ECONOMIC AND BUDGET ISSUE BRIEF

Federal Debt and the Risk of a Fiscal Crisis

Over the past few years, U.S. government debt held by 

the public has grown rapidly—to the point that, compared with the total output of the economy, it is now 

higher than it has ever been except during the period 

around World War II. The recent increase in debt has 

been the result of three sets of factors: an imbalance 

between federal revenues and spending that predates the 

recession and the recent turmoil in financial markets, 

sharply lower revenues and elevated spending that derive 

directly from those economic conditions, and the costs of 

various federal policies implemented in response to the 

conditions.1

Further increases in federal debt relative to the nation’s 

output (gross domestic product, or GDP) almost certainly lie ahead if current policies remain in place. The 

aging of the population and rising costs for health care 

will push federal spending, measured as a percentage of 

GDP, well above the levels experienced in recent decades. 

Unless policymakers restrain the growth of spending, 

increase revenues significantly as a share of GDP, or adopt 

some combination of those two approaches, growing 

budget deficits will cause debt to rise to unsupportable 

levels.

Although deficits during or shortly after a recession generally hasten economic recovery, persistent deficits and 

continually mounting debt would have several negative 

economic consequences for the United States. Some of 

those consequences would arise gradually: A growing portion of people’s savings would go to purchase government 

debt rather than toward investments in productive capital 

goods such as factories and computers; that “crowding 

out” of investment would lead to lower output and 

incomes than would otherwise occur. In addition, if the 

payment of interest on the extra debt was financed by 

imposing higher marginal tax rates, those rates would discourage work and saving and further reduce output. Rising interest costs might also force reductions in spending 

on important government programs. Moreover, rising 

debt would increasingly restrict the ability of policymakers to use fiscal policy to respond to unexpected 

challenges, such as economic downturns or international 

crises. 

Beyond those gradual consequences, a growing level of 

federal debt would also increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to manage its budget, 

and the government would thereby lose its ability to borrow at affordable rates. It is possible that interest rates 

would rise gradually as investors’ confidence declined, 

giving legislators advance warning of the worsening situation and sufficient time to make policy choices that could 

avert a crisis. But as other countries’ experiences show, it 

is also possible that investors would lose confidence 

abruptly and interest rates on government debt would 

rise sharply. The exact point at which such a crisis might 

occur for the United States is unknown, in part because 

the ratio of federal debt to GDP is climbing into unfamiliar territory and in part because the risk of a crisis is influenced by a number of other factors, including the government’s long-term budget outlook, its near-term 

borrowing needs, and the health of the economy. When 

fiscal crises do occur, they often happen during an economic downturn, which amplifies the difficulties of 

adjusting fiscal policy in response.

If the United States encountered a fiscal crisis, the abrupt 

rise in interest rates would reflect investors’ fears that the 

government would renege on the terms of its existing 

debt or that it would increase the supply of money to 

finance its activities or pay creditors and thereby boost 

inflation. To restore investors’ confidence, policymakers 

would probably need to enact spending cuts or tax 

increases more drastic and painful than those that would 

have been necessary had the adjustments come sooner.

CBO A series of issue summaries from

the Congressional Budget Office

JULY 27, 2010

1. For more details, see Congressional Budget Office, The Budget 

and Economic Outlook: Fiscal Years 2010 to 2020 (January 2010); 

The Effects of Automatic Stabilizers on the Federal Budget (May 

2010). 
2 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

Figure 1.

Federal Debt Held by the Public, 1790 to 2035

(Percentage of gross domestic product)

Source: Congressional Budget Office, The Long-Term Budget Outlook (June 2010); Historical Data on Federal Debt Held by the Public

(July 2010).

Note: The extended-baseline scenario adheres closely to current law, following CBO’s 10-year baseline budget projections through 2020 

(with adjustments for the recently enacted health care legislation) and then extending the baseline concept for the rest of the longterm projection period. The alternative fiscal scenario incorporates several changes to current law that are widely expected to occur or 

that would modify some provisions that might be difficult to sustain for a long period.

