Thursday, June 9, 2011

How to Deal With the Deficit

From the Federal Reserve:

The prospect of increasing fiscal drag on the recovery highlights one of the many difficult tradeoffs faced by fiscal policymakers: If the nation is to have a healthy economic future, policymakers urgently need to put the federal government's finances on a sustainable trajectory. But, on the other hand, a sharp fiscal consolidation focused on the very near term could be self-defeating if it were to undercut the still-fragile recovery. The solution to this dilemma, I believe, lies in recognizing that our nation's fiscal problems are inherently long-term in nature. Consequently, the appropriate response is to move quickly to enact a credible, long-term plan for fiscal consolidation. By taking decisions today that lead to fiscal consolidation over a longer horizon, policymakers can avoid a sudden fiscal contraction that could put the recovery at risk. At the same time, establishing a credible plan for reducing future deficits now would not only enhance economic performance in the long run, but could also yield near-term benefits by leading to lower long-term interest rates and increased consumer and business confidence.

I have to admit, I've really grown to like Bernanke, probably because I believe both of us are "wonks" of the highest order.

Above, he outlines the real issue: trying to balance the need for definitive deficit reduction without hurting short-term growth. Remember -- government spending is a variable in the GDP equation. A cut in spending by definition lowers growth. And -- as Kash over at the Streetlight Blog recently pointed pout -- cutting spending too sharply sends negative ripples throughout the economy.

However, regular annual deficits over $1 trillion are also unsustainable in the long run. While some economists have correctly pointed out that the current situation in the US bond market indicates a technical default or inflation are obviously not a concern right now, all it takes is one event to shatter confidence and send yields spiking. And once that happens, getting the market's confidence is difficult, if not impossible. Just ask Argentina about its decade long woes trying to do just that.

Considering the current batch of weak economic data, massive cutting should not be on the table right. But a long-term plan is clearly needed -- one that calls for sacrifice from both parties.