borrowing were to exceed fifty percent of GDP - or about $7 trillion given the current, $14 trillion size of the U.S. economy.

That might seem like plenty, except for the fact that under current Office of Management and Budget projections the “fiscal space” may fast disappear. The OMB projects total U.S. debt to jump by about $4.7 trillion in the next five years, leaving little room after that.

Via Peter Suderman at Reason, Arnold Kling looked into this recently in a paper at the Mercatus Center:

The trigger point for a debt crisis is not quantifiable. This is often true even in the case of private debt, such as a credit card balance. What should be the trigger point at which your bank disallows use of your credit card? If the limit were based solely on your theoretical ability to pay, then the upper limit on your credit card balance would equal the present value of all of your future earnings. However, you clearly are not going to work solely for the purpose of paying the outstanding balance on your credit card. Your willingness to pay is much less than your ability to pay. This presents the bank with a problem in psychological guesswork. The bank has to estimate the maximum amount that you can borrow and still be willing to repay.

If you are a credit card borrower with a large outstanding loan balance, your decision to default depends on the costs and benefits of default. The costs might include various legal penalties as well as reduced access to credit in the future. The benefits of default would include the ability to devote more of your future earnings to consumption, rather than to repaying the debt. If your perception is that the costs of default are less than the benefits, then you will choose to default.

However, another borrower in similar circumstances might evaluate the costs and benefits differently and choose to repay the debt.

The fact that different people may respond differently under similar circumstances poses an analytical challenge for the bank. In addition to assessing the borrower’s financial characteristics, the bank must guess how they are likely to behave under financial distress. The circumstances surrounding sovereign debt are, if anything, even murkier. The holder of sovereign debt has little or no legal redress available in the event of default. For the sovereign borrower, the cost of default is pretty much limited to (temporary) loss of reputation in credit markets.

Kling believes that we will “experience a debt crisis within the next two decades, unless the path for fiscal policy changes from what is projected by the Congressional Budget Office.” There is no sign of any political will to deal with this and the only person putting forward a serious plan is Rep. Paul Ryan (R-WI).