Complicating the fragility around monetary policy, fiscal policy as a pro-growth policy instrument also appears to be approaching its limit. The government’s stimulus efforts to support the economy, along with lower tax revenues, have resulted in historically large fiscal deficits and a very large debt level. Without a dramatic change, the deficit and the debt will only become more daunting with the rising cost of entitlement programs and likely higher interest rates.

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.”

I’ve argued that even if the fiscal authority borrows exclusively in its country’s own currency, the central bank can have a large amount of control over the price level. But the central bank can only achieve that control if it is willing to commit to letting the fiscal authority default. Such a commitment may expose the country to risks of short-term and medium-term output losses. How this trade-off should best be resolved awaits future research. But I suspect that it may be optimal for central banks to guarantee fiscal authority debts in some situations. If so, we again have to think of price level determination as something that is done jointly by the fiscal authority and the central bank.

I was quoted in the Washington Post on Feb. 21 as saying that we had suffered for too long from “Lindsay Lohan” Congresses.[6] Like Ms. Lohan, the American Congress is a beautiful creation, blessed with enormous talent. But it has been waylaid by addiction—in the case of the Congress to spending and debt―and by a proclivity for shoplifting―in the case of the Congress to pocketing for their immediate gratification the economic future of our children and grandchildren and our grandchildren’s children.

Our sense is that $60 billion cut, spread out in the normal way -- because, of course, the reduction of an authorization doesn't mean an immediate reduction in the spending; it usually takes a little time to actually feed through. It would reduce growth, but we think it's, given the size, it's more in the -- a couple, one to two-tenths in the first year, another tenth in the next year, something on that order of magnitude. And that would translate into a couple hundred thousand jobs.

So it's not trivial, but those {private sector estimates of 700,000 job losses) are a little high.

REED: Chairman Bernanke, I assume you're familiar with two recent reports by Moody's Analytics and Goldman Sachs which talked about the proposed House Republican budget. Their conclusion is that if passed without modification, there could be as much as a 2 percent decrease in the growth next year, going forward and as many as 700,000 jobs lost because of the contraction of spending at the federal level.  Do you agree with those -- that analysis?

BERNANKE: If that's referring to a $60 billion cut, obviously, that would be contractionary to some extent, but I -- for us -- our analysis doesn't get a number quite that -- doesn't give a number that high.

REED: Well, the proposed cut this year is $100 billion in the House. Is that you what used for your projections?

BERNANKE: We are assuming $60 billion this year and $40 billion next year, which would be the $100 billion over the fiscal year. And we also assume a normal spend-out, the way -- you know, the impact is not immediate, but is spent out over time. The reduction is effective over time. And we get a -- we get a -- I would have to say, a smaller impact of that. I'm not quite sure where that...

REED: What is your impact?

BERNANKE: Several tenths on GDP.

REED: And jobs?

BERNANKE: I don't have that number, but it would be certainly much less than 700,000.

...

BERNANKE:  But I still -- I still don't -- I'm happy to send you our analysis, Senator. But I frankly don't understand where -- 2 percent is an enormous effect; 2 percent of the -- of the -- of the GDP is $300 billion right there. So assuming a multiplier of -- of 1, you know, $60 billion to $100 billion, is not sufficient to get to that level. But it would, of course, have the effect of reducing growth on the margin, certainly.

The Fed has done its job... It’s now up to fiscal authorities to make it work.

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.

How much adjustment is needed to restore fiscal sustainability in the United States? To help answer this question, it is useful to apply the concept of the primary budget deficit, which is the government budget deficit excluding interest payments on the national debt. To stabilize the ratio of federal debt to the GDP--a convenient benchmark for assessing fiscal sustainability--the primary budget deficit must be reduced to zero.⁵ Under the CBO projection that I noted earlier, the primary budget deficit is expected to be 2 percent of GDP in 2015 and then rise to almost 3 percent of GDP in 2020 and 6 percent of GDP in 2030. These projections provide a gauge of the adjustments that will be necessary to attain fiscal sustainability.

...

