Is the US Heading for Financial Disaster?

Several commentators have been posing that very question recently. The concern is that the US might be heading for a major financial crisis due to increasing debt. For example, in Krugman’s piece in the NYTimes today, he writes

The timing of [economic] crises is hard to predict. But there are warning signs, like big trade and budget deficits and rising debt burdens.

And there’s one thing I can’t help noticing: a third world country with America’s recent numbers — its huge budget and trade deficits, its growing reliance on short-term borrowing from the rest of the world — would definitely be on the watch list.

Similarly, The Economist (subscription required) ran a story recently called “America the Risky?” that reported on the results of a model, developed by economists at Lehman Brothers, designed to predict major financial crises. That model showed that the US was in the danger zone:

The model, called Damocles (as in “sword of”), is an early-warning signal. It puts together ten indicators—from external debt as a percentage of GDP to foreign reserves as a percentage of short-term debt—to assess the overall riskiness of a country, which is expressed as an index.

A reading above 75 indicates that a country has a one-in-three chance of a crisis in the next 12 months; a figure above 100 implies a 50-50 chance.

When Lehman ran America’s economic numbers through Damocles, the outcome was striking. With its rapidly climbing current-account deficit and foreign debt, among other worries, America’s Damocles index is just shy of 75.

So is the US really in danger of facing a severe financial crisis? I think I have to be slightly less bearish than usual in this case, and say probably not.

The US has some serious advantages over any other country in a similar situation. The biggest advantage is that the primary way that the US is borrowing money from the rest of the world is by issuing US government bonds. Those bonds are considered the safest investments in the world, for good reason. It’s impossible for me to imagine that changing anytime in the meaningful future (or at least the next 20 or 30 years, at least). So the US will continue to be able to borrow money from foreign lenders, and thus will be able to avoid a serious international lending crisis.

In addition, unlike most developing countries (such as Mexico in 1994, and Argentina in 2001), the US doesn’t have to worry about currency fluctuations increasing the US’s debt burden. The US will always repay its debt in dollars, which the Fed will ensure continue to exist in adequate quantities to repay international loans.

So, while I think that the US has a host of long-term economic problems facing it, and that the US government’s finances are a dangerous shambles, I disagree with some of the most pessimistic observers about the likelihood of the crisis scenario. The main problem with the government budget deficits is redistributional, in my opinion – it will require much higher taxes on future generations, and redistribute income away from borrowers and to lenders. But those are topics for another day.