In the U.S., our economy's performance near-term and longer-term will depend considerably on fiscal policy. Fiscal issues have led to across-the-board spending cuts, which are slowing U.S. economic growth in the near term. The challenge is for fiscal policymakers to enact a credible plan that will put the U.S. federal budget on a sustainable long-run path without adversely affecting the recovery. The United States is not alone in dealing with fiscal issues that threaten growth and stability. Political environments in various countries result in vastly different outlooks for fiscal action and economic and monetary policies. In Europe, the picture is mixed, with some euro zone countries advocating for fiscal austerity while others resist. In Japan, the central bank is ramping up monetary stimulus, while other parts of its government have pledged to establish a sustainable fiscal structure. Some countries may lean toward becoming more restrictive on trade, which would endanger global growth. Around the world, countries are facing fiscal problems, and how they address those problems could have real economic consequences.

Today, the U.S. economy continues to recover at a moderate pace, but unemployment remains unacceptably high. Monetary policy is supporting economic growth, but monetary policy has limits. In current circumstances, it would be particularly helpful if fiscal and regulatory policies were among the forces supporting economic growth.

Too much fiscal tightening in the near term could harm the economic recovery. Significant near-term reductions in federal spending or large increases in taxes would impose an additional drag on the economy at a time when aggregate demand is already weak. Indeed, under current law, federal fiscal policy is slated to impose considerable restraint on the growth of aggregate demand next year. We need, and I believe we have scope for, an approach to fiscal policy that puts in place a well-timed and credible plan to bring deficits down to sustainable levels over the medium and long terms while also addressing the economy's short-term needs.

Finally, and perhaps most challenging, the country would be well served by a better process for making fiscal decisions. The negotiations that took place over the summer disrupted financial markets and probably the economy as well, and similar events in the future could, over time, seriously jeopardize the willingness of investors around the world to hold U.S. financial assets or to make direct investments in job-creating U.S. businesses.

The debt limit is the wrong tool for that important job. Failing to raise the debt ceiling in a timely way would be self-defeating if the objective is to chart a course toward a better fiscal situation for our nation.

“I think using the debt limit as a bargaining chip is quite risky,” the Fed chief said today in testimony to the Senate Banking Committee in Washington. Failure to raise the debt limit would “at minimum” lead to “an increase in interest rates, which would actually worsen our deficit and would hurt all borrowers in the economy.”

The new Congress and the new staff in the White House have their work cut out for them. You cannot overstate the gravity of their duty on the economic front. Over the years, their predecessors―Republicans and Democrats together―have dug a fiscal sinkhole so deep and so wide that, left unrepaired, it will swallow up the economic future of our children, our grandchildren and their children. They must now engineer a way out of that frightful predicament without thwarting the nascent economic recovery.

I have been outspoken about the limits of monetary policy as a salve for the nation’s fiscal pathology. The Fed has done much, as I see it, to provide the bridge financing until the new Congress gets to work restructuring the tax and regulatory incentives American businesses need to confidently expand their payrolls and capital expenditures here at home.

I strongly supported the Federal Reserve's recent action because I believe it will be helpful in strengthening the recovery.  But it is hardly a panacea.  Thus, a fiscal program that combines a focus on pro-growth policies in the near term with concrete steps to reduce longer-term budget deficits could be a valuable complement to our efforts.

Some people worry about the long-term inflationary implications of sustained federal budget deficits. Others fear that economic slack and downward wage pressure are pushing inflation below rates that are consistent with price stability. I am in the second camp. Persistent large budget deficits may be harmful once the economy recovers because they are apt to boost interest rates and absorb private savings that would otherwise finance productive investments. But experience teaches us that budget deficits do not cause inflation in advanced economies with independent central banks that pursue appropriate monetary policies.

A glance at history shows that many countries with massive structural deficits and without an independent central bank turned to the printing press to pay off their debts. That’s a recipe for high inflation and, in some cases, hyperinflation.

But I don’t believe the United States faces that threat. Looking back in history, runaway fiscal deficits have often been accompanied by high inflation.F7F But, since World War II, such a relationship has only held in developing countries.F8F In countries with advanced financial systems and histories of low inflation, no such connection is found.

It is essential that we come to grips with structural budget deficits but not because such deficits will cause inflation. It’s because large, sustained structural deficits vacuum up savings that could be put to more productive uses. Once the economy is back on track these deficits will make capital more expensive for private borrowers, crowding out the investments that are essential to boost productivity and fuel growth in real wages and living standards.

[T]he idea has been to avoid that {a deflationary trap} during the most difficult period here in 2009, but in doing so we’ve increased the monetary base dramatically. We’re also running very large fiscal deficits; normally those would be considered very inflationary developments; so, we kind of have this medium-term inflation risk even while we have a short-term deflation risk.

Exceptional fiscal expenditures, by their own terms, are intended to replace shortfalls in aggregate demand. And recent extraordinary monetary policy actions are intended to lower risk-free rates and grow balance sheet capacity to help offset the pullback by private financial intermediaries. But financial markets may extract penalty pricing if fiscal authorities are unable to demonstrate a credible return to sustainable budgets. And they are unlikely to look kindly on monetary authorities unless they decidedly and unambiguously chart their own independent paths. The Federal Reserve should not--and will not--compromise another kind of stability--price stability--to help achieve other government policy objectives.

Higher nominal rates in the term Treasuries market can be seen as an expression of creeping doubt that the American polity, and more specifically the policy community, is up to the sacrifices, tradeoff decisions, and the courage of convictions the situation requires.

The concerns about our economic path are crystallized in doubts expressed in some quarters about the Federal Reserve's ability to fulfill its obligation to deliver low and stable inflation in the face of very large current and prospective federal deficits. In a word, the concerns are about monetization of the resulting federal debt.

I do not dismiss these concerns out of hand. I also recognize that the task of pursuing the Fed's dual mandate of price stability and sustainable growth will be greatly complicated should deliberate and timely action to address our fiscal imbalances fail to materialize. But I have full confidence in the Federal Reserve's ability and resolve to meet its inflation objectives in whatever environment presents itself.

For years, we have been able to finance a large share of our budget deficits with relatively cheap capital from abroad, and for years this has worked to our benefit. But our country should not regard international capital markets as a bottomless well. As access to this well becomes more limited, the cost of financing our fiscal deficits could rise.

Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth.