Growing demands on the federal government have invited a massive buildup of government debt now and over the next several years. US fiscal policy must focus on reducing this debt buildup and its consequences.
History holds many examples of severe fiscal strains leading to major inflation. It seems inevitable that a government turns to its central bank to bridge budget shortfalls — with the result being too-rapid money creation and eventually, not immediately, high inflation.
German hyperinflation is one classic and often-cited example, and with good reason. When I was named president of the Federal Reserve Bank of Kansas City in 1991, my 85-year old neighbor gave me a German 500,000 Mark note.
He’d been in Germany during its hyperinflation and told me that in 1921, the note would have bought a house. In 1923, it wouldn’t even buy a loaf of bread. He said, “I want you to have this note as a reminder. Your duty is to protect the value of the currency.”
Many say hyperinflation could never happen here in the United States. To them I ask, “Would anyone have believed three years ago that the Federal Reserve would have $1 1/4 trillion in mortgage-backed securities on its books today?” Not likely. So I ask your indulgence in reminding all that the unthinkable becomes possible when the economy is under severe stress.
IN the 1960s, the Federal Re serve’s willingness to accom modate fiscal demands and help finance spending on the Great Society and the Vietnam War contributed to a period of accelerating price increases. Inflation rose from roughly 1½ percent in 1965 to almost 6 percent in 1970. It also helped set the stage for the Great Inflation of the 1970s as inflation expectations gradually became unanchored.
Today, the immediate concern is the size of the deficit. The CBO projects the deficit was almost 12 percent of GDP in fiscal year 2009 and will be almost 8 percent in the current fiscal year — extraordinarily high levels by historical standards.
In the entire history of the United States, the government has run deficits over 10 percent of GDP in only a few instances, and usually only during or immediately following a major war.
EVEN more disconcerting is the longer-term outlook for the federal debt. The Congressional Budget Offices’s long-term debt projections clearly show that current fiscal policies are unsustainable. In one scenario, the liftoff point for federal debt — that is, the time when debt starts rising without any sign of stabilizing — occurs shortly after 2020. By 2035, federal debt held by the public reaches 80 percent of GDP — a level only exceeded during and just after World War II.
In another, more pessimistic scenario, the liftoff in debt has already begun — with federal debt held by the public reaching 181 percent of GDP in 2035, easily exceeding the peak debt-to-GDP ratio of 113 percent at the end of World War II.
I SEE just three ways forward:
Monetize: One option is for the central bank to succumb to political pressure and monetize the debt.
As deficits and debt levels within a country rise relative to national income, interest rates tend to rise as well. The central bank is often pressured to keep rates low and encouraged or required to assist the markets in facilitating the government’s funding needs. If the central bank succumbs, its balance sheet will expand, bank reserves will grow — and inevitably the money supply will increase. If this goes on unchecked, the outcome is almost always higher inflation and ultimately a loss of confidence in the value of the currency and the economy.
Policy Stalemate: The second path forward is a stalemate between the fiscal and monetary authorities — the fiscal imbalance grows while an independent central bank maintains its focus on long-run price stability.
Although the US government is currently privileged to borrow at favorable rates, the fiscal outlook would inevitably undermine this privilege and its risk premium on debt would increase. Also, as the government competes with private borrowers for funds, the potential exists for the fiscal imbalance to drive up the real cost of borrowing and capital to the private sector as well.
EVENTUALLY, this combina tion weakens economic growth and undermines confidence in the economy’s long-run potential. Slowly, but inevitably, the currency weakens, as does access to global financial markets. And the cycle worsens, leading ultimately to a financial and economic crisis.
An interesting example is Canada in the first half of the ’90s. In this period, Canadian federal debt rose from about 55 percent of GDP to roughly 70 percent. At the same time, the Bank of Canada targeted a steady downward path for inflation from 3 percent at the end of 1992 to 2 percent at the end of 1995.
With no monetary accommodation from the central bank, unsustainable government deficits and debt caused real interest rates in Canada to climb. Canadians paid a substantial risk premium over US rates to borrow. Moreover, the Canadian dollar came under persistent pressure. Overall economic performance suffered, with unemployment climbing as high as 12 percent.
These economic conditions contributed to the election of a new government, which made a credible commitment to balance the budget. In the following years, the federal budget deficit fell dramatically. Revenue increased, and government expenditures were cut sharply. By 1996, Canadian interest rates had fallen below comparable US rates. Inflation remained subdued, real GDP growth picked up and unemployment fell.
Equitable Fiscal Discipline: The Canadian experience in the second half of the ’90s is suggestive of the only responsible way to resolve our growing fiscal imbalance: by addressing its source in an environment of price stability.
All seem to agree this is the way we would prefer to go — but of course the devil is in the details. At the outset, it requires an institutional framework committed to having an independent central bank. This discourages the fiscal authority from turning to its central bank — and, should it do so, strengthens the bank’s ability to say “no.”
KNOWING inflation is not an acceptable alternative to strong fiscal management, a government faced with rising debt levels must provide a credible long-term plan to reestablish fiscal balance. The plan must be clear, have the force of law and its progress measureable so as to reassure markets and the public that the country has the will and ability to repay its debts in a stable currency.
To be broadly accepted, the plan must be seen as fair, in which there is a sense of shared sacrifice across all segments of the economy. These requirements suggest an approach in which we are willing to disappoint a host of special interests.
It means, for example, controlling budget earmarks, trimming subsidies to numerous economic sectors and resolving our banking problems and the perception that Wall Street is favored over Main Street.
There is no way to avoid some short-term pain in fixing the fundamentals in our economy. It is inconvenient for the election cycle, and it is undeniably terrible to have at least 10 percent of the labor force out of work. But shortcuts now mean people out of work again in only a few years because we again try and avoid difficult adjustments.
EVENTUALLY, government budgets that are severely out of balance are inevitably reformed — either by force of the markets or, preferably, by choice. In time, significant and permanent fiscal reforms must occur in the United States. I much prefer this be done well before anyone feels an irresistible impulse to knock on this central bank’s door.
Thomas M. Hoenig is president of the Federal Reserve Bank of Kansas City. Excerpted from his remarks Tuesday at a Peterson- Pew Commission on Budget Re form Policy forum.