January 19, 2007
Bernanke on the deficit
In testimony before the Senate Budget Committee yesterday, Fed Chair Ben Bernanke once again tells it like it is.
Here's some of what Bernanke had to say to the senators:
[T]he deficit in the unified federal budget declined for a second year in fiscal year 2006, falling to $248 billion from $319 billion in fiscal 2005.... Unfortunately, we are experiencing what seems likely to be the calm before the storm....
In fiscal 2006, federal spending for Social Security, Medicare, and Medicaid together totaled about 40 percent of federal expenditures, or roughly 8-1/2 percent of GDP.... By 2030, according to the CBO, they will reach about 15 percent of GDP....
The large projected increases in future entitlement spending have two principal sources. First, like many other industrial countries, the United States has entered what is likely to be a long period of demographic transition, the result both of the reduction in fertility that followed the post-World War II baby boom and of ongoing increases in life expectancy....
The second cause of rising entitlement spending is the expected continued increase in medical costs per beneficiary. Projections of future medical costs are fraught with uncertainty, but history suggests that-- without significant changes in policy-- these costs are likely to continue to rise more quickly than incomes, at least for the foreseeable future. Together with the aging of the population, ongoing increases in medical costs will lead to a rapid expansion of Medicare and Medicaid expenditures....
[O]ne plausible scenario is based on the assumptions that (1) federal retirement and health spending will follow the CBO's intermediate projection; (2) defense spending will drift down over time as a percentage of GDP; (3) other non-interest spending will grow roughly in line with GDP; and (4) federal revenues will remain close to their historical share of GDP-- that is, about where they are today. Under these assumptions, the CBO calculates that, by 2030, the federal budget deficit will approach 9 percent of GDP-- more than four times greater as a share of GDP than the deficit in fiscal year 2006.
Some might wonder why the Chair of the Fed should be lecturing Congress about fiscal policy. I can think of three good reasons. First, the deficit makes the Fed's job of controlling inflation considerably harder. Many of us are persuaded that the large fiscal deficits are one important factor behind the U.S. current account deficit, and that the current account deficit in turn is likely to lead to depreciation of the dollar, which would add to inflationary pressures. And a bigger federal deficit means that a higher interest rate needs to be maintained by the Fed in order to achieve a given target for inflation, compared with what would be necessary with a balanced budget.
A second reason why budget deficits are an appropriate concern for monetary policy-makers is that, one way or another, the debt run-up is going to be stopped, if not by our own self-control, then by the refusal of creditors to roll over the loans. I was surprised at how blunt the Fed Chair was in spelling out what this could mean:
According to the CBO projection that I have been discussing, interest payments on the government's debt will reach 4-1/2 percent of GDP in 2030, nearly three times their current size relative to national output. Under this scenario, the ratio of federal debt held by the public to GDP would climb from 37 percent currently to roughly 100 percent in 2030 and would continue to grow exponentially after that. The only time in U.S. history that the debt-to-GDP ratio has been in the neighborhood of 100 percent was during World War II. People at that time understood the situation to be temporary and expected deficits and the debt-to-GDP ratio to fall rapidly after the war, as in fact they did. In contrast, under the scenario I have been discussing, the debt-to-GDP ratio would rise far into the future at an accelerating rate. Ultimately, this expansion of debt would spark a fiscal crisis, which could be addressed only by very sharp spending cuts or tax increases, or both.
I don't imagine that Bernanke or anyone else would relish handling the reins of monetary policy if we were to arrive at such a point.
A third reason that it is extremely appropriate for Bernanke to raise these issues is that there has been an astonishing immaturity on the part of our elected officials in Washington to openly acknowledge the problem and talk realistically about what needs to be done. As a respected third party, Bernanke has a unique opportunity and responsibility to be the one grown-up at this party. I think he was quite wise to avoid framing the issue in partisan terms. Bernanke does not presume to tell the senators how in particular to address these problems, but only that they need to do something.
I just hope they were all listening.
