A global financial disaster is imminent, says Bernanke

[1]  See Maurizio d’Orlando, “This year, US public debt could reach end game,” in AsiaNews, 3 March 2010.

[2]  See Ben S. Bernanke, “Fiscal Sustainability and Fiscal Rules,” Federal Reserve, 4 October 2010.

[3]  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.

[4]  Although state and local governments face significant fiscal challenges, my primary focus today will be the federal budget situation and its economic implications.1# I will describe the factors underlying current and projected budget deficits and explain why it is crucially important that we put U.S. fiscal policy on a sustainable path. I will also offer some thoughts on whether new fiscal rules or institutions might help promote a successful transition to fiscal sustainability in the United States.

[5]  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.

[6]  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. Over the medium- and long-term, however, the story is quite different. 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.2# 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. Concerns about the government's long-run fiscal position may also constrain the flexibility of fiscal policy to respond to current economic conditions. Accordingly, steps taken today to improve the country's longer-term fiscal position would not only help secure longer-term economic and financial stability, they could also improve the near-term economic outlook.

[7]  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.3# 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. 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.

[8]  The same underlying trends affecting federal finances will also put substantial pressures on state and local budgets, as organizations like yours have helped to highlight.4# In Rhode Island, as in other states, the retirement of state employees, together with continuing increases in health-care costs, will cause public pension and retiree health-care obligations to become increasingly difficult to meet. Estimates of unfunded pension liabilities for the states as whole span a wide range, but some researchers put the figure as high as trillion at the end of 2009.5# Estimates of states' liabilities for retiree health benefits are even more uncertain because of the difficulty of projecting medical costs decades into the future. However, one recent estimate suggests that state governments have a collective liability of almost 0 billion for retiree health benefits.6# These health benefits have usually been handled on a pay-as-you-go basis and therefore could impose a substantial fiscal burden in coming years as large numbers of state workers retire. It may be scant comfort, but the United States is not alone in facing fiscal challenges. The global recession has dealt a blow to the fiscal positions of most other advanced economies, and, as in the United States, their expenditures for public health care and pensions are expected to rise substantially in the coming decades as their populations age.7# Indeed, the population of the United States overall is younger than those of a number of European countries as well as Japan.8# 

[9]  Let me return to the issue of longer-term fiscal sustainability. As I have discussed, projections by the CBO and others show future budget deficits and debts rising indefinitely, and at increasing rates. To be sure, projections are to some degree only hypothetical exercises. Almost by definition, 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. Herbert Stein, a wise economist, once said, "If something cannot go on forever, it will stop."9# One way or the other, fiscal adjustments sufficient to stabilize the federal budget will certainly occur at some point. The only real question is whether these adjustments will take place through a careful and deliberative process that weighs priorities and gives people plenty of time to adjust to changes in government programs or tax policies, or whether the needed fiscal adjustments will be a rapid and painful response to a looming or actual fiscal crisis. Although the choices and tradeoffs necessary to achieve fiscal sustainability are difficult indeed, surely it is better to make these choices deliberatively and thoughtfully.

[10]  Arguably, the imperative to achieve long-term fiscal sustainability is an opportunity as well as a challenge. Opportunities for both taxing and spending reforms are ample. For example, most people agree that the U.S. tax code is less efficient and less equitable than it might be; moreover, the code is excessively complex and imposes heavy administrative and compliance costs. Collecting revenues through a more efficient, better-designed tax system could improve economic growth and make achieving sustainable fiscal policies at least somewhat easier. Likewise, many federal spending programs doubtless could be reformed to achieve their stated objectives more effectively and at lower cost. Certainly, continued efforts to reduce health-care costs and government health spending, while continuing to ensure appropriate care for those who need it, should be a top priority.

[11]  Failing to address our unsustainable fiscal situation exposes our country to serious economic costs and risks. In the short run, as I have noted, concerns and uncertainty about exploding future deficits could make households, businesses, and investors more cautious about spending, capital investment, and hiring. 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. And an increasingly large cost of servicing a growing national debt means that the adjustments, when they come, could be sharp and disruptive. For example, large tax increases that might be imposed to cover the rising interest on the debt would slow potential growth by reducing incentives to work, save, hire, and invest. Finally, a large federal debt decreases the flexibility of policymakers to temporarily increase spending as needed to address future emergencies, such as recessions, wars, or natural disasters.

[12]  Finally, a large federal debt decreases the flexibility of policymakers to temporarily increase spending as needed to address future emergencies, such as recessions, wars, or natural disasters.

[13]  It would be difficult to identify a specific threshold at which federal debt begins to pose more substantial costs and risks to the nation's economy. Perhaps no bright line exists; the costs and risks may grow more or less continuously as the federal debt rises. What we do know, however, is that the threat to our economy is real and growing, which should be sufficient reason for fiscal policymakers to put in place a credible plan for bringing deficits down to sustainable levels over the medium term. The sooner a plan is established, the longer affected individuals will have to prepare for the necessary changes. Indeed, in the past, long lead times have helped make necessary adjustments less painful and thus politically feasible. For example, the gradual step-up in the full retirement age for Social Security was enacted in 1983, but it did not begin to take effect until 2003 and will not be completed until 2027, thus giving future retirees ample time to adjust their plans for work, saving, and retirement.

[14]  Amid all of the uncertainty surrounding the long-term economic and budgetary outlook, one certainty is that both current and future Congresses and Presidents will have to make some very tough decisions to put the budget back on a sustainable trajectory. Can these tough decisions be made easier for our elected leaders? At various times, some U.S. Congresses and foreign governments have adopted fiscal rules to help structure the budget process. [In Italy for example, the 2008 three-year budget law pushed by Finance Minister Tremonti allows parliament to make only small changes.] Fiscal rules are legislative agreements intended to promote fiscal responsibility by constraining decisions about spending and taxes. For example, fiscal rules may impose constraints on key budget aggregates, such as total government expenditures, deficits, or debt. In the remainder of my remarks I will discuss the use of fiscal rules to address longer-term budget problems, beginning with a review of the U.S. and foreign experience.

[15]  Many other countries have experience with fiscal rules. The European Union, by treaty, established fiscal rules in the early 1990s, with the goal of ensuring that all members would maintain sustainable fiscal policies. The rules specified that countries should keep their government deficits at or below 3 percent of their gross domestic products (GDP), and that government debt should not exceed 60 percent of GDP. [The reference here is to the 1997 Stability and Growth Pact (SGP) that came into force in 1999. The pact requires member states to meet the so-called Maastricht convergence criteria. Deficits and public debts are thus placed under the supervision of the European Commission by means of the Excessive Deficit Procedure (EDP) adopted by the EU Council of Ministers, a political body, on the proposal of the European Commission, an unelected body.] Even before the recent financial crisis and recession, however, the enforcement mechanisms for these rules did not prevent these targets from being breached, and fiscal problems in several euro-area countries have recently been a source of financial and economic stress. European leaders are working to strengthen their tools for enforcing fiscal discipline. [The reference here is to the new European Stability Pact proposed by the European Commission in mid-May this year, following the debt crisis that hit Greece and other smaller EU states, which entails heavier penalties for countries that breach the rules. The main difference is that the final decision will not be made by the EU Council of Ministers, but will be automatically imposed by the European Commissions on governments of member states and their elected parliaments on the basis of predefined bureaucratic rules.]