US fiscal spending is unsustainable because its is escalating too high too fast but the threshold that would make the US a basket case is unknown.
“There is some level of debt that is high enough – although we don’t know how high that is – that generating the required amount of future surpluses required would be infeasible,” says Richmond Fed Economic Brief.
The problem with determining the threshold is because the market may suddenly realize that the government is unable to repay its loans and, as we have seen in the case of the European sovereigns, may too suddenly turn on selling.
At issue is the federal debt held by the public based on the current laws versus the expected laws.
Based on the current laws, public is seen holding, over time, less debt while based on expected laws, the percent of debt that the public is expected to hold goes exponentially higher (graph above).
As a result, Fed says that there is a divergence between belief and expectations: the belief is that by 2042 debt held by the public as percentage of GDP is to sink below 50% whereas the expectation is that it will explode to 250% of GDP… and the Fed may be impotent.
“In practice, however, a central bank’s credibility cannot constrain fiscal policy in any meaningful sense. It cannot stop fiscal policy makers from running budget deficits that continually expand the debt,” warns the Fed.
Ostensibly, minding its mandate, the Fed is concerned that the break-down in the belief that the US debt is unsustainable may cause inflation, yet it warns the politicians that such inflation may wreck havoc across the economy.
“That situation would inevitably invite monetary policy makers to intervene since inflation presents one possible source of revenue. In fact, economic research suggests that high debt levels ultimately could overwhelm a central bank’s efforts to keep prices stable, an effect discussed next,” says the Fed.