Greater Risk of a Fiscal Crisis

High and rising federal debt increases the likelihood of a fiscal crisis. Such a crisis can occur as investors’ confidence in the U.S. government’s fiscal position erodes, undermining the value of Treasury securities and driving up interest rates on federal debt because investors would demand higher yields to purchase those securities. Concerns about the government’s fiscal position could lead to a sudden and potentially spiraling increase in people’s expectations of inflation, a large drop in the value of the dollar, or a loss of confidence in the government’s ability or commitment to repay its debt in full. The risk of a fiscal crisis appears to be low in the short run despite the higher deficits and debt stemming from the pandemic. That risk is also mitigated in the short run by certain characteristics of the U.S. financial system, including independent monetary policy, government debt issued in U.S. dollars, and a central place in the global financial system. Nonetheless, the much higher debt over time would raise the risk of a fiscal crisis in the years ahead.

In a fiscal crisis, dramatic increases in Treasury rates would reduce the market value of outstanding government securities, and the resulting losses incurred by holders of those securities—including mutual funds, pension funds, insurance companies, and banks—could be large enough to cause some financial institutions to fail. A fiscal crisis could thus lead to a financial crisis. Because the United States plays a central role in the international financial system, such a crisis could spread globally.

Policymakers would have several options to respond to a fiscal crisis. Each option would have economic and distributional consequences, though, and choosing among them would involve difficult trade-offs. One policy option would be to dramatically cut noninterest spending or increase taxes, which would have adverse effects on the economy in the short run. Two other options would have more significant effects on currency and financial markets. One option would be to use monetary policy to purchase Treasury securities, which may initially have limited adverse effects but which ultimately would in all likelihood raise inflation (relative to prior inflation expectations), thereby reducing the real cost of financing outstanding debt. Such an action could lead to depreciation of the dollar and undermine its role in international currency markets, which in turn could lead to even higher inflation and declines in real wealth and purchasing power. The other option would be to restructure the debt (that is, modify the contractual terms of existing obligations) so that repayment was feasible. (Restructuring the debt is generally viewed as less likely because it would undermine investors’ confidence in the government’s commitment to repay its debt in full.) Coordination of fiscal and monetary policies in times of crisis also could present significant challenges.