Past and Projected Federal Debt 

Held by the Public

Compared with the size of the economy, federal debt held 

by the public is high by historical standards but is not 

without precedent (see Figure 1).2

 Previous sharp run-ups 

have generally occurred during wars: During the Civil 

War and World War I, debt climbed by about 30 percent 

of GDP; in World War II, debt surged by nearly 80 percent of GDP. In contrast, the recent jump in debt—so 

far, roughly 25 percent of GDP—can be attributed in 

part to an ongoing imbalance between federal revenues 

and spending but, more important, to the financial 

crisis and deep recession and the policy responses to those 

developments. According to the Congressional Budget 

Office’s (CBO’s) projections, federal debt held by the 

public will stand at 62 percent of GDP at the end of fiscal 

year 2010, having risen from 36 percent at the end of fiscal year 2007, just before the recession began. In only one 

other period in U.S. history—during and shortly after 

World War II—has that figure exceeded 50 percent.

Looking forward, CBO has projected long-term budget 

outcomes under two different sets of assumptions about 

future policies for revenues and spending.3

 The extendedbaseline scenario adheres closely to current law, following 

CBO’s 10-year baseline budget projections through 2020 

(with adjustments for the recently enacted health care legislation) and then roughly extending the baseline concept 

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010 2030

0

50

100

150

200

World War I

World War II

The Great

Depression

Actual Projected

CBO's

ExtendedBaseline

Scenario

CBO's

Alternative

Fiscal

Scenario

2. The size of a country’s economy provides a measure of its ability to 

pay interest on government debt, in the same way that a family’s 

income helps to determine the amount of mortgage interest that it 

can afford. Federal debt has two main components: debt held by 

the public, and debt held by government trust funds and other 

government accounts. This issue brief focuses on the former as the 

most meaningful measure for assessing the relationship between 

federal debt and the economy. Debt held by the public represents 

the amount that the government has borrowed in financial 

markets to pay for its operations and activities; in pursuing such 

borrowing, the government competes with other participants in 

credit markets for financial resources. In contrast, debt held by 

government trust funds and other government accounts represents 

internal transactions of the government.

3. For details about the assumptions underlying the scenarios, see 

Congressional Budget Office, The Long-Term Budget Outlook

(June 2010), Table 1-1. 
ECONOMIC AND BUDGET ISSUE BRIEF

FEDERAL DEBT AND THE RISK OF A FISCAL CRISIS 3

for subsequent decades. Under that scenario, annual 

budget deficits would decline over the next few years, and 

both deficits and debt would remain stable relative to 

GDP for several years after that. But then growth in 

spending on health care programs and Social Security 

would cause deficits to increase, and debt would once 

again grow faster than the economy. By 2035, the debt 

would equal about 80 percent of GDP. 

However, certain changes to current law are widely 

expected to be made in some form over the next few 

years, and other provisions of current law might be difficult to sustain for a long period. Therefore, CBO also 

developed an alternative fiscal scenario, in which most of 

the tax cuts originally enacted in 2001 and 2003 are 

extended (rather than allowed to expire at the end of this 

year as scheduled under current law); the alternative minimum tax is indexed for inflation (halting its growing 

reach under current law); Medicare’s payments to physicians rise over time (which would not happen under current law); tax law evolves in the long run so that tax revenues remain at about 19 percent of GDP; and some other 

aspects of current law are adjusted in coming years. 

Under that scenario, deficits would also decline for a few 

years after 2010 and then grow again, but that growth 

would occur sooner and at a much faster rate than under 

the extended-baseline scenario. By 2020, debt would 

equal nearly 90 percent of GDP. After that, the growing 

imbalance between revenues and noninterest spending, 

combined with the spiraling cost of interest payments, 

would swiftly push federal debt to unsustainable levels. 

Debt held by the public would exceed its historical peak 

of about 110 percent of GDP by 2025 and would reach 

about 180 percent of GDP in 2035. Indeed, if those estimates took into account the harmful effects that rising 

debt would have on economic growth and interest rates, 

the projected increase in debt would occur even more 

rapidly. Under the alternative fiscal scenario, the surge in 

debt relative to the country’s output would pose a clear 

threat of a fiscal crisis during the next two decades.

