Chairman Bernanke may, if he likes, try to define "fiscal sustainability" as a stable ratio of public debt to GDP.  But this is, of course, nonsense. It is Ben Bernanke as Humpty-Dumpty, straight from Lewis Carroll, announcing that words mean whatever he chooses them to mean.

Now, we may admit that the power of the Chairman of the Board of Governors of the Federal Reserve System is very great.  But would someone please point out to me, the section of the Federal Reserve Act, wherein that functionary is empowered to define phrases just as he likes?

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.

In World War II, from 1940 through 1945, the ratio of US federal debt to GDP rose to about 125 percent.  Was this unsustainable?  Evidently not. The country won the war, and went on to 30 years of prosperity, during which the debt/GDP ratio gradually fell. Then, beginning in the early 1980s, the ratio started rising again, peaked around 1993, and fell once more.   

Thus, a stable ratio of debt to GDP is not a normal feature of modern history.  Gradual drift in one direction or the other is normal.  There seems no great reason to fear drift in one direction or the other, so long as it is appropriate to the underlying economic conditions.

History has a second lesson. In a crisis, the ratio of public debt to GDP must rise.  Why?  Because a crisis – and this really is by definition – is a national emergency, and national emergencies demand government action.  That was true of the Great Depression, true of war, and true of the Great Crisis we're now in.  Moreover, we've designed the system to do much of this work automatically. As income falls and unemployment rises, we have an automatic system of progressive taxation and relief, which generates large budget deficits and rising deficits.  Hooray!  This is precisely what puts dollars in the pockets of households and private businesses, and stabilizes the economy.  Then, when the private economy recovers, the same mechanisms go to work in the opposite direction.

For this reason, a sharp rise in the ratio of debt to GDP, reflecting the strong fiscal response to the crisis, was necessary, desirable, and a good thing.  It is not 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.

It is therefore a big mistake to argue that the next thing the administration and Congress should do, is focus on stabilizing the debt-to-GDP ratio or bringing it back to some "desired" value. Instead, the ratio should go to whatever value is consistent with a policy of economic recovery and a return to high employment.  The primary test of the policy is not what happens to the debt ratio, but what happens to the economy.

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Now, what about those frightening budget projections?  My friend Bob Reischauer has a scary scenario, in which a very high public-debt-to-GDP ratio leaves the US vulnerable to "pressure from foreign creditors" – a euphemism, one presumes, for the very scary Chinese. Under that pressure, interest rates rise, and interest payments crowd out other spending, forcing draconian cuts down the line.  To avert this, Bob has persuaded himself that social spending cuts are required now, not less draconian but implemented gradually.  Thus the frog should be cooked bit by bit, to avoid an unpleasant scene later on when the water is really boiling hot.

With due respect, Bob's argument displays a very vague view of monetary operations and the determination of interest rates. The reality is in front of our noses: Ben Bernanke sets whatever short term interest rate he likes. And Treasury can and does issue whatever short-term securities it likes at a rate pretty close to Bernanke's fed funds rate. If the Treasury doesn't like the long term rate, it doesn't need to issue long-term securities: it can always fund itself at very close to whatever short rate Ben Bernanke chooses to set.

The Chinese can do nothing about this.  If they choose not to renew their T-bills as they mature, what does the Federal Reserve do?  It debits the securities account, and credits the reserve account!  This is like moving funds from a savings account to a checking account.  Pretty soon, a Beijing bureaucrat will have to answer why he isn't earning the tiny bit of extra interest available on the T-bills.  End of story.

The only thing the scary foreign creditors can do, if they really do not like the returns available from the US, is sell their dollar assets for some other currency.  This will cause a decline in the dollar, some rise in US inflation, and an improvement in our exports.  (It will also cause shrieks of pain from European exporters, who will urge their central bank to buy the dollars that the foreigners choose to sell.)   The rise in inflation will bring up nominal GDP relative to the debt, and lower the debt-to-GDP ratio.  Thus, the crowding-out scenario Bob sketches will not occur.

I'm not particularly in favor of this outcome.  But unlike Bob Reischauer's scenario, this one could possibly occur. If it did, it would lower real living standards across the board.  This is unpleasant, but it would be much fairer than focusing preemptive cuts on the low-income and vulnerable elderly, as those who keep talking about Social Security and Medicare would do.  

