REPORT: U.S. lacks fiscal space to respond to next recession

  • Many economists say it is important to keep national debt levels low in order to give the government “fiscal space” to respond to a recession or financial crisis.
  • With the federal government running unprecedented debt levels, the next recession to hit the U.S. could be exceptionally painful and long.
  • State governments, however, appear to be reasonably well-prepared for the next recession, according to a recent report from Moody’s Investor Services.

The value of fiscal space

What is “fiscal space,” and why does it matter? Fiscal space, according to the International Monetary Fund, is the “amount of room countries have for temporarily increasing their budget deficits without jeopardizing their access to markets or the sustainability of their debt.”

Many federal budget experts believe that one of the most important reasons to keep debt at moderate and controlled levels, especially during periods of economic growth, is to allow the government to more aggressively respond to a recession or financial crisis. Adequate fiscal space allows policymakers to blunt the negative economic effects of such events by cutting taxes or increasing spending, providing the government with an “insurance policy,” of sorts.

Recent research from economists Christina Romer and David Romer at the University of California, Berkely, into how countries respond to financial crises found that fiscal space is indeed significant. When confronted with a crisis, Romer and Romer noted that countries with more fiscal space were able to respond more aggressively, thereby mitigating the negative economic effects. Countries with less fiscal space, on the other hand, tended to be more austere during financial crises and thus suffered more negative economic consequences.

Why the austerity? Romer and Romer theorized that it is in large part out of a concern for the risks of continued high levels of debt. They also suggested that perhaps policymakers did not want the burden of servicing higher levels of debt in the future.

Recession preparedness in the U.S.

As of June, the U.S. has enjoyed 10 years of uninterrupted economic expansion. If that streak continues into July it will be the nation’s longest growth cycle ever since 1854, which is as far back as economists attempt to date business cycles. At some point, however, the economy will take a downturn, and many experts fear it will happen soon. A recent survey by the National Association for Business Economics found that 75 percent of respondents predict a recession before 2021.

“Given the historically high levels of debt and its projected increase, it is more and more likely that the United States will not have the ‘fiscal space’ to respond aggressively to the next recession,” the Peter G. Peterson Foundation wrote in a recent blog post. It warned that the federal government’s record debt levels mean Americans are more likely to face a longer and more challenging recovery, the effects of which would ripple across the lives of every American.

If there’s any silver lining to the situation, is that state governments as a whole appear to be reasonably well-prepared for the next recession. A recent report from Moody’s Investor Services found that 22 states are well prepared for the next recession and 26 states are moderately prepared. Only Illinois and New Jersey ranked as weak in recession preparedness. This is important because Moody’s predicts that high levels of national debt will hinder the federal government from giving states as much assistance as they received during the Great Recession.

“The economy will enter the next recession with less fiscal space than before the financial crisis. Thus the next time the economy experiences a large negative shock that pushes it into a recession, concerns around the level of federal deficits and debt, in addition to a polarized political environment, may hinder adequate counter cyclical fiscal response at the federal level,” Moody’s warned.

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Image credit:   Photo by Aditya Vyas on Unsplash

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