Some Consequences of Growing Debt

The economic effects of budget deficits and accumulating 

government debt can differ in the short run and the 

long run, depending importantly on the prevailing economic conditions when the deficits are incurred. During 

and shortly after a recession, the higher spending or lower 

taxes that generate larger deficits generally hasten 

economic recovery. In particular, when many workers 

are unemployed, and much capacity (such as equipment 

and buildings) is unused, higher government spending and 

lower tax revenues usually increase overall demand for 

goods and services, which leads firms to boost their output 

and hire more workers.4

 But those short-term benefits 

carry with them long-term costs: Unless offsetting actions 

are taken at some point to pay off the additional government debt accumulated while the economy was weak, 

people’s future incomes will tend to be lower than they 

otherwise would have been. 

More generally, persistent, large deficits that are not 

related to economic slowdowns—like the deficits that 

CBO projects for coming decades—have a number of 

significant negative consequences. Therefore, the sooner 

that policymakers agree on credible long-term changes to 

government spending and revenues, and the sooner that 

those changes are carried out without impeding the economic recovery, the smaller will be the damage to the 

economy from growing federal debt.

Crowding Out of Investment

One impact of rising debt is that increased government 

borrowing tends to crowd out private investment in productive capital, because the portion of people’s savings 

used to buy government securities is not available to fund 

such investment. The result is a smaller capital stock and 

lower output and incomes in the long run than would 

otherwise be the case.

The effect of debt on investment can be offset by borrowing from foreign individuals or institutions. But additional inflows of foreign capital also create the obligation 

for more profits and interest to flow overseas in the 

future. Thus, although flows of capital into a country 

can help maintain domestic investment, most of the gains 

from that additional investment do not accrue to the 

residents.

Need for Higher Taxes or Less Spending on 

Government Programs

Another impact of rising debt is that, as government debt 

grows, so does the amount of interest the government 

pays to its lenders (all else being equal). If policymakers 

wished to maintain government benefits and services 

4. See Congressional Budget Office, Policies for Increasing Economic 

Growth and Employment in 2010 and 2011 (January 2010).
4 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

while the amount of interest paid grew, tax revenues 

would eventually have to rise as well. To the extent that 

additional tax revenues were generated by increasing marginal tax rates, those rates would discourage work and 

saving, further reducing output and incomes. Alternatively, policymakers could choose to offset the rising 

interest costs, at least in part, by reductions in benefits 

and services. 

To be sure, slowing the growth of government debt to 

hold down future interest payments would require 

increases in taxes or reductions in government benefits 

and services anyway. However, earlier action would permit the changes in policy to be smaller and more gradual, 

and it would give people more time to adjust to the 

changes—although it would also require more sacrifices 

by current generations to benefit future ones. 

Reduced Ability to Respond to Domestic and 

International Problems

Having a small amount of debt outstanding gives policymakers the ability to borrow to address significant 

unexpected events such as recessions, financial crises, 

and wars. A large amount of debt, however, leaves less 

flexibility for government actions to address financial and 

economic crises, which, in many countries, have been 

very costly to the government (as well as to residents).5

A large amount of debt could also harm national security 

by constraining military spending in times of crisis or 

limiting the ability to prepare for a crisis.

In the United States, the level of federal debt a few years 

ago gave the government the flexibility to boost spending 

and cut taxes to stimulate economic activity, to provide 

public funding to stabilize the financial sector, and to 

continue paying for other programs, even as tax revenues 

dropped sharply because of the decline in output and 

incomes. If the amount of federal debt (relative to output) stays at its current level or increases further, the government would find it more difficult to undertake similar 

policies in the future. Moreover, the reduced financial 

flexibility and increased dependence on foreign investors 

that would accompany a rising debt could weaken the 

United States’ international leadership.

An Increased Chance of a Fiscal Crisis

A rising level of government debt would have another 

significant negative consequence. Combined with an 

unfavorable long-term budget outlook, it would increase 

the probability of a fiscal crisis for the United States. In 

such a crisis, investors become unwilling to finance all of 

a government’s borrowing needs unless they are compensated with very high interest rates; as a result, the interest 

rates on government debt rise suddenly and sharply relative to rates of return on other assets. Unfortunately, there 

is no way to predict with any confidence whether and 

when such a crisis might occur in the United States; in 

particular, there is no identifiable tipping point of debt 

relative to GDP indicating that a crisis is likely or imminent. But all else being equal, the higher the debt, the 

greater the risk of such a crisis.

