Bernanke’s Warning

Fed chief Ben Bernanke testified before the House Committee on the Budget last week. Bernanke’s testimony was insightful and in some ways reassuring. But one theme that came through clearly was the grave danger posed by the nation’s burgeoning debt. This comes from Bernanke’s prepared statement:

The administration recently submitted a proposed budget that projects the federal deficit to reach about $1.8 trillion this fiscal year before declining to 1.3 trillion in 2010 and roughly $900 billion in 2011.

As a consequence of this elevated level of borrowing, the ratio of federal debt held by the public, the nominal GDP, is likely to move up from about 40 percent before the onset of the financial crisis to about 70 percent in 2011. These developments will leave the debt-to-GDP ratio at its highest level since the early 1950s, the years following the massive debt buildup during World War II.

[E]ven as we take steps to address the recession and threats to financial stability, maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby boom generation and continued increases in medical costs. … With the ratio of debt to GDP already elevated, we will not be able to continue borrowing indefinitely to meet these demands.

In particular, over the longer term, achieving fiscal sustainability — defined, for example, as a situation in which the ratios of government debt and interest payments to GDP are stable or declining, and tax rates are not so high as to impede economic growth — requires that spending and budget deficits be well controlled.

But no one expects that to happen under the current Congressional leadership.

Congressman Hensarling put up a chart that illustrated the exploding debt-to-GDP ration that Bernanke alluded to. I believe this is it; in any event, it shows the CBO data:

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This chart is based on OMB projections; it provides useful historical context. Click to enlarge:

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This exchange is from Congressman Hensarling’s questioning of Bernanke, based on the CBO chart:

HENSARLING: I’ve seen one analysis, that clearly to keep the debt at — at today’s level, 41 percent of GDP, that either, number one, you’re going to have to monetize the debt and essentially inflate the money supply 100 percent, or that tax increases across the board in the neighborhood of 60 percent would be necessary to balance the budget in 10 years.

Has the Federal Reserve done its own calculations? Does this seem to be an accurate analysis?

BERNANKE: We haven’t done that particular analysis. I don’t think it’s realistic to get back to 41 percent that quickly.

HENSARLING: Which means perhaps some level of tax increase, spending decrease, or inflating the money supply is going to be necessary.

BERNANKE: Relative to that CBO baseline, I mean, it’s evident that either cuts in spending, increases in taxes, will be necessary to stabilize the fiscal condition.

And, finally, this:

QUESTION: Recently, as I believe you know, S&P downgraded U.K.’s debt on May 21st from stable to negative. So what’s going to happen if the U.S. loses its AAA rating? Or what happens if we have a 60 percent tax increase over the next 10 years to deal with this massive infusion of debt?

BERNANKE: At — at some point, you have to have a path of spending and taxes that will give you a stabilization of the debt-to- GDP ratio. If you don’t, then fear that the debt will continue to rise will make it very difficult to finance it.

And at some point, you’ll hit a point where you’ll have to have both very draconian cuts and very large tax increases, which is not something we want. So in order to avoid that outcome down the road, we need to begin now to plan how we’re going to get the fiscal situation into a better balance in the medium term. …

QUESTION: If I look at the bills we’ve had here on the floor the last couple of weeks we were in session and this week, virtually everything we’re doing either authorizes or appropriates more money — spending — even, in many cases, than what is anticipated in the charts that we have talked about today. What are the economic consequences of continuing that sort of trend?

BERNANKE: Congressman, as I’ve — as I’ve indicated, we as a country are going to have to make some hard choices. We can’t expect to continue to borrow certainly not 12 percent of GDP, but not even 4 or 5 percent of GDP, indefinitely.

And so we need to make a plan, some decisions, about how we’re going to bring the budget closer to balance over the medium term. And that means that as you discuss various programs that include spending, you need to think about the revenue sources that would be related to that.

If you don’t do that, then, again, you’ll see interest rates rise and you’ll see reluctance of lenders to provide credit to the U.S. government. That would be a very bad outcome.

There is obviously no desire in the Democratic Congress to control spending, so extraordinary tax increases are no doubt in the offing. Still, there is no way the Democrats will raise taxes broadly or steeply enough to address the medium-term fiscal crisis. So it seems safe to predict that Bernanke’s warning will go unheeded.

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