In a surprisingly candid speech at the annual Rhode Island Public Expenditure Council meeting Monday, Federal Reserve Chair Ben Bernanke warned of a potentially dangerous economic future for the country if government spending is not curbed within a few years.
“It is crucially important that we put US fiscal policy on a sustainable path,” Bernanke said. “We should not underestimate these fiscal challenges. Failing to respond to them would endanger our economic future.”
If budget deficits continue to rise at their current pace, Bernanke said, higher interest rates could slow formation of businesses, productivity and economic growth, while a large federal debt could hurt the amount of government funds available for future emergencies, from war to natural disasters.
“The threat to our economy is real and growing,” Bernanke said.
Bernanke outlined a number of “fiscal rules” for Congress to consider implementing through legislation, including constraints on total government expenditure, deficits or debt. Today, Congress operates under a “pay-as-you-go” (PAYGO ) approach that requires tax cuts and spending increases to be offset within a ten-year budget time span, but may not be strong enough for the current economy. “The key question is whether the traditional PAYGO approach is sufficiently ambitious,” Bernanke said. “At its best, PAYGO prevents new tax cuts and mandatory spending increases from making projected budget deficits worse; by construction, PAYGO does not require the Congress to reduce the ever-increasing deficits that are already built into current law.”
Countries like Canada, Switzerland, Finland and the Netherlands have all seen marked improvements in their budgets since adopting fiscal rules that cap government spending. According to the International Monetary Fund, approximately 80 countries have implemented similar fiscal rules. “The weight of the evidence suggests that well-designed rules can help promote improved fiscal performance,” Bernanke said.
If the nation’s economic challenges are not addressed in the near future, Bernanke said, “projections by the CBO (Congressional Budget Office) and others show future budget deficits and debts rising indefinitely and at increasing rates … unsustainable trajectories of deficits and debts will never actually transpire, because creditors would never be willing to lend to a country in which the fiscal debt relative to the national income is rising without limit.”
According to the World Bank’s “Finding the Tipping Point – When Sovereign Debt Turns Bad,” the level at which a country is no longer viable to receive lending is a 77 percent public debt-to-GDP ratio. “If the debt is above this threshold, each percentage point costs 0.017 percentage points of annual real growth.”
According to the International Monetary Fund, the 2009 debt-to-GDP ratio in the United States was 83.2 percent. James A. Bacon Jr. of the Washington Examiner states, “the US is experiencing a small growth penalty today: about one-tenth of a percentage point. By mid-decade, however, the growth penalty could swell to .56 percent yearly – more than a half percentage point.”
The challenge of reducing deficit doesn’t end with capping government spending. In fact, Bernanke said, “economic conditions provide little scope for reducing deficits significantly further over the next year or two … premature fiscal tightening could put the recovery at risk.” But at the same time, “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.”
Congress faces several unpopular choices to cut the deficit. The CBO has projected that federal spending for Medicare and Medicaid could be double the national income over the next 25 years. Social Security is also threatened as the country’s population ages and the number of workers paying taxes grows at a slower rate than the number of people receiving benefits. State and local budgets will also struggle to meet public pension and health care obligations for retired people. “Estimates of unfunded pension liabilities for the states as whole span a wide range, but some researchers put the figure as high as $2 trillion at the end of 2009,” Bernanke said, “[and] one recent estimate suggests that state governments have a collective liability of almost $600 billion for retiree health benefits.”
“Herbert Stein, a wise economist, once said, ‘If something cannot go on forever, it will stop.’ One way or the other, fiscal adjustments sufficient to stabilize the federal budget will certainly occur at some point,” Bernanke said. “The only real question is whether these adjustments will take place through a careful and deliberative process that weighs priorities … or whether the needed fiscal adjustments will be a rapid and painful response to a looming or actual fiscal crisis.”
Although Bernanke did not plainly endorse any particular methods of reducing the deficit, his message was clear throughout the speech. “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.”