Fiscal crises around the world have often begun during 

recessions and, in turn, have often exacerbated them.6

Frequently, such a crisis was triggered by news that a government would, for any number of reasons, need to borrow an unexpectedly large amount of money. Then, as 

investors lost confidence and interest rates spiked, borrowing became more difficult and expensive for the government. That development forced policymakers to 

immediately and substantially cut spending and increase 

taxes to reassure investors—or to renege on the terms of 

its existing debt or increase the supply of money and 

boost inflation. In some cases, the crisis made borrowing 

more expensive for private borrowers as well, because 

uncertainty about the government’s policy response to the 

crisis raised risk premiums throughout the economy. 

Higher private interest rates, combined with reductions 

in government spending and increases in taxes, have 

tended to worsen economic conditions in the short term. 

The history of fiscal crises in other countries does not 

necessarily indicate the conditions under which investors 

might lose confidence in the U.S. government’s ability 

to manage its budget or the consequences for the nation 

of such a loss of confidence. On the one hand, the 

5. See Carmen M. Reinhart and Kenneth S. Rogoff, Banking Crises: 

An Equal Opportunity Menace, Discussion Paper DP7131 

(London: Centre for Economic Policy Research, January 2009). 

The authors estimate that debt in countries with banking crises 

increases by an average of 86 percent in the three years after 

those crises. See also Luc Laeven and Fabian Valencia, Systemic 

Banking Crises: A New Database, Working Paper No. 08-224 

(Washington, D.C.: International Monetary Fund, November 

2008).

6. See Eduardo Borensztein and Ugo Panizza, The Costs of Sovereign 

Default, Working Paper No. 08-238 (Washington, D.C.: 

International Monetary Fund, October 2008).
ECONOMIC AND BUDGET ISSUE BRIEF

FEDERAL DEBT AND THE RISK OF A FISCAL CRISIS 5

United States may be able to issue more debt (relative to 

output) than the governments of other countries can, 

without triggering a crisis, because the United States has 

often been viewed as a “safe haven” by investors around 

the world, and the U.S. government’s securities have 

often been viewed as being among the safest investments 

in the world. On the other hand, the United States may 

not be able to issue as much debt as the governments of 

other countries can because the private saving rate has 

been lower in the United States than in most developed 

countries, and a significant share of U.S. debt has been 

sold to foreign investors. Quantifying those factors and 

the many other factors that could be relevant to how a 

fiscal crisis would unfold in the United States is beyond 

the scope of this brief. 

Nonetheless, a review of fiscal crises in Argentina, 

Ireland, and Greece in the past decade reveals instructive 

common features and differences. For all three countries, 

the crises occurred abruptly and during recessions. However, the crises occurred at different levels of government 

debt relative to GDP, showing that the tipping point for a 

crisis does not depend solely on the debt-to-GDP ratio; 

the government’s long-term budget outlook, its near-term 

borrowing needs, and the health of the economy are also 

important. All three of those crises illustrate the difficulty 

of formulating effective policy responses once investors 

lose confidence in a government. 

Argentina

Argentina’s experience offers an example of the very serious consequences that can arise from a fiscal crisis. 

Although interest rates on Argentina’s debt had been 

comparable for many years with those on debt of other 

countries in emerging markets, Argentina’s fortunes 

changed quickly when it found itself suffering from a significant recession in 2000 and 2001. During the first half 

of 2001, with government debt equal to about 50 percent 

of the country’s GDP, investors became increasingly worried about Argentina’s fiscal situation—in part because of 

the country’s earlier defaults on its debt. As a result, investors demanded premiums for holding government debt 

that increased interest rates by more than 5 percentage 

points.7

 A few months later, as it became clear that 

Argentina was not able to afford (or willing to make) the 

interest payments on its debt, interest rates jumped again 

to levels so high that the government was effectively 

unable to borrow. Subsequently, Argentina ceased paying 

its creditors, and ever since it has been unable to raise 

funds in international markets. Argentina’s fiscal crisis 

accentuated its underlying economic problems, and from 

2001 to 2002, the country’s GDP dropped by nearly 

11 percent. 

Ireland

In spite of a good credit history and a relatively small 

amount of government debt, Ireland experienced a fiscal 

crisis after being overwhelmed by large spending obligations, including those related to the recent financial crisis. 

