America's Shrinking 'Fiscal Space'

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by: James Bacon

Debt-to-GDP ratiosThe United States has limited room to borrow before hitting its debt limit, the point at which interest payments on the national debt become so devouring that the solvency of the federal government is called into question. So concludes the International Monetary Fund paper, “Fiscal Space,” published last week.

The paper explores the concept of “fiscal space” — the difference between the current level of debt and a theoretical debt limit. The more fiscal space a country has, the greater its ability to maneuver economically. The smaller the fiscal space, the more constrained its fiscal options are. Once a country hits the debt limit, investors become so concerned about its ability to repay its debt that they demand higher interest rates as a risk premium. The higher rates drive up interest payments, worsening the deficits and adding more debt, creating even greater fear in a vicious cycle. Says the IMF:

A finding that a country has little or no fiscal space is not a prediction that public debt will explode or that the government will default … but rather that something must change and fiscal policy cannot proceed on a “business as usual” basis. Specifically, fiscal policy will need to react more strongly to debt than past behavior would suggest.

Using an elaborate methodology, the IMF concluded that Greece, Italy, Japan and Portugal appear to have the least fiscal space. Iceland, Ireland, Spain, the United Kingdom and the United States are “constrained in their degree of fiscal maneuver,” especially given the run-up in debt projected over the next several years.

The chart above, adapted from IMF data, shows the countries with the highest projected debt/GDP ratios in 2015. Although nations differ in their ability to carry debt, the debt/GDP ratio is a pretty good proxy for the level of fiscal stress. Countries with low ratios experience relatively little stress — if the debt is low, the country enjoys the added advantages of stronger investor confidence and lower interest rates. Conversely, if the debt is high, the country must deal with investor skepticism and higher interest rates.

Because there are so many variables that affect a country’s credit-worthiness, however, the IMF does not state outright what it deems the “debt limit” for each country to be. To reflect inevitable uncertainties, the authors of the paper provide a probability that a given country has a certain amount of Fiscal Space expressed as a percentage of GDP.

Thus, by the IMF’s reckoning, Japan has 99.9% probability of reaching its fiscal limit. Uh, oh. Greece has a 93.7% of reaching its fiscal limit. That’s a tiny margin for error. The U.S. has a 28.2% probability of reaching its fiscal limit, and a 47.8% probability of having “fiscal space” equivalent to half of its GDP. In other words, the odds are, we will still have some breathing room in 2015 — but not a lot. An economic shock could push us over our fiscal limit.

If we project another five years ahead to 2020, when, even according to Obama administration forecasts, the ratio of national debt to the GDP will continue to grow, our “fiscal space” will continue to diminish.

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