Posted by James Hamilton at January 19, 2007 05:25 AMdigg this | reddit
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» Bernanke: Entitlement Spending Threatens Future Economy from Economist's View
Federal Reserve Chair Ben Bernanke testified before the Senate Budget Committee today. Greg Ip summarizes his testimony [Update: Video of testimony from CSPAN]: Bernanke to Congress: Time for Action, by Greg Ip, Washington Wire: Bernanke Federal Reserv... [Read More]
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» What About the Deficit? from Businomics Blog
That's the most frequent question I'm asked after I give a speech, partly because I seldom talk about it. Today's federal budget deficit and accumulated debt are manageable. We've learned that they don't cause high interest rates, at least not [Read More]
Tracked on January 19, 2007 10:29 AM
Greenspan preached this religion as well. Greenspan got hammered from the left, however, when he seemed to favor using the Soc. Sec. Trust Fund reserves to subsidize the General Fund deficits. Bernanke seemed to be doing the same thing - and Dean Baker is preaching to the choir over at his blog.
Posted by: pgl at January 19, 2007 05:56 AM
I don't think the world will be the same place in 2030 that it is now, and a linear projection as to what will be required seems bizarre. Have you read Kurzweil's book The Singularity is Near, or followed some of the research in medicine/life extension technology? By 2030, working lifetimes will be dramatically longer and we should have cured almost all disease. The result should be lower costs for both SS (increased retirement age) and medicine (although it is possible that new treatments will be more expensive for some period, and it is hard to see from today exactly what the cost curves will be, but our medical productivity will certainly increase dramatically at some point in the next 40 years).
Posted by: Tim Lundeen at January 19, 2007 09:14 AM
> I don't think the world will be the same place
> in 2030 that it is now, and a linear projection
> as to what will be required seems bizarre.
Let alone 2075, where many of these predictions top out! What is it about economics or economists that leads them to think such long range predictions have any common sense to them? Just imagine how bizarre an idea people living in 1931 would have had about the world of 2006. I guess the concept of chaos, of path dependency, of sensitivity to initial conditions, just hasn't sunk into this corner of the intelligentsia...
Posted by: Fred Hapgood at January 19, 2007 09:35 AM
Tim and Fred, I agree that nobody can predict 2075. But projecting demographic trends out to 2030 is quite sound, in my opinion-- the people who will be of retirement age then have all been born. And while the trend of medical costs to rise faster than GDP could in principle be reversed, it has been that way for long enough that it seems by far the most natural assumption in any projection.
As I mentioned in the earlier post I linked to, if you project these out to 2150, you conclude that federal expenditures would consume 370% of GDP! Obviously I offer that just for humor value. What these projections tell us, in my opinion, is not how the world is going to be at that time, but rather that something surely must change between now and then. The sooner we acknowledge that reality, the better, in my opinion, since the problems of staying the course are already with us, right now.
Posted by: JDH at January 19, 2007 09:44 AM
A fourth reason that it is a appropriate (if that is the right word) for Bernanke to testify on the budget is that he has been asked to do so. To anyone receiving a Federal pay check, requested testimony is a command performance. Once there, he can decline to offer policy prescriptions, but he can very well decline to show up.
Your assertion that Social Security should cost less in the future relies on both a policy prescription - retirement should be delayed - and on a forecast based on popular futurist literature that is contrary to experience. It may well prove true that medical costs will fall, but we have absolutely no reason to base policy on that hope.
As things now stand, the US is running a structural deficit of considerable size. Waving our collective hand at the trend in medical costs and saying it will go away makes it far to convenient to leave the structural deficit in place. There is no good reason other than political convenience to leave a structural deficit in place in a country with an aging population.
Posted by: kharris at January 19, 2007 10:54 AM
pgl is onto it, and I hope that you are not one of those who takes the intermediate projection of the SS Trustees seriously. This is the basis of Bernanke's testimony, which I will credit with at least citing the basis of his remarks, thereby implicitly recognizing that there are other projections, the more optimistic low cost one projecting a surplus forever on the SS fund, and if anyone thinks it is not to be taken seriously, reality has regularly outperformed it over the last decade (and, no, the Trustees have not adjusted the projections at all).
There is a problem, but Bernanke seems to put all the weight for curing it on cutting all the entitlement programs. The Medicare fund is running a rising deficit, but the SS fund is running a still-rising surplus. Assuming no changes in immigration, the magic cutoff is 2.2% growth per year. Above that, the SS fund runs that surplus forever, even if it declines after the baby boomer retirement wave kicks in. As it is, even with the housing slowdown dragging the US economy down, our current growth rate (last time I checked anyway) was 2.4%, still above the cut that gives us those annual fund flow surpluses forever.
