Risks of raising federal debt

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13 Terms

1
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What are the primary adverse effects when federal debt grows faster than the economy?

  • Increased interest rates: Government borrowing drives up rates

  • Crowding out of private investment: Higher rates make borrowing expensive for businesses/consumers

  • Reduced investment in productive activities: Less business expansion and innovation

  • Hampered productivity growth: Essential for improving living standards

  • Lower future income levels: Reduced economic prosperity for future generations

2
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How does high debt affect future generations even if economic growth continues?

  • Economic growth can still lead to overall improvements in living standards

  • However, high debt burden diminishes the benefits for future generations

  • Future generations experience lower income levels than they would with prudent debt management

  • Reduces potential economic prosperity compared to scenarios with managed debt growth

3
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What defines a fiscal crisis and what are its immediate effects?

  • Definition: Sudden, large, and sustained downturn in demand for U.S. Treasury securities relative to supply

  • Immediate effects:

    • Sharp and persistent increase in interest rates

    • Steep decline in U.S. dollar value

    • Stock market decline

    • Financial instability

4
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What is the most severe risk of a fiscal crisis?

  • Breakdown in Treasury markets could escalate into global financial crisis

  • Consequences:

    • Asset values plummet

    • Financial institutions destabilized

    • Economies pushed into recession

    • Prolonged crisis could severely impair economic stability and growth

5
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What are the potential triggers of a fiscal crisis?

  • No specific debt level automatically causes crisis

  • Risk factors include:

    • Political brinkmanship (failing to raise debt ceiling)

    • Loss of investor confidence

    • Fears Federal Reserve might abandon inflation target to reduce debt

    • Investor beliefs about potential U.S. default

  • Outcome depends on: Policy responses and market percept

6
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What are the different degrees of default on U.S. debt?

  • Minor default: Temporary delay caused by debt limit impasse

  • Strategic default: Deliberate decision to default on all outstanding debt

  • Inflationary default: Actions that reduce real value of debt through inflation

  • All forms: Erode confidence, raise borrowing costs, trigger loss of access to capital markets

7
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How do major Treasury holders like China affect market stability?

  • China holds about $1 trillion (roughly 3% of total outstanding debt)

  • Sell-off by major holder could cause temporary disruptions

  • Federal Reserve has capacity to intervene by purchasing Treasuries

  • Fed can buy unlimited quantities during market stress

  • Stabilization only effective if sell-off is limited and doesn't trigger widespread panic

8
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What role does the Federal Reserve play in crisis mitigation?

  • During market sell-offs not driven by fundamentals:

    • Can purchase Treasuries to stabilize prices and interest rates

    • Provides policymakers window to reassure markets

    • Enables implementation of long-term fiscal reforms

  • Limitations:

    • Effectiveness diminishes if default seems unavoidable

    • Credibility depends on maintaining confidence in fiscal responsibility

9
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What happens if the debt ceiling is not raised?

A31:

  • Treasury forced to prioritize debt payments over other expenditures

  • Introduces uncertainty into financial markets

  • Could cause interest rates to spike if investors fear default

  • Impact depends on:

    • Duration of impasse

    • Policymaker responses

  • Prolonged crisis could lead to sharp economic downturn and loss of confidence

10
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Why is inflation limited as a debt reduction strategy?

  • Potential benefits:

    • Can lower real value of existing debt

  • Major limitations:

    • Doesn't address structural fiscal imbalances (revenue-spending gaps)

    • Risk of spiraling out of control

    • Erodes savings and undermines economic stability

    • Increases interest costs on short-term debt

    • Complicates future borrowing

    • Ineffective as long-term solution

11
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What would be the consequences of strategic default on U.S. debt?

  • Immediate effects:

    • Trigger global financial crisis

    • Interest rates on U.S. Treasuries spike

    • Loss of access to international capital markets

  • Long-term effects:

    • Undermine U.S. reputation as reliable borrower

    • Loss of global financial leadership status

    • Significant decline in dollar value

    • Destabilize global economy

  • Conclusion: Costs far outweigh any short-term fiscal gains

12
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What policy actions are necessary to address the U.S. fiscal challenge?

  • Required actions:

    • Raising taxes

    • Cutting spending

    • Combination of both approaches

  • Importance of timing:

    • Delaying measures shifts burden to future generations

    • Increases risk of crisis if markets lose confidence

  • Goals:

    • Prevent breakdown in financial markets

    • Maintain economic stability

    • Preserve U.S. status as global financial leader

13
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Why is responsible fiscal management essential?

  • Prevents:

    • Financial market breakdown

    • Loss of economic stability

    • Catastrophic outcomes

  • Preserves:

    • U.S. status as global financial leader

    • Long-term economic health

    • Confidence in U.S. fiscal management

  • Ensures:

    • Sustainable fiscal policies

    • Intergenerational equity

    • Economic prosperity for future generations