Long-term fiscal health is a tangible indicator of effective governance and an essential aspect of an attractive business environment. Nations that manage their fiscal and monetary affairs responsibly are rewarded by the marketplace with low borrowing costs and strong currencies. Conversely, a growing and unsustainable debt burden can undermine confidence, increase business uncertainty, disrupt financial markets and increase government borrowing costs. If not addressed, large debt burdens will have painful economic consequences, including high unemployment, chronically weak consumer confidence and a slowdown in investment.

 

U.S. debt levels have jumped sharply in recent years. The ratio of publicly held debt to GDP has nearly doubled in the last four years, up from 36 percent in 2007 to 68 percent in 2011, driven in large part by the recession of 2007–09 and the financial meltdown of 2008. However, the CBO has estimated that even if the economy were operating at full capacity today, the deficit would be reduced by only about one-third, and total debt would continue to grow. 

 

As debt grows relative to the economy’s ability to service it, private investment may be seriously reduced. As seen in Greece and other European nations, where unproductive economies cannot service fast-rising debt, the resulting loss of international confidence can cause interest rates to soar in a matter of months or even weeks — and quickly make a debt situation unsustainable. Economists Carmen Reinhart and Kenneth Rogoff have recently estimated that levels of indebtedness as high as those on the United States’ horizon are associated with sharply lower growth.

 

While some reduction in U.S. deficits should be expected as the economy continues to recover, the most significant long-term obstacle to reducing the nation’s large and growing annual budget deficits is the increasingly unsound financial footing of the entitlement programs: Social Security, Medicare, Medicaid and other health programs. Driven by demographic trends and fast-rising medical costs, these programs will claim an ever-growing portion of the federal budget and, without meaningful policy reforms, will produce a number of negative consequences for the U.S. economy. 

 

Projections of fast-rising government debt tend to erode confidence among financial markets and their investors. As the economy recovers, increased borrowing by the government will drive up interest rates, crowd out private investment, and make the U.S. economy more dependent on foreign borrowing and foreign investment. To the extent that private capital stock investment is smaller than it would be otherwise, the United States will experience a smaller productive capacity, reduced GDP and lower future living standards for American families. 

 

Although an unsustainable debt position need not — and usually cannot — be addressed in a short period of time, markets and investors may be reassured by tangible and credible steps taken by political leaders seeking long-term solutions. 

First, policies to enhance the credibility of long-term fiscal realignment, including immediate efforts to place Social Security, Medicare and Medicaid on a sustainable path, can boost consumer, business and market confidence in the near term. Second, medium-term and long-term fiscal consolidation must balance spending and revenues. Fiscal consolidation efforts undertaken primarily through cuts in government spending are likely to be more successful over the longer term than fiscal consolidation that relies primarily on tax increases.

 

Sound fiscal and monetary policies can reduce real interest rates and stimulate private investment. These results support higher levels of capital spending and employment, which in turn increase productivity and consumer confidence, creating a virtuous cycle of economic prosperity.