I hope that, in addressing our long-term fiscal challenges, the Congress and the Administration will seek reforms to the government's tax policies and spending priorities that serve not only to reduce the deficit, but also to enhance the long-term growth potential of our economy... Our nation cannot reasonably expect to grow its way out of our fiscal imbalances, but a more productive economy will ease the tradeoffs that we face.

In this particular case, when we were -- when we are making our projections, we had already taken into account most of what is in that package. I mean we had anticipated that the Bush tax cuts would most likely be extended, at least in large part. We had anticipated that the U.I. insurance would be extended, at least in large part.
The part of the package that was surprising to us, and which does create a little additional stimulus, is the payroll tax rebate. So we factor that into our analysis. And, of course, on the margin, we'll respond to the way that affects the outlook.   But it wasn't that we were surprised by this package. We expected a lot of it to happen, and that was already built into our forecast when we made our policy decisions.

In response to a question about how the December 2010 stimulus package had affected the monetary policy outlook

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.

Given [the current] constraint on monetary policy, I believe it is important to ask if it is possible to synthesize the effects of a one-year interest rate cut of, say, 100 basis points using fiscal policy tools. In his current and past work, Minneapolis Fed staff researcher Juan Pablo Nicolini and his co-authors have answered this question in the affirmative. Their key insight is that there is a broad equivalence between monetary and fiscal policy. They argue that the essence of an FOMC interest rate cut is that it makes current consumption cheaper relative to future consumption. With that in mind, the fiscal authorities can use the time path of consumption taxes to accomplish this same change in relative prices.

In sum, I asked that the FOMC consider that we might be prescribing the wrong medicine for the ailment from which our economy is suffering. Liquidity and abundant money are not the binding constraints on the economic activity we wish to see. The binding constraints are uncertainty about income and future aggregate demand, the disincentives fiscal and regulatory policy impose on ridding decisionmakers of that uncertainty, and the reluctance, given those disincentives, of those who have the power to create jobs for our people to invest in undertakings that would create them.

The remedy for what ails the economy is, in my view, in the hands of the fiscal and regulatory authorities, not the Fed. I could not state with conviction that purchasing another several hundred billion dollars of Treasuries—on top of the amount we were already committed to buy in order to compensate for the run-off in our $1.25 trillion portfolio of mortgage-backed securities—would lead to job creation and final-demand-spurring behavior. But I could envision such action would lead to a declining dollar, encourage further speculation, provoke commodity hoarding, accelerate the transfer of wealth from the deliberate saver and the unfortunate, and possibly place at risk the stature and independence of the Fed.

My perspective, as with those of all other members of the FOMC, was given a thoughtful and fair hearing at the table. After deliberation, the majority of the committee concluded that under current and foreseeable conditions, the better approach was to purchase $600 billion in Treasuries between now and the end of the second quarter of next year, on top of the amount projected to replace the paydown in mortgage backed-securities. The math of this new exercise is readily transparent: The Federal Reserve will buy $110 billion a month in Treasuries, an amount that, annualized, represents the projected deficit of the federal government for next year. For the next eight months, the nation’s central bank will be monetizing the federal debt.

This is risky business. We know that history is littered with the economic carcasses of nations that incorporated this as a regular central bank practice. So how can the decision made last Wednesday be justified?

[T]o paraphrase the early 20th century progressive Clarence Day―the once-ubiquitous contributor to my favorite magazine, The New Yorker―“Too many (theorists) begin with a dislike of reality." The reality of fiscal and regulatory policy inhibiting the transmission mechanism of monetary policy is most definitely present and is vexing to monetary policy makers. It is indisputably a significant factor holding back the economic recovery.

[I]f fiscal and regulatory authorities are able to dispel the angst that businesses are reporting and put together a credible plan for deficit reduction that does not choke off growth, further accommodation might not even be needed. If job-creating businesses are more certain about future policy and are satisfactorily incentivized, they are more likely to take advantage of low interest rates, release the liquidity they are hoarding and invest it robustly in hiring and training a workforce that will propel the American economy to new levels of prosperity. This would render moot the argument for QE2, or a second round of quantitative easing. The key is to remove or reduce the tax and regulatory uncertainties that act as an impediment to businesses as they respond to increases in final demand. I think most all would consider this to be a far more desirable outcome than being saddled with a bloated Fed balance sheet.