Resident Fellow Desmond Lachman

There can be little doubt that the loss of control over the US public finances poses a real long-run risk of high interest rates and high inflation that in turn could reduce the US economy’s longer run growth potential. This is particularly the case when one considers the very high degree to which the US government deficit is financed from abroad, which exposes the country to the risk of a dollar crisis. For this reason, one has to regret that the Obama Administration is yet to spell out in a credible manner how the US public finances are to be placed on a more sustainable medium-term basis.

The long-run US fiscal outlook must give rise for serious concern about how the government will crowd out private investment once the economy fully recovers. On evaluating the 2009 budget, the Congressional Budget Office estimated that on present policies, the US public debt would approximately double from around 40 percent of GDP in 2008 to over 80 percent of GDP by 2019. The CBO also estimated that, even once the economy fully recovered, the government deficit would remain in the range of between 4 percent and 6 percent of GDP.

While prospectively very large budget deficits pose clear long-run inflation risks to the US economy, in the immediate term those risks would seem of a very much lesser order. Indeed, it would seem that the very weak economic recovery in prospect and the very large gaps that will continue to characterize the labor and output markets for some time will keep downward pressure on inflation and will keep interest rates in check.

In the immediate term, one has to expect an unusually weak US economic recovery. The presently large gaps in the labor market are bound to severely constrain household income growth while attempts by households to repair damaged balance sheets will cause the savings rate to continue to rise to a more normal level. In the absence of meaningful consumption growth, it is difficult to see how the US gets an overall economic recovery of any strength or how unemployment comes down from its presently high level.

The weakness of the US economic recovery in the period immediately ahead is bound to give rise to calls for a second stimulus package that would further compromise the US public finances. One must hope that if the Administration does need to introduce a second fiscal stimulus package, it does so in a more targeted and thoughtful way than it did the first time around. One must also hope that it does so in conjunction with a clearly articulated and credible medium-term budget program that includes specific commitments to bring the US public finances back under control within a reasonable time-frame. Failing that, the Administration should not be surprised by negative reactions in the US bond market and on the foreign currency exchanges that could further complicate economic recovery prospects.

Desmond Lachman is a resident fellow at AEI.