How to avoid a debt doomsday

By Maya MacGuineas, CNNMoney guest columnist


Commentary: Maya MacGuineas is the director of the fiscal policy program at the New America Foundation.

Here is a scary question: What could trigger a full-blown fiscal crisis in the United States?

OK, now breathe. It is not at all clear that we will have one. There is the highly desirable possibility that policymakers will act preemptively and gradually phase in major entitlement reforms, spending cuts and tax reform.

You know the old Winston Churchill saying that Americans can always be depended on to do the right thing -- after exhausting all other alternatives. Well, there's still time.

And then there is the scenario one step removed from a full crisis: a Japan-style "lost decade" situation in which the economy muddles along. Job growth is lackluster for an extended period. Low interest rates allow Washington to keep borrowing. And the country gets stuck in an ineffective borrow and stimulate cycle with little to show for it other than more debt.

If that muddle-along scenario is the frog in the boiling water, then a full-blown fiscal crisis is the frog hopping along the interstate until he abruptly becomes road kill.

A fiscal crisis would not be pretty. Creditors could lose faith and pull their money from the United States. Interest rates would spike, causing interest payments to grow. The government would be forced to borrow more, which would push rates even higher. The endgame would be a vicious debt spiral and another recession.

Yes, rates are now extremely low. But that's because, as one of my colleagues likes to say, "We are the best looking horse in the glue factory." It's not because anyone looks at our economy as the next great investment story. Because of that, things could change on a dime. (Take the CNNMoney debt quiz.)

What could trigger a worst-case scenario? Even if it's not likely to happen anytime soon, it's important to understand the possibilities.

Sovereign debt contagion: We have already seen how quickly markets can turn against overly indebted countries. While the United States is not likely to become Greece in the immediate future, the parallels are too similar for comfort.

The fact is debt investors eventually grow intolerant of countries that don't have plans to improve their fiscal condition.

And markets may eventually turn against the United States. If that happens, the situation could deteriorate very quickly. No money manager will want to be the last one invested in a place from which other investors are pulling their capital.

Ticking time bombs in the budget: The government runs all sorts of potentially risky and costly programs.

The Pension Benefit Guarantee Corp., Fannie Mae and Freddie Mac and the Federal Deposit Insurance Corp. are some examples. These agencies embody trillions of dollars in government obligations, and the full extent of the exposure is not well-known.

The dramatic deterioration in the balance sheet of any of these institutions could lead to a chain of events where markets conclude that the government is not as sound as they had previously believed.

The White House's fiscal commission: President Obama has shifted the responsibility for coming up with a deficit reduction plan to his bipartisan commission.

But there is no guarantee that Congress will do anything other than glance at the commission's recommendations and tuck them away. This could be the confirmation that U.S.-debt watchers fear -- that the political system is incapable of dealing with the country's fiscal challenges.

As the chairman of Standard & Poor's sovereign rating committee recently warned, it is critical that policymakers consider the recommendations of the commission or it could jeopardize our AAA credit rating.

The states: If the fiscal situation is bad at the federal level, it's even worse for many states. A state or even a local government attempting to default on its legal obligations could be enough to roil credit markets.

Just a few years back it would have been hard to imagine that talk of a full-blown U.S. fiscal crisis would be anything other than fear mongering. Now, however, these scenarios are starting to feel alarmingly possible. Let's hope Churchill was right. To top of page

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