There simply is no problem with social security, and the stealth bipartisan panel that Sen. Conrad is putting together to go after it is simply a wild misdirection of energy and focus.
Posted by: Barkley Rosser at January 19, 2007 10:57 AM
The focus really needs to be on Medicare. Dealing with Medicare will require solving healthcare. We should start now to get experience dealing with it and finding a solution that works.
Posted by: Lord at January 19, 2007 11:11 AM
With that type of rise in Medicaid/Medicare, wouldn't we in essence have national health care? Unless this bloated system of insurers and gov't. bureaucrats is replaced by a market-driven patient controlled system, health care costs will continue to grow faster than inflation.
It's interesting to see how fields such as plastic and laser-eye surgeries, ones that insurers typically do not touch, have a much better cost-control system as well as options for the consumer. God forbid we should make doctors compete for customer dollars.
Posted by: Marc V at January 19, 2007 11:41 AM
Bernanke tell it like it is? Well certainly not the except I heard on CSPAN. A supply-side Senator asked Bernanke about the Laffer curve, a long speech starting with the silly high school math description about how both a 100% and 0% tax rate produce zero revenue. Thankfully we didn't have to listen to a discourse on Rolle's Theorem, but finally he put the direct question to Bernanke of which side of the peak we are on. Bernanke hemmed and hawed but finally guessed that we are on the left side but said that he could be wrong about that.
Now tell me, is there a single honest economist on earth that thinks that cutting income taxes at this point will increase total revenues? Bernanke may as well have said that he believes that the earth is round, but he could be wrong about that. Even Greg Mankiw and Bush's Council of Economic Advisors concede that tax cuts don't pay for themselves.
I can understand Brenanke's reluctance to take sides in political questions, but his is not one. If he is unwilling to tell a senator that there is no free lunch, then I can't conclude that he's telling it like it is, and he is not serving the public interest.
Posted by: Joseph at January 19, 2007 03:03 PM
A timid question from an amateur...
"The ratio of Federal debt held by the public to gdp only approached 100% during world war 2."
Following that conflict, the U.S. economy grew spectacularly, all boats were lifted.
Why the fear?
Posted by: oo at January 20, 2007 12:55 AM
Joseph, in these cases I always pay more attention to someone's prepared remarks than to their answers to spontaneous questions, because for the former they have had the opportunity to exercise the greatest care in choice of words and issues they believe need to be addressed. I think if you study this or any of Bernanke's other prepared testimony, you will find that he is very much a straight shooter. On the other hand, if pinned down on a question he'd really rather not address, I can certainly imagine that he might fail to give the most straightforward answer.
Bernanke is extremely anxious not to take sides in the political debate and maintain his status as an objective third party. Doing so requires abstaining from openly contradicting a senator or the president, even though there are obviously many issues on which Bernanke's views would differ from some or even most of our elected officials. I believe that Bernanke is extremely wise to have chosen this role for himself.
Posted by: JDH at January 20, 2007 06:27 AM
oo, everyone correctly perceived at the time that the World War II run-up in debt would be temporary, followed by post-war surpluses. But what's going to make the Medicare issue become anything but much larger in the future? We needed to borrow to fight the second world war, but why should we borrow to provide for the current elderly when the problem of caring for future elderly will be that much more challenging?
Posted by: JDH at January 20, 2007 06:34 AM
> And while the trend of medical costs to rise
faster than GDP could in principle be reversed,
it has been that way for long enough that it
seems by far the most natural assumption in any
Certainly a fair point, but it is also reasonable to remember that at some point not too far off the key issues involved with making very early diagnoses of heart disease and cancer (see The End of Medicine, by Andy Kessler) will fall into place, and when that happens a new chapter in the economics of health care will open.
There is nothing about health care as such that prevents it from getting cheap. The problem is that we happen to live in an era when the engineering is in advance of the science, like steam engines before thermodynamics. That won't last forever. When we really know how cells work, when we can model them on computers like people model circuits and materials flows, health care, defined as something like the basket of issues that occupy us today, costs will be far more tractable.
That said, I agree that planning for 2030 is a lot more sensible than planning for 2075.
Posted by: Fred Hapgood at January 20, 2007 09:30 AM
Just maybe helicopter Ben is not the clown that the media like to tell us that he is? Given more time he may yet prove to be good for the economy, that is if the the dollar does not die in the mean time!
