Ben on the Hill: Fiscal Policy

Federal Reserve Chairman Ben Bernanke testified to the House Budget committee today. Below is the fiscal policy part his prepared testimony and my reaction/translation of it.

Fiscal Policy

“Fiscal policymakers…face significant challenges. Our nation’s fiscal position has deteriorated appreciably since the onset of the financial crisis and the recession. To a significant extent, this deterioration is the result of the effects of the weak economy on revenues and outlays, along with the actions that the Administration and the Congress took to ease the recession and steady financial markets.

“However, even after economic and financial conditions return to normal, the federal budget will remain on an unsustainable path, with the budget gap becoming increasingly large over time, unless the Congress enacts significant changes in fiscal programs.”

Federal tax revenues are still far below where they were in 2007. Some of that is simply due to people having less income, and some is due to tax cuts designed to help the economy get moving again. As a share of the economy, Federal tax revenues are at a post-WWII low. The 2% cut in the payroll tax means that revenues as a share of GDP are not likely to rise significantly in 2011.

There are also automatic stabilizers which are designed so that spending goes up when the economy weakens. There are two parts to the budget deficit: the cyclical portion, which should go away as the economy gets back on track; and the structural part, which will remain. It is the structural part of the deficit that is the biggest part of the problem for the long term.

“For example, under plausible assumptions about how fiscal policies might evolve in the absence of major legislative changes, the Congressional Budget Office (CBO) projects the deficit to fall from its current level of about 9 percent of gross domestic product (GDP) to 5 percent of GDP by 2015, but then to rise to about 6-1/2 percent of GDP by the end of the decade.

“In subsequent years, the budget situation is projected to deteriorate even more rapidly, with federal debt held by the public reaching almost 90 percent of GDP by 2020 and 150 percent by 2030, up from about 60 percent at the end of fiscal year 2010.”

It is one thing to run a budget deficit of 9% when the economy is in the tank, it is quite another to be running a big deficit — and yes, even 5% is a big deficit — when the economy is running near full potential (which is what is assumed for 2015). On the spending side, there are really 4 things that matter, Social Security, Medicare/Medicaid, Defense, and interest on the national debt. Everything else is pretty insignificant relative to the size of the overall budget.

Social Security has a dedicated funding source, and has been running a surplus for close to 30 years, and has built up a big trust fund in the process. In effect, the Social Security system has been lending vast amounts of money to the rest of the government. The payroll tax that funds Social Security is largely paid for by the lower and middle classes. The rest of the government is largely funded by income taxes, which are for the most part paid by the upper middle class and the rich.

Cutting Social Security would, in effect, then be the rich defaulting on the loan they took out from the poor. Medicare is the most pressing problem in terms of rising costs. The Health Care Reform Act helped to bring down the projected growth rate a little bit, but nowhere close to enough. Defaulting on the rest of the debt is unthinkable to the markets. If we did that, the fall of 2008 would look like a minor correction by comparison.

Even though we are still fighting two wars, cutting Defense has to be on the table. We do, after all, spend more on defense than the rest of the world combined, and many of the other large spenders are our allies, not our potential adversaries.

Spending cuts alone will not do the trick, particularly if the “big four” are off the table. Higher revenues will be needed. It might be better to get those higher revenues by eliminating various deductions and credits in the tax code rather than by raising rates, but it would still mean people sending in bigger checks to the Federal Government. Those who insist that we can solve the problem by only cutting non-Defense discretionary spending and not raise taxes are simply not serious about getting the long-term structural deficits under control.

“The long-term fiscal challenges confronting the nation are especially daunting because they are mostly the product of powerful underlying trends, not short-term or temporary factors. The two most important driving forces behind the budget deficit are the aging of the population and rapidly rising health-care costs. Indeed, the CBO projects that federal spending for health-care programs will roughly double as a percentage of GDP over the next 25 years.

“The ability to control health-care spending, while still providing high-quality care to those who need it, will be critical for bringing the federal budget onto a sustainable path.”

Further Health Care Reforms are clearly needed. Ultimately, we probably need to scrap the fee for service model our Health Care System is based on. Don’t hold your breath for that to happen, though, as it would run up against very powerful political forces. We spend almost twice as much per capita for health care relative to the other developed economies, and our health outcomes are no better, and often much worse than theirs.

“The CBO’s long-term budget projections, by design, do not account for the likely adverse economic effects of such high debt and deficits. But if government debt and deficits were actually to grow at the pace envisioned, the economic and financial effects would be severe. Sustained high rates of government borrowing would both drain funds away from private investment and increase our debt to foreigners, with adverse long-run effects on U.S. output, incomes, and standards of living.

