Assuming that the economy is back to close to full employment, you know, by 2013 or 2014, that 4 to 7 percent is the medium-term structure deficit. And that is too high to keep the debt-to-GDP ratio constant over time. It's going to lead to an unsustainable situation.

So, in particular, just to give a specific example, the deficit commission, I believe, has been tasked to bring the deficit down to 3 or 3.5 percent, something in that range, by 2015. I think we ought to be shooting for a sustainable path -- 3 percent, maybe even less -- of GDP as a deficit starting two or three years from now and going out to the next decade would be one broad trajectory that would be, I think, reassuring to the financial markets.

From the Q&A session

I don't think there's anything magic about 90 percent. However, I do think that if we were to go out as, say, the CBO's alternative scenario projects, then debt and interest payments are going to get explosive in 10 or 15 years. And so I think we are close to a situation where we need to be paying very close attention to our fiscal sustainability.

In response to a question about whether a 90% debt-to-GDP ratio represents a tipping point for fiscal sustainability.

We have politely made clear in all our speeches ... that we will not monetize the deficits.

Although sizable deficits are unavoidable in the near term, maintaining the confidence of the public and financial markets requires that policymakers move decisively to set the federal budget on a trajectory toward sustainable fiscal balance. A credible plan for fiscal sustainability could yield substantial near-term benefits in terms of lower long-term interest rates and increased consumer and business confidence. Timely attention to these issues is important, not only for maintaining credibility, but because budgetary changes are less likely to create hardship or dislocations when the individuals affected are given adequate time to plan and adjust. In other words, addressing the country's fiscal problems will require difficult choices, but postponing them will only make them more difficult.

One of these is the path of future federal budget deficits implied by current and planned fiscal policies. The government's debt cannot grow indefinitely at a rate much faster than the economy itself grows, so ultimately, something has got to change — either taxes are raised, spending is reduced, or the real value of the debt is eroded through an increase in inflation, an outcome the Federal Reserve is committed to preventing. Failure to establish credible plans for bringing the fiscal position back into balance is likely to dampen economic growth, since growing government debt relative to GDP would ultimately compete with private borrowing by businesses and households.

The economist Herb Stein once famously said, "If something cannot go on forever, it will stop."⁷ That adage certainly applies to our nation's fiscal situation. Inevitably, addressing the fiscal challenges posed by an aging population will require a willingness to make difficult choices. The arithmetic is, unfortunately, quite clear. To avoid large and unsustainable budget deficits, the nation will ultimately have to choose among higher taxes, modifications to entitlement programs such as Social Security and Medicare, less spending on everything else from education to defense, or some combination of the above. These choices are difficult, and it always seems easier to put them off--until the day they cannot be put off any more. But unless we as a nation demonstrate a strong commitment to fiscal responsibility, in the longer run we will have neither financial stability nor healthy economic growth.

Today the economy continues to operate well below its potential, which implies that a sharp near-term reduction in our fiscal deficit is probably neither practical nor advisable. However, nothing prevents us from beginning now to develop a credible plan for meeting our long-run fiscal challenges. Indeed, a credible plan that demonstrated a commitment to achieving long-run fiscal sustainability could lead to lower interest rates and more rapid growth in the near term.

Deposit institutions are holding over a trillion dollars in excess reserves (that is, over 15 times what they are required to hold given their deposits). These excess reserves create the potential for high inflation. Suppose that households believe that prices will rise. They would then demand more deposits to use for transactions. Banks can readily accommodate this extra demand, because they are holding so many excess reserves. These extra deposits become extra money chasing the same amount of goods and so generate upward pressure on prices. The households’ inflationary expectations would, in fact, become self-fulfilling.

Why might households expect an increase in inflation? The amount of federal government debt held by the private sector has gone up by over 30 percent since the beginning of 2008. This debt can only be paid by tax collections or by the Federal Reserve’s debt monetization (that is, by printing dollars to pay off the obligations incurred by Congress). If households begin to expect that the latter will be true—even if it is not—their inflationary expectations will rise as well.

