6 For analysis of this and other data, go to www.brookings.edu/index

How we're doing as debt fears rise

By Karen Dynan and Ted Gayer
Sunday, May 23, 2010

With the worst of the credit crunch of 2008-09 behind us, U.S. economic activity has been improving since last summer. Greece's recent fiscal problems, however, have sparked serious concerns about global credit markets. A central lesson of the financial crisis is that disruptions in credit markets can damage the broader economy. In the fourth "How We're Doing" Index, a team of scholars at the Brookings Institution has looked at the past five quarters to determine where U.S. credit markets stand and what strains may arise from long-term fiscal imbalances.

The availability of credit to American households and businesses is uneven, mirroring broad economic conditions. Many sound large firms can find funding cheaply through the corporate bond market. Likewise, families that meet certain standards can obtain low-rate mortgages. But many high-risk homebuyers can no longer find inexpensive mortgage financing, and small businesses are still struggling to obtain credit.

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.

Emerging concerns about sovereign debt default present a barrier to global economic growth. Greece's near-default has sharply raised the cost of its government debt and triggered fear that the contagion will spread to other eurozone countries such as Portugal and, to a lesser extent, Spain.

The good news is that Greece's fiscal situation differs in important ways from that of the United States. Greece has higher debt and a larger deficit relative to its GDP and a lack of competitiveness stemming in part from high labor costs. Greece cannot compensate for its competitiveness problem by adjusting its exchange rate because it uses the euro. Its government has embarked on a difficult fiscal austerity program, but results -- aided by foreign support on realistic terms and, ideally, a stronger world economy -- will take awhile.

In contrast, U.S. competitiveness remains relatively high. Although the U.S. debt-to-GDP ratio is increasing, it remains well below that of Greece (86 percent as of last year). The U.S. dollar is in high demand, and if anything, concerns about sovereign debt elsewhere have increased demand for U.S. Treasury securities, thereby holding our borrowing costs down.

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.

For analysis of this and other data, go to www.brookings.edu/index.

The writers are co-directors of the economic studies program at the Brookings Institution.

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