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Now, it is true, of course, that you can run a model in which some part of the budget – say, health care – is projected to grow more rapidly than GDP for, say, 50 years, thus blowing itself up to some fantastic proportion of total income and blowing the public finances to smithereens. But this ignores Stein's Law, which states that when a trend cannot continue it will stop, and Galbraith's Corollary, which states that when something is impossible, it will not happen.

Why can't health care rise to 50 percent of GDP?  Because, obviously, such a cost inflation would show up in – the inflation statistics! – which are part of GDP.  So the assumption of gross, uncontrolled inflation in health care costs contradicts the assumption of stable nominal GDP growth.   Again, the consequence of uncontrolled inflation is... inflation!  And this increases GDP relative to the debt, so that the ratio of debt to GDP does not, in fact, explode as predicted.

I do not know why the CBO and OMB continue to issue blatantly inconsistent forecasts, but someone should ask them.

Further confusion in this area stems from treating Social Security alongside Medicare as part of some common "entitlement problem."   In reality, health care costs and haphazard health insurance coverage are genuine problems, and should be dealt with. Social Security is just a transfer program. It merely rearranges income. For this reason it cannot be inflationary; the only issue posed is whether the elderly population as a whole deserves to kept out of poverty, or not.

Paying the expenses of the elderly through a public insurance program has the enormous advantage of spreading the burden over all other citizens, whether they have living parents or not, and of ensuring that all the elderly are covered, whether they have living children or not.  A public system is also low-cost and efficient, and this too is a big advantage.  Apart from that, whether the identical revenue streams are passed through public or private budgets obviously has no implications whatever for the fiscal sustainability of the country as a whole.

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What is politically sustainable is nothing more than what the political community agrees to at any given time.  I have been surprised, and pleased, by the political community's acquiescence in the working of the automatic stabilizers and expansion program so far.  The deficits are bigger, and therefore more effective, than many economists thought would be tolerated.  That's a good sign.  But it would be a tragedy if alarmist arguments now prevailed, grossly undermining job prospects for millions of the unemployed.

Let me note, in passing, that Chairman Bernanke should please read the Federal Reserve Act, and focus on the objectives actually specified in it, including "maximum employment, stable prices and moderate long-term interest rates." He does not have a remit to add stable debt-to-GDP ratios or other transient academic ideas to the list.  One might think that the embarrassing experience with inflation targeting would be enough to warn the Chairman against bringing too much of his academic baggage to the day job.
 

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A stable debt-GDP ratio might seem like a reasonable policy objective, but closer consideration reveals its inadequacy in the current fiscal environment.

We need to start with two simple facts. First, a stable ratio of debt to GDP requires that the gap between non-interest spending and revenues cannot grow at a faster rate than GDP does. Second, three programs that together already account for nearly half of all non-interest federal spending – Medicare, Medicaid and Social Security – are, under current program rules, certain to grow much faster than GDP does for the foreseeable future, as a consequence of the economy’s ongoing demographic transition and the inexorable rise in health spending (private and public) relative to GDP. These two facts together imply that achieving a stable debt-GDP ratio will require adjustments to revenue and spending that will grow over time as a share of GDP. That is, an adjustment that will suffice in 2019 will be inadequate in 2029; the bigger adjustment that will do the trick in 2029 won’t be enough in 2039, and so forth. And with so much of spending accounted for by the big-three entitlement programs, cuts on the spending side must eventually bite very heavily into these programs.

In short, as a policy objective, a stable debt-GDP ratio pushes too much of the needed fiscal adjustment into the future. An alternative approach would be to adopt stronger measures sooner, which would allow more stable adjustments to revenue and spending over time. Such an objective might be fairer and more economically efficient, but it faces serious political challenges, for it would mean accumulating budget surpluses to help cover future costs.

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Would a firm today decide how to spend every additional dollar it planned on making over the next 100 years?  Should households sign contracts for the houses they will build and trips they will take years into the future based on growing wages?  Or should they wait to make many of those commitments until that future arrives.  I have derived a fiscal democracy index, which shows what most of us know: that over the past half century we have pre-committed an ever rising portion of our expected revenues—leaving current generations and currently elected officials little maneuver room without running deficits or taking back past promises.  This is just downright silly and determined partly by a “prisoners’ dilemma” where each political party fears that if it doesn’t pre-commit the future, the other party will.   Bottom line: sustainability is a minimalist goal; we need slack in the budget, measured as future revenues well in excess of today’s commitments as to how those revenues will be spent.