As recently as 2007, Ireland carried a central government 

debt of only about 20 percent of output; interest rates on 

Irish bonds at the time suggested that investors considered those bonds to be almost as safe as German bonds, 

which are generally perceived as stable and reliable investments. Over the next two years, however, Ireland’s debt 

grew very rapidly as the country dealt with massive failures of financial institutions and a major economic 

downturn. Investors began to lose confidence that Ireland 

could manage its rapidly expanding obligations, and by 

March of last year, investors in 10-year Irish bonds 

demanded almost 3 percentage points in extra annual 

interest relative to the rate for German bonds of the same 

maturity (see Figure 2). 

Starting in April 2009, Ireland responded with an aggressive fiscal austerity program in which it raised taxes and 

reduced spending significantly. The program included 

cutting wages for public-sector employees by 15 percent, 

levying additional taxes, and sharply trimming a number 

of social programs. Investors initially responded with 

renewed confidence, which was reflected in reduced 

interest rates on Irish debt and lower rates for insurance 

on Irish bonds (although those measures of perceived risk 

remained less favorable than they had been before the crisis).8

 However, the budget deficit in Ireland remains large

7. All interest rates cited in this issue brief are in nominal terms. The 

data on Argentina are drawn from Donald Mathieson, Garry 

Schinasi, and others, International Capital Markets: Developments, 

Prospects, and Key Policy Issues (Washington, D.C.: International 

Monetary Fund, 2001), p. 63. The data on Ireland and Greece are 

from Bloomberg.

8. Investors can purchase insurance that pays off in the event that a 

government defaults on its debt. The cost of such insurance is one 

indicator of a fiscal crisis; all else being equal, the higher the cost 

of insurance, the higher the perceived probability of a government 

default.
6 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

Figure 2.

Interest Rates on 10-Year Debt Issued by Greece and Ireland 

(Percentage points above the rate for comparable German bonds)

Source: Bloomberg.

Note: German bonds, denominated in euros, are generally perceived as stable and reliable investments. The difference in interest rates 

between German bonds and other countries’ euro-denominated bonds reflects investors’ relative level of confidence in the safety and 

security of those other countries’ debts.

and the Organisation for Economic Co-operation and 

Development (OECD) projected late last year that 

Ireland’s debt would increase to approximately 70 percent 

of GDP by the end of 2010.9

 Some observers believe that 

the austerity program may not be sufficient to put Ireland’s debt on a sustainable path, and investors may share 

that view, because interest rates on 10-year Irish bonds 

have risen again to almost 3 percentage points above 

those on comparable German bonds.10

Greece

In 2008, before the recent global recession, the central 

government in Greece owed its creditors an amount equal 

to approximately 110 percent of the country’s GDP, a 

ratio that rose further as the recession lowered output and 

increased the deficit by weakening the country’s tax base. 

In early 2009, interest rates on 10-year Greek bonds 

jumped by 2 percentage points over rates on comparable 

German bonds (see Figure 2). Investors’ confidence, as 

measured by both interest rates on Greek government 

debt and the cost of buying insurance against a default 

on such debt, deteriorated throughout 2009. By January 

2010, Greece was forced to pay an interest rate on 

10-year bonds that was 4 percentage points higher than 

Germany was paying. 

Greece’s crisis continued to worsen as interest rates 

climbed higher in the spring. In May 2010, a consortium 

of European countries and the International Monetary 

Fund pledged to lend to the Greek government up to 

120 billion euros (an amount equal to just over 50 percent of Greece’s GDP last year). Greece also adopted a fiscal austerity program that includes significant reductions 

in benefits and public services as well as increases in taxes. 

