The Bankwatch

Tracking the consumer evolution of financial services

Nice summary of the US dilemma from Brookings but no answers

How We’re Doing as Debt Fears Rise | Brookings

The policy response to the Great Recession — while reducing some risks to credit markets — has created new problems. The loss of household wealth, income and credit was partially replaced with a substantial increase in government borrowing to mitigate the drop in demand for goods and services. The U.S. debt held by the public has risen to 53 percent of gross domestic product and is projected to reach 67 percent by 2020. Further, the increase in the Federal Reserve’s balance sheet from $0.9 trillion at the end of 2007 to $2.4 trillion has led some analysts to worry about inflationary pressures.

However there is no solution offered, with the obvious answer being something difficult involving taxes and politically hard cutbacks.

Even if the massive policy response to Greece succeeds in stabilizing world financial markets, there are longer-term implications of rising U.S. public indebtedness. The textbook concern is that it eventually leads to higher interest rates, which will lower capital formation and productivity, ultimately reducing economic wealth. But the financial crisis of the past two years provides further lessons. First, the government must be prepared to step in when private demand for goods and services deteriorates, but significant long-term debt will constrain the U.S. government’s ability to respond to an economic crisis if required. Second, in the highly interconnected global economy, markets can respond suddenly and punitively to highly leveraged institutions. Financial markets in 2008 witnessed an abrupt loss in investor confidence, triggering runs on such financial institutions (remember Lehman Brothers?).

The U.S. government provided — and should continue to provide — critical short-term support for the still-recovering domestic economy. But to reduce the chances of future economic crises, we urgently need to show a convincing commitment to longer-term fiscal strength.

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Written by Colin Henderson

June 1, 2010 at 21:57

Posted in Uncategorized

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