The OECD usefully defines a country’s fiscal policy to be sustainable if one can judge that the government might be able to continue servicing its debt without an unrealistically large future correction to the balance of its income and expenditure. Judged by that definition, it would seem that the Obama budget proposal is now raising major issues of fiscal sustainability for the United States. It would also seem that the US political system would do well to address these issues head on before they do further economic damage by offering a clear plan as to how public expenditures are to be cut and tax revenues to be raised to put the budget deficit on a more sustainable path.

            In the present US context, there would seem to be four separate but inter-related issues that should now be raising red flags about fiscal sustainability as an issue that needs immediate attention:

·        The trajectory of the deficit: The Administration’s recently budget proposal projects that the public deficit will rise to US$1.8 trillion or around 12 ½ percent of GDP in FY2009 and it will remain at US$1.3 trillion in FY2010 and US$900 billion in FY2011. Meanwhile, the CBO estimates that the US budget deficits will average US$1 trillion a year between 2011 and 2019 and will not decline to below 4-5 percent of GDP by 2019.

·        The level of the public debt: The Obama budget proposal implies that the public debt to GDP level would rise from around 40 percent in 2008 to 70 percent in 2011 and to 82 percent by 2019. This sort of increase has no precedent in peacetime years and would take the US public debt ratio well above the 60 percent level considered by the Europe Maastricht criteria to be a prudent limit for the public debt

·        Further major long run budget challenges: The aging of the baby boom generation poses further major challenges to the US public debt outlook that must raise even greater concern about the present budget trajectory. In the absence of policy changes, Social Security and Medicare outlays will together increase from 8 ½ percent of GDP today to 10 percent of GDP by 2020 and to 12 ½ percent of GDP by 2030.

·        The high proportion of foreign budget financing. Already foreigners finance close to 50 percent of the US budget deficit and hold over US$3 trillion in US government paper. It would seem foolhardy to expect foreigners to indefinitely fund large budget deficits especially when they are already voicing concerns about sustainability issues.

Over the past few weeks, the markets have begun to focus on the issue of the unsustainable path of the US public finances in a manner that could undermine any incipient economic recovery. The market’s concern has already been reflected in a 100 basis point back-up in long-bond yields to 3 ¾ percent and to more than a 50 basis point increase in long dated mortgage interest rates that threatens to delay recovery in the all important US housing market. At the same time, the dollar has been coming under increased pressure, which has fueled an increase in commodity prices that is hardly helpful to the government’s efforts to increase consumer demand.

One has to hope that the US political system responds soon to the clear messages coming out of the market about its growing concern about US long run debt sustainability before further economic damage is done. At the very least, one would hope that the political system moves from a state of denial to one of advance planning.

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“Political sustainability,”  I would define, as a system that allows economically sustainable policies to be enacted and enforced.  Most economists – and certainly Bernanke, are naïve about their abilities to rebind Leviathan.  As Robert Samuelson makes clear in his recent book, “The Great Inflation” , our escape from inflation in the 80s required an amazing and very unusual alliance between a President who had long been aware of the fatal consequences of inflation and a Fed Reserve Chief willing to reign in the money supply. Absent Reagan and Volker, Samuelson argues, we would have reverted to the earlier polcies of tightening up the money supply but then quickly retreating when the economy effects of that tightening became apparent. 

Do either Bernanke or Obama have that level of understanding and courage?  And, if they do, will they be able to resist the pressures that will mount?  “The Fed is killing what, at last, looks like recovery!”   The Fed, as Arthur Burns noted long ago, can only retain its “independence” by bowing to political pressures unless there are offsetting political defenders.  Where are those in today’s political world?

Also, the current welfare regulatory state that has become the major feature of the political economies of the United States and Europe, there is much less accountability than in the older and more honest forms of traditional socialism.  Under traditional socialism, government owned the facility, it was therefore held accountability for its performance, had to approve its budgets and operating policies and so forth.  Today, we preserve the nominal elements of private enterprise but then “guide” their performance by increasingly rigid regulations, encouraging their obedience by various forms of subsidies and protectionism.  None of these policies are readily monitored or observed; the costs are all off-budget. 

