There is the Fiscal Cliff, Then There is the “Fiscal Limit“

In the media recently much has been said of the fiscal cliff such as the following from the Associated Press May 22, 2012:

“A new government study says that allowing Bush-era tax cuts to expire and a scheduled round of automatic spending cuts to take effect would probably throw the economy into a recession.

The Congressional Budget Office report says that the economy would shrink by 1.3 percent in the first half of next year if the government is allowed to fall off this so-called "fiscal cliff" on Jan. 1. The cliff is what experts call the combination of higher tax rates and more than $100 billion in automatic cuts to the Pentagon and domestic agencies.”


The recent and ongoing discussion of the fiscal cliff is interesting, informative and needed. However, an examination of the “fiscal limit” is insightful as well. What is the fiscal limit?


“The intertemporal budget constraint suggests that any
time the real debt increases by even a small amount—a
budget deficit is run in a single year—the expectation
of future taxes or spending must adjust to put the equation in balance. However, the equation says only that surpluses must eventually rise; it provides no guidance on when that must occur. Historical experience doesn’t provide a great deal more insight. For
example, the U.S. government ran moderate deficits,
averaging roughly 3 percent of GDP every year, from
1970 to 1997, with no obvious concern from financial
market participants about the sources of future surpluses.
That experience would imply that governments
can sustain moderate deficits seemingly indefinitely.


　

That is less likely to be true when the imbalance
between outstanding debt and future surpluses is
very large. The larger the debt grows, the larger future
surpluses—revenues in excess of spending—must be
to satisfy the equation. However, there are limits to
future surpluses. Spending cannot drop to zero; to
the contrary, spending is expected to rise to historically
high levels as a percent of GDP even under the
CBO’s most optimistic scenario, and tax revenues
have an upper limit. As tax rates grow higher, they
distort incentives to work and produce, and at very
high rates would shrink the revenue collected by the
government. There are likely to be political limits to
tax revenues even before that point is reached, a reality
reflected in the CBO’s alternative scenario assumption
that tax revenues will revert to their historical average
of 18.4 percent of GDP within a decade. With debt levels
predicted to grow much larger than GDP within
two decades, it is clear that many years of higher taxes
would be required to produce enough surpluses to
resolve the resulting imbalance. There is some level
of debt that is high enough—although how high is
difficult to predict—that generating the amount of
future surpluses required would simply be infeasible.


That point is what economists have called the “fiscal
limit.” At the fiscal limit, the government cannot borrow
further, and the government’s existing spending
promises therefore cannot be funded. At least one of
two events must occur at the fiscal limit: the government
would reduce its debt levels by defaulting, or real
debt levels would be reduced through actions taken
by the central bank.” (1)


For a grand discussion regarding the fiscal limit and what scenarios lead up to a fiscal limit and what actions are taken by central banks at the fiscal limit one may find insight in the newly published Federal Reserve Bank of Richmond’s 2011 Annual Report lead story of interest: Unsustainable Fiscal Policy Implications for Monetary Policy. The fifteen page essay is written in everyday language and is very informative. Link appears below:

http://www.richmondfed.org/publications/research/annual_report/2011/pdf/article.pdf

Notes:

(1) Federal Reserve Bank of Richmond’s 2011 Annual Report, Unsustainable Fiscal Policy Implications for Monetary Policy, pages 8, 9 and 10.