Fiscal Implications of Rising Market Pressures

In a recently released IMF working paper, economists Salvatore Dell’Erba, Todd Mattina, and Agustin Roitman looked into the precursors of fiscal consolidations across 17 OECD countries during the 1980 to 2011 time frame. The report finds that market pressures -- as evidenced by changes in government interest rates, currency values, and credit ratings -- under roughly a third of fiscal consolidations. Within the scenarios with market pressure, larger fiscal consolidations were generally taken.

The larger than typical consolidations under market pressure is particularly relevant to our country's financial position. With public debt elevated and facing an upward long-term trajectory, a downgraded Standard & Poor's credit rating, and no agreement on how to control future deficits and debt, the U.S. is exposed to risks. The relevant question remains: whether significant deficit reduction will be the result of an economic shock (be it rising interest rates, reduced appetite for holding U.S. Treasuries, or another form of market pressure) or result from our own foresight and leadership.

The working report ultimately concludes that approximately one-third of fiscal consolidations occurred under market pressure. This suggests that market pressure does play a significant role in spurring action to reduce a nation's deficits, although this is not the majority of all cases. The second point should provide some hope; based on history, lawmakers may be successful in pushing for reform before the markets force their hand. The paper closely resembles the conclusion that George Mason Professor Paul Posner found in his report, Will It Take a Crisis? Posner writes:

...Democratic nations are not doomed to be reactive to market pressures alone. Rather, the record shows that policy makers and publics alike can be summoned to fiscal sacrifice and longer-term vision by compelling ideas presented in ways designed to mobilize broader publics traditionally unengaged in budget decision-making. Elected leaders at times are rewarded by publics that are persuaded to view sacrifices as necessary for the broader public good. While leaders may indeed attempt to justify their actions based on what they define as a “crisis”, often these actions are taken to head off a serious exogenous crisis, as we have defined it in this paper.

Lawmakers can enact deficit reduction plans by communicating the issue, even if market forces have not yet taken hold. This is to the country's benefit - if inaction ultimately leads to increasing market pressures that force consolidation, the resulting backlash is much more dangerous. As the IMF working paper suggests, "market based and market forced fiscal consolidations will be much larger than non-market forced consolidations." This is largely in line what we have often warned - making changes now will allow for smart, phased-in policies that might not be available further down the road. The kick the can approach is much more risky.

The IMF paper leaves us with a simple conclusion: we must act soon. By dealing with our debt now, we can get our fiscal house in order under our terms. If we wait too long, we won't have that luxury.