Reforming the regulatory state would require that Congress be held directly responsible for the rules it encourages.  This need not be overly complex – one partial reform would be for the appropriate congressional committees to be informed as soon as an agency began a rule-making relevant to the responsibilities of that committee.  The Committee would be encouraged to comment at each stage of the process.  When that process was completed, however, the rule would not go into effect until – and unless – that rule received congressional and presidential approval.  This would restore to Congress its constitutional responsibilities – something they almost certainly do not want.  Yet, this is the way in which our Founders saw laws being enacted – not the total delegation of such powers to obscure and often inscrutable agencies.

Reforms that might increase the prospects for Political Sustainabillty would be to index taxes so that one paid taxes on real – not nominal – earnings and profits.  That would make inflation more painful to political authorities as would eliminating all inflation-adjusted COLAs for government programs.  Inflation hurts the citizenry, it should also encourage reflection by the politicians. 

Over time, no politically managed monetary system will long resist inflation.  Debtors always benefit from it – and governments over time are always the largest debtors.  Thus, a commission should be created to examine ways of moving monetary policy into the competitive marketplace.  Frederick Hayek’s classic monograph, “The Denationalization of Money”, would be an excellent place to begin that review.

Few societies in history have found any way of achieving political sustainability.  Our Founders knew that gloomy history well and sought to build as many safeguards as possible – a federalist system, separation of powers, limited power to the federal government – all remaining powers to the states  and citizenry.  They did assume that government must – and would with reasonable certainty – exercise the monetary role responsiblty, sustainably.  They were wrong.  

The Constitution, like all human products, is not perfect but it is vastly better – and more politically sustainable – than the current mixed economy system. 

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Fiscal sustainability means moving from defined benefit/pay as you go/ Ponzi sheme financing of Social Security and Medicare to fully funded defined contribution pensions and health care funding.

This is not just a government funding problem.  Private companies that have defined benefit pensions have found themselves uncompetitive compared to defined contribution pensions.  There

are no unfunded liabilities in a defined contribution pension system—i.e. 401ks or Individual Retirement Accounts.  The savings for retirement is done up front and each individual is responsible for his or her own retirement.  Pay as you go/defined benefit plans have your children taxed (or their pay docked) to pay for your health care or retirement pension.

 Fullly funded, individually controlled.  This is the only way to get control of entitlement costs for government or for union contracts in the private sector.

Chairman Bernanke and the Obama Administration have defined "fiscal sustainability" to be achieving stability in the debt to GDP ratio.  In an era when this ratio is projected to explode--from 41 percent in 2008 to 82 percent in 2019 under the Congressional Budget Office's re-estimate of the President's budget--this is a tough but achievable initial objective. 

But over the longer run, we should ask whether we want we want to live always clinging to the edge of fiscal un-sustainability or would it be better to have a public sector that is a bit further from the cliff's edge, one more capable of responding to the inevitable economic and political crises that will occur.  We have to ask at what level we want to stabilize the debt to GDP ratio: should it be at 80 percent, 40 percent, or, perhaps the 25 percent achieved in the mid 1970s?  

The higher the ratio at which stability is achieved, the larger the deficits the government can incur while keeping the ratio stable.  The higher the ratio, the larger the fraction of spending devoted to interest payments and the more exposed the budget is to adverse interest rate movements and pressure from our foreign creditors. Furthermore, taxpayers already upset that they don't get their money's worth in services, won't be happy campers when a growing fraction of their taxes are absorbed paying for past services-- which is what interest payments represent.  For these reasons, long run sustainability should involve lowering the debt to GDP ratio from the projected 80 plus percent range back to levels that are more compatible with healthy economic growth and political stability.  

The question of whether revenues should remain close to their historic norms is really a question about what we expect government to do.  If government is expected to provide national security, help with access to health care, offer a safety net for vulnerable populations, and assure a decent retirement for former workers and their dependent, and these needs grow faster than the economy, we should be willing to accept rising tax burdens, or be willing to reduce significantly other government activities.  Borrowing more, should not be an option.

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