Posted by: Bob at January 20, 2007 10:18 AM
You seem to be one of the willing dupes of government propaganda concerning Social Security. Taxes are taxes and when you realize that social spending is the biggest individual cost to government, it is naive to say that it is solvent simply because the government assigns it a higher portion of the budget than it spends.
For example what if we assigned a flat percentage of taxes to military spending at 40% of the budget. Then we could always justify increased military spending by saying it is paying for itself. We would then defer the deficit problem to the other parts of the budget because it couldn't be the military since it is below the assigned budget.
Never forget the government does not produce, we do. Whether they say it is for Social Security or the study of the mating rituals of green toad frogs the money comes from us to spend on legislators' pet projects or to get them reelected.
Posted by: DickF at January 23, 2007 04:45 AM
Why now ? After six years of avoiding the issue, the Republican appointee comes to town to scare the pants off the Democratic majority and the American people.
Immediately followed by another push from the administration to privatize Social Security. Wall Street's hired gun, Hank Paulson, is going to look into the matter. This is probably Hank's primary purpose for taking the Treasury job - get the money.
I am sceptical of Bernanke's mission.Where was all the indignation as the Cheney Administration was giving away the store to the pharmacutical industry
Posted by: zinc at January 23, 2007 04:46 AM
It's not too hard to imagine smart investors around the world instigating a correction themselves. The question in my mind is when? I'm betting it won't take 20 years.
Posted by: Anchoku at January 25, 2007 11:24 AM
You should take a look at the Veteran's Administration. They have done amazing things in improving care-- they are quite leading edge in a number of areas.
If patients ran healthcare, the cost inflation would be even higher. We would demand the best for ourselves, our children, and our parents.
Unless of course you are planning to abolish private insurance?
Posted by: Valuethinker at January 25, 2007 01:31 PM
To understand Bernanke's remarks we must understand the following that was sent to me by a friend as we discussed this issue.
However, the following exchange is relevant to your concerns. It took place between former Fed chairman Greenspan and Congressman Paul Ryan of of the 1st District in Wisconson in February of 2005 during the Q&A session of Greenspan's semi-annual monetary policy report to Congress:
RYAN: "Do you believe that personal retirement accounts can help us achieve solvency for the system and make those future retiree benefits more secure?"
GREENSPAN: "Well, I wouldn't say that the pay-as-you-go benefits are insecure, in the sense that there's nothing to prevent the federal government from creating as much money as it wants and paying it to somebody. [My emphasis] The question is, how do you set up a system which assures that the real assets are created which those benefits are employed to purchase."
...the government can create money at will. This means that financing future social security benefits of baby boomers is not the problem because the government doesn't finance anything when it taxes the private sector or borrows from it. Both activities ought to be properly seen as a draining of reserves.
The challenge for policy makers, that Greenspan alluded to in his response to Congressman Ryan, is in making sure that a dollar of social security benefits will buy as much relative value of goods and services 15 years from now as it does today. Problem is that today it takes about 3 employed workers to produce the social surplus of goods and services for social security beneficiaries who no longer work, while in 15 years or sooner there will only be about two employed workers available to create the same surplus of goods and services going to social security recipients.
So, how will two workers produce the same relative value for each social security recipient in 15 years that it current takes three workers to produce without cutting back on their own standards of living, i.e. without raising taxes on the working population, or without reducing benefits for SS beneficiaries that have already been promised? The answer is that our work force must become more productive, and the way to achieve that goal is by increasing the ratio of capital to labor. That can be accomplished by cutting or preferrably eliminating the capital gains tax.
Posted by: DickF at January 27, 2007 09:38 AM
Here is my response back to my friend.
This drives right to the heart of our fiat currency system. Because our currency does not have a foundation no one knows the extent of the inflation in the system, and honestly I don't think they care. Inflation will create the illusion of prosperity while all around the economy will be crumbling. Inflation is much like white wash. You can cover the areas of rot and termite infestation, but the rot and infestation will continue to eat at the house until it falls.
We not only need to elminate the capital gains tax but we need to return to a sound currency. This would remove a significant uncertainty drag on the economy and give businessmen more sound price signals.
Posted by: DickF at January 27, 2007 09:45 AM