The actions by the Greek government and other governments caused the crisis to abate temporarily. However, it 

is unclear whether investors will be convinced that spending will be cut or taxes increased sufficiently to put the 

country on a sustainable fiscal path. Moreover, the 

amount of maturing debt that the country needs to refinance in the next few years, in addition to the debt that it 

needs to sell to finance its ongoing deficit, has reinforced 

investors’ concerns that Greece will be unable to make all 

of the required payments on its debt. As a result, interest 

Jan. 1,

2008

Mar. 11,

2008

May 20,

2008

Jul. 29,

2008

Oct. 7,

2008

Dec. 16,

2008

Feb. 24,

2009

May 5,

2009

Jul. 14,

2009

Sep. 22,

2009

Dec. 1,

2009

Feb. 9,

2010

Apr. 20,

2010

Jun. 29,

2010

0

1

2

3

4

5

6

7

8

9

10

Ireland

Greece

9. Organisation for Economic Co-operation and Development, 

OECD Economic Surveys: Ireland 2009, vol. 2009, no. 17 

(Paris: OECD, November 2009).

10. For one observer’s point of view, see Barry Eichengreen, “Emerald 

Isle to Golden State,” Eurointelligence, February 25, 2009, 

available at www.eurointelligence.com/artile.581+M5accb03957e.

0.html.
ECONOMIC AND BUDGET ISSUE BRIEF

FEDERAL DEBT AND THE RISK OF A FISCAL CRISIS 7

rates on 10-year Greek bonds have climbed to 8 percentage points above the rates on 10-year German bonds. 

How Might a Fiscal Crisis Affect the 

United States? 

In all three of those fiscal crises in other countries, sharp 

increases in interest rates on government debt forced the 

affected governments to make difficult choices. The U.S. 

government would also face difficult choices if interest 

rates on its debt spiked. For example, a 4-percentagepoint across-the-board increase in interest rates would 

raise federal interest payments next year by about 

$100 billion relative to CBO’s baseline projection—a 

jump of more than 40 percent. As longer-term debt 

matured and was refinanced at such higher rates, the difference in the annual interest burden would mount; by 

2015, if such higher-than-anticipated rates persisted, net 

interest would be nearly double the roughly $460 billion 

that CBO currently projects for that year.11 Moreover, if 

debt grew over time relative to GDP, the effect of a spike 

in interest rates would become increasingly pronounced. 

A sudden increase in interest rates would also reduce the 

market value of outstanding government bonds, inflicting losses on investors who hold them. That decline 

could precipitate a broader financial crisis by causing 

losses for mutual funds, pension funds, insurance companies, banks, and other holders of federal debt—losses that 

might be large enough to cause some financial institutions to fail.12 Foreign investors, who owned nearly half 

of U.S. debt held by the public in May 2010 (or about 

$4.0 trillion, $1.7 trillion of which was held by Japan and 

China alone), would also face substantial losses.13

If a fiscal crisis occurred in the United States, policy 

options for responding to it would be limited and 

unattractive. In particular, the government would need 

to undertake some combination of three actions:

restructuring its debt (that is, seeking to modify the 

contractual terms of existing obligations); pursuing 

inflationary monetary policy (that is, increasing the 

supply of money); and adopting an austerity program 

of spending cuts and tax increases.

Restructuring Debt

Governments can attempt to change the terms of their 

existing debt—for example, by changing the payment 

schedule—but that approach tends to be very costly for 

countries that try it.14 Any discussions or actions by 

U.S. policymakers that raised the perceived likelihood of 

that outcome would cause investors to demand higher 

interest rates immediately, if they were willing to extend 

additional credit at all.15 Furthermore, investors would 

demand a large interest premium on subsequent loans 

for many years. 

Inflationary Monetary Policy

An alternative approach is to increase the supply of 

money in the economy. But as governments create money 

to finance their activities or pay creditors during fiscal 

crises, they raise inflation. Higher inflation has negative 

consequences for the economy, especially if inflation 

moves above the moderate rates seen in most developed 

countries in recent years.16 Higher inflation might appear 

to benefit the U.S. government financially because the 

value of the outstanding debt (which is mostly fixed in 

dollar terms) would be lowered relative to the size of the 

economy (which would increase when measured in dollar 

terms).17 However, higher inflation would also increase 

the size of future budget deficits. 

Specifically, if inflation was 1 percentage point higher 

over the next decade than the rate CBO has projected, 

budget deficits during those years would be roughly

11. See Congressional Budget Office, An Analysis of the President’s 

Budgetary Proposals for Fiscal Year 2011 (March 2010).

12. U.S. banks, insurance companies, and mutual funds held 

approximately $1 trillion worth of U.S. debt as of the first quarter 

of 2010. See Department of the Treasury, Financial Management 

Service, “Ownership of Federal Securities,” Treasury Bulletin

(June 2010), Table OFS-2. 

