Big Ben Strikes Midnight for the American Economy

By Dr. Duru written for One-Twenty

January 22, 2007

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Listening last week to Federal Reserve chairman "Big Ben" Bernanke testify before the Senate Committee on the Budget was like getting a gentle wake-up call in the middle of a dream about, uh, chocolate. The stock market has been going gangbusters for months now as most of us have chosen to focus on the potential of a "goldilocks" economy that both regains robust growth and gets the loving kiss of a rate cut or three. As the economic (and inflation) news has come in stronger, earlier than expected, the market finally seems ready to give up hope for an imminent rate cut. As you all know, I have actually been arguing that the Fed will raise rates again before it starts cutting, and it seems we have moved one step closer to that possibility. Perhaps only the continued troubles in the housing market have stayed the Fed's hand. Anyway, during his testimony, Big Ben warned America with a familiar refrain that we generally love to blithely ignore: on the present course, the U.S. budget deficit will soon spin out of control and lower the standard of living for all of America.

Below, I have pieced together some key highlights from Big Ben's testimony:

"Official projections suggest that the unified budget deficit may stabilize or moderate further over the next few years. Unfortunately, we are experiencing what seems likely to be the calm before the storm...The outcomes that appear most likely, in the absence of policy changes, involve rising budget deficits and increases in the amount of federal debt outstanding to unprecedented levels...A vicious cycle may develop in which large deficits lead to rapid growth in debt and interest payments, which in turn adds to subsequent deficits...If government debt and deficits were actually to grow at the pace envisioned by the CBO's [Congressional Budge Office's] scenario, the effects on the U.S. economy would be severe. High rates of government borrowing would drain funds away from private capital formation and thus slow the growth of real incomes and living standards over time. Some fraction of the additional debt would likely be financed abroad, which would lessen the negative influence on domestic investment; however, the necessity of paying interest on the foreign-held debt would leave a smaller portion of our nation's future output available for domestic consumption. Moreover, uncertainty about the ultimate resolution of the fiscal imbalances would reduce the confidence of consumers, businesses, and investors in the U.S. economy, with adverse implications for investment and growth... To the extent that federal budgetary policies inhibit capital formation and increase our net liabilities to foreigners, future generations of Americans will bear a growing burden of the debt and experience slower growth in per-capita incomes than would otherwise have been the case."

I can hear all of America say 'yeah, yeah, yeah, we have heard it all before, and somehow, things always work out.' This has indeed been true. But the key is that we have to make changes to avoid disaster. And we have been stuck in a political environment and a national ethos that has refused to come to terms with the budgetary madness for years. We have offered ourselves the excuses of recession and war for being fiscally irresponsible, but excuses will not pay the bills when our (increasingly foreign) creditors come a-knocking. Faith in "something" happening to save us is certainly reflected in the persistence of low long-term interest rates. Bernanke and his Senate inquisitors had a mild chuckle over the conundrum this faith continues to present to many baffled observers. And when asked how soon the Congress needs to take action to avert this coming financial disaster, Bernanke flat-out said that we should have started "ten years ago"!

Bernanke's prescription was so simple, yet, in stating the obvious he made clear just how irresponsible we have become:

"To some extent, strong economic growth can help to mitigate budgetary pressures, and all else being equal, fiscal policies that are supportive of growth would be beneficial. Unfortunately, economic growth alone is unlikely to solve the nation's impending fiscal problems...Whatever size of government is chosen, tax rates must ultimately be set at a level sufficient to achieve an appropriate balance of spending and revenues in the long run. Thus, members of the Congress who put special emphasis on keeping tax rates low must accept that low tax rates can be sustained only if outlays, including those on entitlements, are kept low as well. Likewise, members who favor a more expansive role of the government, including relatively more-generous benefits payments, must recognize the burden imposed by the additional taxes needed to pay for the higher spending, a burden that includes not only the resources transferred from the private sector but also any adverse economic incentives associated with higher tax rates."

So far, our answer to the budget deficit has been to cut taxes and increase spending. As Bernanke said, in the short-term, this has managed to work, but it will soon begin to fail. And eventually, it will fail spectacularly. If I am reading the tea leaves correctly, I think this also means the Fed will become increasingly reluctant to support our growing debt with low (lower) interest rates. History will soon tell whether they will share the blame for supporting our ballooning debts in the first place.

Be careful out there!

DrDuru, 2007