The Economics of the Fiscal Cliff

As 2013 gets closer, the calls get louder to reverse earlier decisions by the US government and Congress that would lead to public spending cuts and higher tax rates beginning next year. The United States is moving towards a “fiscal cliff” we are told which would bring down the American economy because of the massive “extraction” of funds. What is behind these claims? What are the determinants of public debt, the essentials of debt management and where is the economy headed?

Public Debt

The size of a country’s total public debt is the result of past budget deficits. A budget deficit comes into existence when a government spends more than it collects as revenue. If taxes and other sources of government receipts fall short of public spending, government needs to borrow. With each new budget deficit the size of debt increases and along with the principal the obligation to pay interest also rises.

As an indicator of the debt burden serves the so-called debt coefficient which relates overall debt to the gross domestic product (gdp). In the light of this number a rise of total debt need not necessarily denote an increase of the relative debt burden. If the rise of total debt is matched by an equivalent increase of national income, relative debt as measured by the debt coefficient remains constant. By the same token, the relative debt burden would increase even without new debt if national production should shrink.

The distinction between the so-called “primary deficit” and that part of the budget deficit which pertains to interest payments is important because the amount of interest payments varies not only with the size of outstanding debt but also with the interest rate.

When assessing the debt burden, the rate of price inflation constitutes an important factor. Price inflation devalues outstanding debt. This happens in a creeping way when inflation rates are low and in a dramatic way when inflation rates are high. In the case of hyperinflation when ordinary goods of daily consumption fetch prices in the billions or trillions even a gargantuan public debt would evaporate. However, a deliberate fabrication of hyperinflation in order to get rid of the debt burden can hardly count as a rational strategy. Such a policy would come at the price of wreaking havoc with the economy as a whole.

In order to capture the impact of the price level on the debt burden, one must distinguish between the nominal rate and the real rate of interest. The current nominal interest rate is composed of the real interest rate plus the expected inflation rate. While the real interest rate is relatively stable, the expected inflation rate and therefore nominal interest rates are volatile because of the uncertainty concerning the future inflation rate.

Determinants of Public Debt

Public debt in terms of the debt coefficient – total debt in per cent of gross domestic production – will rise or fall according to the movement of the following determinants.

The relative debt burden will be higher the more

  • government will spend
  • the interest rate will rise
  • there has been debt accumulation in the past.

The relative debt burden will be lower the more

  • tax revenue will augment
  • the rate of price inflation will rise
  • economic growth will increase.

Representing the impact of the variables on the debt coefficient with a plus sign (+) for increase and the negative sign (-) for reduction, one can summarize these findings in a simple table.

Table 1

The debt coefficient as overall debt in percentage of gross domestic product will rise (+) and fall (-) with the increase of the following variables

Debt coefficientGovernment spending risesGovernment revenue risesReal interest rate riseNominal interest rate risesPrice inflation risesRate of economic growth risesSize of past debt accumulation
rises (+) falls (-)+-++--+

Debt Management

According to the enumeration above (table 1) it may appear easy to construct a package for bringing down the debt burden without cutting expenditures. Such a simplistic plan would include measures to

  • raise taxes
  • decrease the interest rate
  • increase price inflation
  • stimulate economic growth
  • reduce size of accumulated debt (by forgiveness or default)

The problem with such a policy is that while each measure would work in isolation, the factors are interdependent and therefore such a package would contain contradictory measures.

Taxes: A government cannot simply raise taxes. All it can do is to impose the tax rate. Higher tax rates do not imply higher tax revenue but a rate that is set too high can actually lead to lower tax revenue.

Interest rates: Central banks control the nominal interest rate mainly for short maturities by setting the policy rate such as the federal funds rate in the case of the United States. The monetary authorities have much less power over the interest rate for longer maturities. An additional limitation of interest rate policy comes from the fact that when nominal interest rates hit zero bound the occurrence of price deflation would mean rising real interest rates.

Inflation: The monetary authorities are able to push the monetary base but the size of money in circulation results from the interaction of borrowers and lenders in the financial markets.

Economic growth: The long-term rate of economic growth depends on factors beyond manipulation by fiscal and monetary policies. Economic growth is the result of a confluence of hard and soft factors that include the quality of macroeconomic management, governance and culture. Education, infrastructure and the legal framework exert their influence on economic growth not over years but decades.

Debt reduction: One way to reduce the amount of past debt accumulation is debt forgiveness. Such a measure reduces the amount of the outstanding debt right away and lowers the coefficient. A well-negotiated debt reduction may contribute to lower interest rates and accelerate an economic recovery. Economic expansion would mean an increase of government revenue particularly when it is accompanied by lower interest payments. Yet granting debt forgiveness and managing an orderly debt restructuring depends on the willingness of the lenders. Whether lenders agree on rescheduling in order to reduce the debt burden depends not only on financial factors but very much on the geostrategic position of the indebted country when foreign lending is involved as it is mostly the case with public debt.

Default: Another way of reducing the amount of current debt is through default. Yet deliberate nonpayment provides no way out of the debt trap. Such a policy would forfeit access to the capital market and crush economic growth right away. Any kind of default exacerbates a return to prosperity. The detrimental impact of default on economic growth may be long-lasting. As easy as it is to lose confidence as hard is it to regain trust.

Is There a Way Out of the Debt Trap?

An effective debt reduction strategy, which would bring down the debt coefficient, must address both variables of the debt quotient. Such a policy must seek to bring down total debt combined with lifting the rate of economic growth. It makes no sense to bring down debt when at the same time the economy would shrink and the gross domestic product would fall. Likewise the relative debt burden would not go away even with a larger gross domestic product, when the boost of economic growth rates has come mainly from more public spending. What is needed in order to bring down the debt coefficient is a reduction of absolute debt in combination with a larger economy.

The way to bring down total debt is to cut spending in combination with higher rates of economic growth which would require a boost in private investment. Only a very superficial analysis would point to lower interest rates as the way to get more investment. If the central bank forces down interest rates in order to stimulate more investment, it will provoke investment errors. Because of the resulting economic distortions due to these malinvestments, such a kind of economic growth would not be sustainable.

In order to achieve enduring debt reduction, spending cuts must be accompanied by an improvement of the investment climate for private enterprise. This happened after the end of World War II in the Western world when the reduction of military spending went hand in hand with a return to the principles of free markets. Different from Roosevelt’s anti-capitalist rhetoric that had prolonged the Great Depression and the government’s political sway over the war economy that has suppressed free enterprise, the decades after World War II saw the return to solid capitalist economic principles and economic growth accelerated despite massive budget cuts.

The failure of a country such a Greece to bring down the debt quotient results from the fact that the various Greek governments before and after the debt crisis have failed to coalesce the policy of spending cuts with adequate measures to increase private business confidence and to liberate the economy. Greece is the exemplary case how the march towards the debt crisis begins as a joy ride and ends in a horror trip. The higher the debt burden, the harder it is to restrain its future growth. Passing through the limit from the manageable to the unmanageable size of public debt goes without much notice. It is only after the barrier is broken that the trouble begins. Then it is often too late for a turn-around. More often than not the ride over the cliff into state bankruptcy happens as if programmed once the critical threshold is taken.


Theory and evidence show that in order to overcome a debt crisis, policy must combine the debt reduction program with incentives for private enterprise to fill up quickly and in an efficient way the space that is left by government. With the right incentives in place, private business will generate employment and income not despite but because government does cut spending. The task ahead not only for the US but for all countries which are in a debt trap is to bring down debt in combination with a forceful surge towards free enterprise.

About the Author

Economics Professor
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