13. Department of the Treasury, Major Foreign Holders of Treasury 

Securities, May 2010, available at www.ustreas.gov/tic/mfh.txt.

14. See Borensztein and Panizza, The Costs of Sovereign Default.

15. See Carmen M. Reinhart, Kenneth S. Rogoff, and Miguel A. 

Savastano, “Debt Intolerance,” Brookings Papers on Economic 

Activity, no. 1 (2003). 

16. For a discussion of the issues, see N. Gregory Mankiw, 

Macroeconomics, 5th ed. (New York: Worth Publishers, 2003), 

pp. 95–107.

17. Higher inflation would not enhance the U.S. government’s ability 

to redeem Treasury inflation-protected securities, which are 

indexed to inflation; however, such debt constitutes only about 

7 percent of publicly held U.S. debt.
8 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

$700 billion larger.18 Several factors contribute to that 

estimate. Investors, after having their investments 

devalued by the rise in prices in the economy, would 

demand higher interest rates in the future, even if inflation was eventually reduced; thus, as debt matured, it 

would be refinanced at higher rates. Indeed, even raising 

the perceived likelihood of higher inflation during a fiscal 

crisis would trigger immediate further increases in interest rates. Moreover, the amounts of many government 

benefits rise when prices rise, and much of the income tax 

system is indexed to inflation. On balance, the increase in 

tax revenues resulting from higher inflation would be 

more than offset by higher payments for benefit programs 

and higher interest payments as the outstanding debt 

rolled over and ongoing deficits required the issuance 

of more debt.19

Increasing Taxes and Reducing Spending

Austerity programs generally include both tax increases 

and spending reductions. When fiscal crises occur during 

recessions, as they often do, such policy changes can 

exacerbate the economic downturns—although some 

studies suggest that certain types of fiscal austerity programs tend, at least in some circumstances, to stimulate 

economic growth.20

The later that actions are taken to address persistent 

budget imbalances, the more severe they will have to be. 

CBO’s long-term projections for the federal budget 

indicate that an immediate, permanent cut in spending 

or increase in revenues equal to about 1 percent of GDP 

(relative to the policies assumed for the extended-baseline 

scenario) or about 5 percent of GDP (relative to the 

policies assumed for the alternative fiscal scenario) would 

prevent a net increase in the U.S. debt-to-GDP ratio over 

the next 25 years. The latter would be equivalent to 

roughly 20 percent of all of the government’s noninterest 

spending this year. Actions taken later, particularly if 

there was a fiscal crisis, would need to be significantly 

greater to achieve that same objective. Larger and more 

abrupt changes in fiscal policy, such as substantial cuts in 

government benefit programs, would be more difficult 

for people to adjust to than smaller and more gradual 

changes.

20. See, for example, Alberto Alesina, “Fiscal Adjustments: Lessons 

from Recent History” (paper presented at a meeting of Ecofin, 

Madrid, April 15, 2010); Alberto Alesina and Silvia Ardagna, 

Large Changes in Fiscal Policy: Taxes Versus Spending, Working 

Paper No. 15438 (Cambridge, Mass.: National Bureau of 

Economic Research, October 2009); Roberto Perotti, “Fiscal 

Policy in Good Times and Bad,” Quarterly Journal of Economics,

vol. 114, no. 4 (November 1999), pp. 1399–1436; and Alberto 

Alesina and Silvia Ardagna, “Tales of Fiscal Adjustment,” 

Economic Policy, vol. 13, no. 27 (October 1998), pp. 487–545.

18. See Congressional Budget Office, The Budget and Economic 

Outlook: Fiscal Years 2010 to 2020, Appendix C.

19. Historically, the long-term effects of countries’ inflating away part 

of their debt—very high borrowing costs and reduced economic 

output—have been similar to the effects of explicit debt 

restructurings. See Reinhart, Rogoff, and Savastano, “Debt 

Intolerance.” 

This brief was prepared by Jonathan Huntley of CBO’s 

Macroeconomic Analysis Division. It and other 

CBO publications are available at the agency’s Web site 

(www.cbo.gov).

Douglas W. Elmendorf

Director