Yesterday, Fed Chairman Ben Bernanke gave a speech in which he discussed fiscal policy. I am not a big fan of the Fed Chairman doing so, and historically they have avoided doing so to help preserve the independence of the Fed.
The one major exception to that was Alan Greenspan’s endorsement of the Bush tax cuts at the time, on the grounds that the Federal Debt was in danger of disappearing altogether, and without a significant amount of Federal debt outstanding it would be difficult for the Fed to conduct open market operations. Greenspan has since said that doing so was a big mistake, both on the grounds that he was dead wrong, and because it is just not something that a Fed Chairman should be talking about, regardless if he knows the difference between his derriere and the joint in the middle of his arm.
That being said, here are some key excerpts from the speech, with my commentary and interpretation of those passages (if you wish to read it in its entirety you can do so here: http://www.federalreserve.gov/newsevents/speech/bernanke20101004a.htm).
“The recent deep recession and the subsequent slow recovery have created severe budgetary pressures not only for many households and businesses, but for governments as well. Indeed, in the United States, governments at all levels are grappling not only with the near-term effects of economic weakness, but also with the longer-run pressures that will be generated by the need to provide health care and retirement security to an aging population.
“There is no way around it — meeting these challenges will require policymakers and the public to make some very difficult decisions and to accept some sacrifices. But history makes clear that countries that continually spend beyond their means suffer slower growth in incomes and living standards and are prone to greater economic and financial instability. Conversely, good fiscal management is a cornerstone of sustainable growth and prosperity.”
Not a lot in this passage is terribly controversial. However, what he is setting up is the idea that there are two sources of the deficit, one cyclical (near-term economic weakness), and the other structural (aging population). It is not clear to me that the budget always has to be balanced or the economy will suffer slower growth in incomes, but there is a clearly a limit to how big a budget deficit can be, particularly a structural deficit.
Balanced budgets or surpluses have been a rarity since the end of WWII, yet somehow the republic has managed to survive. When they become problematic is when the deficit as a percentage of GDP is larger than the growth in nominal GDP. When that situation arises, then it means that debt relative to GDP is rising. That is a very big problem if it is caused by structural deficits that go on for a long time rather than by cyclical deficits that tend to go down dramatically as the economy recovers, causing tax revenues to rise and social safety net spending to decline.
“The budgetary position of the federal government has deteriorated substantially during the past two fiscal years, with the budget deficit averaging 9-1/2 percent of national income during that time. For comparison, the deficit averaged 2 percent of national income for the fiscal years 2005 to 2007, prior to the onset of the recession and financial crisis.
“The recent deterioration was largely the result of a sharp decline in tax revenues brought about by the recession and the subsequent slow recovery, as well as by increases in federal spending needed to alleviate the recession and stabilize the financial system. As a result of these deficits, the accumulated federal debt measured relative to national income has increased to a level not seen since the aftermath of World War II.”
In other words, the big increase in the deficit overt the last two years is primarily cyclical, with an added layer from TARP spending. However, it is now clear that the net cost of the TARP is going to be far less than originally feared. Only about $465 billion of the original $700 billion authorized what actually disbursed, and we have already gotten much of that back.
The current estimates are that the ultimate cost of the TARP will be somewhere in the $50 to $60 billion range. To some extent, how big the eventual bill is will depend on the share prices of Citigroup (C), American International Group (AIG) and General Motors (will IPO soon, probably with its old GM ticker symbol). If the banking system had been allowed to collapse, the recession would have been far deeper, and as a result the cyclical portion of the deficit would have been much larger. In that sense, at least the TARP has already more than repaid itself.
“For now, the budget deficit has stabilized and, so long as the economy and financial markets continue to recover, it should narrow relative to national income over the next few years. Economic conditions provide little scope for reducing deficits significantly further over the next year or two; indeed, premature fiscal tightening could put the recovery at risk.”
This is a very key point. Just go back to the basic GDP accounting framework. Consumers are not spending because their wealth has been devastated by the collapse of the housing bubble, and they need to get their household balance sheets into better shape. Then businesses have no reason to invest to expand output. It doesn’t really matter what the cost of capital is — if consumers are not going to buy more widgets, it is stupid to invest in more widget-making capacity.
What investment that will take place is generally limited to things that allow you to make the same number of widgets at a lower cost (usually by having fewer people making the widgets). If both consumer spending and business investment are weak, then absent a big improvement in the trade deficit, the only remaining source of spending (and hence GDP growth) is government spending.
Just remember that GDP = C + I +G + (X-M). Those who say that we can grow the economy faster by cutting government spending in this environment simply fail this elementary arithmetic.
“If current policy settings are maintained, and under reasonable assumptions about economic growth, the federal budget will be on an unsustainable path in coming years, with the ratio of federal debt held by the public to national income rising at an increasing pace. Moreover, as the national debt grows, so will the associated interest payments, which in turn will lead to further increases in projected deficits.
“Expectations of large and increasing deficits in the future could inhibit current household and business spending — for example, by reducing confidence in the longer-term prospects for the economy or by increasing uncertainty about future tax burdens and government spending — and thus restrain the recovery.”