“Moreover, diminishing investor confidence that deficits will be brought under control would ultimately lead to sharply rising interest rates on government debt and, potentially, to broader financial turmoil. In a vicious circle, high and rising interest rates would cause debt-service payments on the federal debt to grow even faster, resulting in further increases in the debt-to-GDP ratio and making fiscal adjustment all the more difficult.”

We are going to be in deep doo-doo if we don’t tackle the long-term structural deficits. The sooner we have a credible plan in place the more confident the markets will be and ultimately the easier (not easy, but easier) the adjustment will be.

“In thinking about achieving fiscal sustainability, it is useful to apply the concept of the primary budget deficit, which is the government budget deficit excluding interest payments on the national debt. To stabilize the ratio of federal debt to the GDP — a useful benchmark for assessing fiscal sustainability — the primary budget deficit must be reduced to zero.4 Under the CBO projection that I noted earlier, the primary budget deficit is expected to be 2 percent of GDP in 2015 and then rise to almost 3 percent of GDP in 2020 and 6 percent of GDP in 2030.

“These projections provide a gauge of the adjustments that will be necessary to attain fiscal sustainability. To put the budget on a sustainable trajectory, policy actions–either reductions in spending, increases in revenues, or some combination of the two–will have to be taken to eventually close these primary budget gaps.”

Interesting point about separating out the primary deficit from the total deficit.

“By definition, the unsustainable trajectories of deficits and debt that the CBO outlines cannot actually happen, because creditors would never be willing to lend to a government with debt, relative to national income, that is rising without limit. One way or the other, fiscal adjustments sufficient to stabilize the federal budget must occur at some point. The question is whether these adjustments will take place through a careful and deliberative process that weighs priorities and gives people adequate time to adjust to changes in government programs or tax policies, or whether the needed fiscal adjustments will come as a rapid and painful response to a looming or actual fiscal crisis.

“Acting now to develop a credible program to reduce future deficits would not only enhance economic growth and stability in the long run, but could also yield substantial near-term benefits in terms of lower long-term interest rates and increased consumer and business confidence. Plans recently put forward by the President’s National Commission on Fiscal Responsibility and Reform and other prominent groups provide useful starting points for a much-needed national conversation. Although these proposals differ on many details, they demonstrate that realistic solutions to our fiscal problems do exist.”

As Herb Stein once put it, if something is unsustainable, eventually it will stop. One way or another, the Budget deficits will have to come under control, at least to the point where we have a primary balanced budget.

Another way of thinking about it would be that we need to at least bring the overall budget deficit as a percentage of GDP down below the growth rate in nominal GDP. Once we do that, the national debt will start to fall as a percentage of GDP. Starting sooner would be better than starting later.

After all, if a car is going 90 MPH and you want to stop it, it is better to apply the brakes and stop over the distance length of a football field than to slam it into a brick wall and stop it in 0 feet. Getting a plan in place now is braking, waiting until the markets revolt and refuse to buy our debt is the equivalent of driving full speed into the brick wall.

“Of course, economic growth is affected not only by the levels of taxes and spending, but also by their composition and structure. I hope that, in addressing our long-term fiscal challenges, the Congress and the Administration will undertake reforms to the government’s tax policies and spending priorities that serve not only to reduce the deficit, but also to enhance the long-term growth potential of our economy — for example, by reducing disincentives to work and to save, by encouraging investment in the skills of our workforce as well as new machinery and equipment, by promoting research and development, and by providing necessary public infrastructure. Our nation cannot reasonably expect to grow its way out of our fiscal imbalances, but a more productive economy will ease the tradeoffs that we face.”

Note that the things he is calling for — investment in the skills of our workforce (aka education), promoting R&D and providing infrastructure — all fall under the category of “non-defense discretionary spending.” That further reinforces the point that those who think we can solve the problem only by relying on cuts there are delusional, or at best innumerate.

Not all spending is bad — some of it is desperately needed for the economy to function and hopefully flourish. Economic growth will help a great deal in bringing down the deficit, but it will not be able to do the job on its own. Higher taxes will be needed, but we have to be careful to structure them so they do not hurt economic growth.

He talked mostly in generalities, and did not get into specifics. That was by design. It is not the role of the Fed Chairman to endorse or oppose any specific spending or tax proposal. To do so would further draw the Fed into the political realm, and ultimately result in the loss of the independence of the Central Bank.

About Dirk van Dijk 112 Articles

Affiliation: Zacks Investment Research

Dirk van Dijk, CFA is the Chief Equity Strategist for With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

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