Bernanke Fesses Up: America Has No ‘Insolvency’ Issue

Marshall Auerback explores the Fed Chairman’s obsession with fiscal sustainability.

Usually, we dread the regular Congressional testimonies of the Fed Chairman. They generally constitute a mix of obfuscation on the part of Mr. Bernanke mixed with political grandstanding on the part of Congress. But occasionally, a glimmer of truth comes through, as occurred today in this exchange between the chairman of the Federal Reserve and Congressman Barney Frank:

Frank: Do you think there is any realistic prospect of America’s defaulting on its debt in the near future?

Bernanke: Not unless Congress decides not to pay….

So there you have it. If Congress doesn’t pass the debt ceiling, the Treasury can default. But this constraint is not operationally inherent in the monetary system. It is put there by the same Congress that could (and should) revoke the unnecessary constraints, much as the European Union could (if it chose to do so) eliminate its arbitrary rules limiting government expenditure. This is a problem of “willingness to pay” and not “ability to pay”, as the government is at all times in control of its spending process. In short, here we have the Chairman of the Federal Reserve openly acknowledging that, short of voluntary political constraints, there are no financial constraints on the ability of a sovereign nation to deficit spend.

To anticipate the usual objections that we encounter whenever we point this out, please note that this doesn’t mean that there are no real resource constraints on government spending; this should be the real concern, not financial constraints. Government spending should be analyzed in regard to its effects on the real economy, which means that it should, like Goldilocks, be neither “too hot” (or else inflation will result), or “too cold” (as is the case today, where we have an economy characterized by high unemployment and significant resource underutilization). Debating whether the social losses due to operating below full employment are higher than economic losses due to inflation or currency depreciation, are germane discussions to POLITICAL debate. But they are totally separate from the issue of national solvency.

So what’s with the Fed Chairman’s obsession with fiscal sustainability, when Bernanke knows that there is no insolvency issue?

There’s obviously a degree of self-interest here. As head of the nation’s central bank, Mr. Bernanke (like any other central banker) is keen to assert the primacy of monetary policy over fiscal policy, despite the fact that the former’s impact on real economic activity is far more ambiguous. The manipulation of interest rates may be used to control inflation and that inflation expectation may have an influence on the spreads at the longer end of the yield curve. But the way in which interest rate manipulation (that is, monetary policy) impacts on inflation is unclear: rising interest rates certainly increase costs for borrowers and may choke of aggregate demand, but equally they increase incomes for those with interest-rate sensitive portfolios which may add to aggregate demand. Fiscal policy, by contrast is far more targeted in terms of the impact it seeks to achieve.

There is also a political dimension: the financial class (whose views still reflect the predominant economic thinking at the Fed and on Wall Street) benefits from the deflationary bias imparted as a consequence of these artificial financing rules, which are remnants of the gold standard era. But in reality, this is a denial of the essence of the fiat monetary system that we now live in and there is thus no economic basis for these constraints. Keeping unemployment high provides a strong means of disciplining wage demands and enhancing profits.

A stable ratio of federal debt to GDP may or may not be the right policy objective. But it is neither more nor less “sustainable,” under different economic conditions, than a rising or a falling ratio and Mr. Bernanke implicitly recognized that in his testimony today. We wish he had gone further. It is not, as Professor James Galbraith has argued, “a hidden evil. It is not a secret shame, or even an embarrassment. It does not need to be reversed in the near or even the medium term. If and as the private economy recovers, the ratio will begin again to drift down. And if the private economy does not recover, we will have much bigger problems to worry about, than the debt-to-GDP ratio”.

The public is told that government spending causes inflation and is warned that if we do not control the budget deficits that a Weimar Germany fate awaits us. Conveniently forgotten is that German production capacity was either significantly damaged by WWI, or redirected toward output required by the military. Additionally, Weimar Germany faced large foreign claims from war reparations, as well as exploding budget deficits. By 1919, it is reported that the German budget deficit was equal to half of GDP, and by 1921, war reparation payments represented one third of government spending (the so-called London ultimatum required annual installment payments of $2b in gold or foreign currency, in addition to a claim on just over a quarter of the value of German exports).

Neither of these conditions remotely pertains to the US today. The budget deficit represents a mere 6% of GDP. And, as Randy Wray and Yeva Nersisyan argue in an as yet unpublished paper for the Levy Institute, during WWII the government’s deficit (which reached 25% of GDP) raised the publicly held debt ratio above 100% — much higher than the ratio forecast to be by 2015 (just under 73%). This, in spite of the warnings issued in a recent study by Ken Rogoff and Carmen Reinhart to the effect that once the gross debt to GDP ratio crosses the threshold of 90%, economic growth slows dramatically.

Wray and Nersiyan illustrate that US growth in the postwar period was robust: “a golden age of US economic growth, and that the debt ratio came down rather rapidly-mostly not due to budget surpluses and debt retirement … but rather due to rapid growth that raised the denominator of the debt ratio. By contrast, slower economic growth post 1973, accompanied by budget deficits, led to slow growth of the debt ratio until the Clinton boom (that saw growth return nearly to golden age rates) and budget surpluses lowered the ratio.”

In the highly unlikely event that inflation started to accelerate in the US as a consequence of today’s fiscal stimulus (which has simply prevented another Great Depression, rather than ushering in a new era of growth), a highly non-unionized workforce has neither the bargaining power nor the access to credit to keep up with rising prices. Household claims on real resources would wither under inflation as real wages would simply fall behind.

In any case, there is NOTHING to suggest that any kind of inflation is upon us. The latest economic data suggests quite the opposite. Recently, the Conference Board reported a surprise 10 point decline in its confidence index to the lowest reading in ten months. With the stock market up more than 60% off its recession low, consumers must be very depressed about their actual financial and economic conditions if, given the bullish stock market message, their survey responses are so downbeat. Similarly, sales of new single-family homes in the U.S. sank 11% in January to a seasonally adjusted annual rate of 309,000. It was an unexpected tumble that sent sales to their lowest level since records began in 1963 and wiped out much of the progress made in the last year.

Bernanke’s remarks to Congressman Frank expose the dirty reality lurking beneath all questions pertaining to “national insolvency” or fiscal profligacy. These issues go by the wayside whenever Wall Street or some other major corporate interest demands a hand-out from the government. And if they don’t get satisfaction from one party, they’ll shift their support to the other, as Wall Street is doing today.

According to new data compiled for The Washington Post by the Center for Responsive Politics, the securities and investment industry went from giving 2 to 1 to Democrats at the start of 2009 to providing almost half of its donations to Republicans by the end of the year. Similarly, commercial banks and their employees also returned to their traditional tilt in favor of the GOP after a brief dalliance with Democrats, giving nearly twice as much to Republicans during the last three months of 2009.

The naked self-interest of our business oligarchs trumps all. All this talk about “free markets” and the virtues of “private market disciplines” goes out the window at times when the actual discipline of markets impose losses on these institutions. Losses are socialized and these institutions are left to wreak havoc on the global economy. Virtually the moment the handouts are made, in comes the discussion of national insolvency and the public mobilization against further government spending. A monomaniacal focus on fiscal sustainability demonstrates that policy makers fail to think coherently about the connectedness of the financial balances before they demand what is being currently called fiscal sustainability. As it turns out, pursuing fiscal sustainability as it is currently defined will in all likelihood just lead many nations to further private sector debt destabilization.

Never do we step back and ask the question — what is the public purpose being served by net government spending? Perhaps this is the line of enquiry that should be directed at Ben Bernanke the next time he appears before Congress and lectures us on fiscal and monetary policy.