The amount of federal government debt held by the private sector has gone up by over 30 percent since the beginning of 2008. This debt can only be paid by tax collections or by the Federal Reserve’s debt monetization (that is, by printing dollars to pay off the obligations incurred by Congress). If households begin to expect that the latter will be true—even if it is not—their inflationary expectations will rise as well.

You might well ask the "what if" question regarding Treasury borrowings. "What if the insatiable borrowing of the Treasury leads to upward pressure on rates? Would the Fed then step in and buy a bundle of Treasuries just to hold rates down?" I think not. For, should we do so, we would only become an accomplice to the fiscal incontinence of Congress. We would be perceived as "monetizing the debt," a trap that inevitably leads to hyperinflation and economic destruction. We would lose all the hard-earned credibility we have gained by our conduct in the crisis if we came to be viewed by markets as a handmaiden of spendthrift political forces. That would be a bit of lead piping we could ill afford.

The idea here is if you have a growing economy, you can run deficits and still maintain a flat ratio of debt to GDP, which is a sustainable situation. And one way -- normally, that would involve having what's called a "primary deficit," that is, a deficit excluding interest payments of about zero. Normally, that would involve about 2.5 percent to 3 percent of a total deficit, including interest payments.

"Depending on your assumptions about the economy, that federal debt will grow at an unsustainable level starting immediately, or in a very few years,” Hoenig said. “We do have significant private debt, so that’s in place, so what worries me about that [is] that puts pressure on the Fed to keep interest rates artificially low as you try to deal with that debt.”

In a C-SPAN interview, as reported by the Wall Street Journal

In attempting to explain why he signed an open letter opposing the 2009 stimulus package

A No, in fact I didn't sign that with a view of being opposed to the stimulus. I viewed signing that as stating my opposition to the idea that we all agree that the stimulus was good.

Q You mean, you were opposed to this assumption that, "we're all Keynesians" now that we're in a severe recession?

A Yes. The idea that there is some kind of uniform agreement among economists that the stimulus was a good thing, or more specifically, would lead to higher output, I didn't view that as being a settled question within the academe.

Let me be clear for everyone that there is a big distinction between quantitative easing and the -- and the fiscal debt, the government debt. We engaged in quantitative easing, or if you like -- or I've called it credit easing, because it's been focused at trying to get key credit markets functioning again.

We did that for two reasons: first, because we hit the zero bound and therefore normal interest-rate cuts couldn't achieve the goal anymore, and secondly because, in this extraordinary environment, many markets were not functioning properly and we thought we found ways to help those markets work better. And I think we've had some success in doing that.

Now, we have already begun a process of phasing out or reducing many of these extraordinary actions. For example, if you look at the portion of our balance sheet related to short-term lending to financial institutions, to commercial paper markets and to other kinds of international swaps with foreign central banks and other kinds of short-term lending, that amount has dropped from about $1.5 trillion at the beginning of the year to about roughly a fifth of that or less today. And we have announced the closing of certain facilities and planned closings going forward.

So we have already taken some very substantial steps towards moving towards a more normal type of monetary policy. And as long as the economy proceeds along the path that we think it will, we want to continue to move back to more normal monetary policy functioning. We will move to normal monetary policy as called for by the state of the economy, independent of the fiscal situation. We are not involved in that; we are involved in looking at the economy and trying to stabilize the economy.

With respect to fiscal policy, I think everybody knows, including the Treasury, the administration and the Congress, that the kinds of deficits we've seen this year and next year, about 10 percent of GDP, are not sustainable, that we have to find a(n) exit strategy for fiscal policy that will bring deficits down to a level of a few percentage points of GDP, which will result in a sustainable situation where debt, relative to the gross national product, gross domestic product, doesn't grow indefinitely.

From the audience Q&A

The Congress also has taken substantial actions, including the passage of a fiscal stimulus package. Nevertheless, even as important steps have been taken to address the recession and the intense threats to financial stability, maintaining the confidence of the public and financial markets requires that policymakers begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby-boom generation and continued increases in the costs of Medicare and Medicaid.

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.