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) could 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 usually 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 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 expectations 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 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. In the highly unlikely event that inflation started to accelerate in the US, 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.
The reality is that all questions of “national insolvency” or fiscal sustainability 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 the financial sector trumps all. All this talk about “free markets” and the virtues of “private market disciplines” go out the window should the actual discipline of markets impose losses on these institutions. Virtually the moment the handouts are made, in comes the discussion of national insolvency and the public mobilization against further government spending. 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.