Here he is talking about the structural budget deficit, not the current deficit. I’m not sure that I buy the David Ricardo idea that consumers are businesses look at the debt and say I have to not spend and save because eventually I will have to pay higher taxes to repay the higher debt. When was the last time that the decision you made about say replacing the carpet in the living room was seriously impacted by a calculation of what your tax rate might be ten years from now? Wasn’t the amount of cash you had in the bank, the current level of your take home pay, and how big your credit line on your Visa (V) a much bigger factor in making that decision?
Taken to its logical extreme, this Ricardian equivalence would say that fiscal policy can never influence the economy. Because any fiscal stimulus (i.e. running a higher budget deficit) would be instantly and 100% offset by countervailing decisions by businesses and consumers. If you get a tax cut today and that tax cut results in a higher budget deficit, then you will save every cent of it because you know you have to pay it back in higher taxes later! Yet when Bush cut taxes dramatically, the savings rate then fell to its lowest level in post war history, by a fairly wide margin.
The one group for which the equivalence is most likely to hold for is the wealthy, since they are not likely to be liquidity constrained. They have savings already that they can draw on, and have access to credit, so they can adjust their spending more easily to what they perceive as their permanent level of after tax income (including any tax hikes in the future). People who are living paycheck to paycheck and have to use pawn shops to get credit do not act that way.
“Our fiscal challenges are especially daunting because they are mostly the product of powerful underlying trends, not short-term or temporary factors. Two of the most important driving forces are the aging of the U.S. population, the pace of which will intensify over the next couple of decades as the baby-boom generation retires, and rapidly rising health-care costs.
“As the health-care needs of the aging population increase, federal health-care programs are on track to be by far the biggest single source of fiscal imbalances over the longer term. Indeed, the Congressional Budget Office (CBO) projects that the ratio of federal spending for health-care programs (principally Medicare and Medicaid) to national income will double over the next 25 years, and continue to rise significantly further after that.
“The ability to control health-care costs as our population gets older, while still providing high-quality care to those who need it, will be critical not only for budgetary reasons but for maintaining the dynamism of the broader economy as well.”
Ultimately, the long-term structural deficit comes down to two words: Health Care. The recent health care reforms did make a start at controlling costs, but did not go nearly far enough. It did help to stabilize the situation in Medicare, according to the Medicare Trustees report. The 75-year actuarial deficit fell to 0.66% of taxable payroll, from 3.88% before the Health Care reform was enacted.
The date when the Medicare fund will be exhausted was extended by 12 years with the passage of Health Care reform, to 2029 from 2017. However, that report was met with near total silence by the major business media (most notably CNBC and the Wall Street Journal since it would run counter to their ideological position that health-care reform was just awful). Bernanke was seriously remiss in not pointing that out in this speech. Still the central point that we need to control health care costs further is a valid one.
“The aging of the U.S. population will also strain Social Security, as the number of workers paying taxes into the system rises more slowly than the number of people receiving benefits. This year, there are about five individuals between the ages of 20 and 64 for each person aged 65 and older.
“By 2030, when most of the baby boomers will have retired, this ratio is projected to decline to around 3, and it may subsequently fall yet further as life expectancies continue to increase. Overall, the projected fiscal pressures associated with Social Security are considerably smaller than the pressures associated with federal health programs, but they still present a significant challenge to policymakers.”
Bernanke fails to point out that Social Security has been collecting far more in taxes than it pays out ever since 1983 precisely to deal with that challenge. Those extra taxes were invested in a very safe asset class, namely U.S. T-bonds. The problem is not on the Social Security side, it is that we blew that money on tax cuts for the wealthy, two unfunded wars, and a major increase in Medicare Benefits (Part D) that was not funded, and was designed in such a way that the biggest beneficiary of it was the drug companies, not the seniors.
“In the longer term, a rising level of government debt relative to national income is likely to put upward pressure on interest rates and thus inhibit capital formation, productivity, and economic growth. Larger government deficits increase our reliance on foreign lenders, all else being equal, implying that the share of U.S. national income devoted to paying interest to foreign investors will increase over time. Income paid to foreign investors is not available for domestic consumption or investment.”
While theoretically true that ever rising debt levels relative to GDP would put upward pressure on interest rates, we have no idea when that would start to kick in. Clearly with long-term T-note and bond yields at record lows, that has not been the case so far, despite very large current budget deficits. His second point about budget deficits increasing our reliance on foreign lenders is just plain wrong, or at least he hangs an awful lot on the “all else being equal” phrase.
The increase in reliance foreign lenders is due to the trade deficit, not the budget deficit. That is simply an accounting identity, and Bernanke should know that. After all, we ran even bigger budget deficits (by a pretty large margin) relative to GDP during WWII, and we emerged from the war as a huge net creditor. The difference is that we ran a trade surplus and were able to finance the budget deficits internally (war bond drives). It is true that to the extent that we pay interest to people or governments overseas that the money is not available for domestic consumption or investment.
There is much more to the speech, but this post is already getting too long. While there are areas where I disagree with Bernanke, there are also many areas where we agree. Regardless it is not a good idea for the Fed Chairman to be weighing in on fiscal policy. Central bankers should stand above the immediate political fray and not involve themselves in issues best left to elected representatives.
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