If global investors lose confidence in governments tomorrow, then we have a huge crisis--and they are right to lose confidence. If global investors do not lose confidence, then we are fine--and those crying "the sky is falling" are wrong and will lose money--as long as we don't let fear of a loss of confidence panic us into prematurely cutting the government deficits that are maintaining demand.
The right policy, therefore, is (a) big deficits now, and (b) big automatic tax increases enacted now to take effect in the future if we then fail to grow our way out of the debt.
But are we smart enough to enact such policies? Certainly not with today's Republican Party.
From Financial Crisis to Debt Crisis?: Everyone from the Queen of England to laid-off Detroit autoworkers wants to know why more experts did not see the financial crisis coming. It is an awkward question. How can policymakers be so certain that financial catastrophe won't soon recur when they seemed to have no idea that such a crisis would happen in the first place? The answer is not very reassuring. Essentially, there is still a risk that the financial crisis is simply hibernating as it slowly morphs into a government debt crisis.
For better or for worse, the reason most investors are now much more confident than they were a few months ago is that governments around the world have cast a vast safety net under much of the financial system. At the same time, they have propped up economies by running massive deficits, while central banks have cut interest rates nearly to zero. But can blanket government largesse be the final answer? Government backstops work because taxpayers have deep pockets, but no pocket is bottomless. And when governments, particularly large ones, get into trouble, there is no backstop. With government debt levels around the world reaching heights usually seen only after wars, it is obvious that the current strategy is not sustainable.
If the trajectory is unsustainable, how long can debt keep piling up? We don't know. Academic economists have developed useful tools to predict which economies are most vulnerable to a financial crisis. But, although we can identify vulnerabilities, getting the timing right is virtually impossible. Our models show that even an economy that is massively overleveraged can, in theory, plod along for years, even many decades, before crashing and burning. It all boils down to confidence and coordination of expectations, which depend, in turn, on the vagaries of human nature. Thus, we can tell which countries are most vulnerable, but specifying exactly where and when crises will erupt is next to impossible....
Unfortunately, we live in a world where the political and regulatory system is often very weak and shortsighted.... For now, the good news is that the crisis will be contained as long as government credit holds up. The bad news is that the rate at which government debt is piling up could easily lead to a second wave of financial crises within a few years.... The question today is not why no one is warning about the next crisis. They are. The question is whether political leaders are listening.