WASHINGTON (MNI) – The following is the second and final section of
the text of Federal Reserve Chairman Ben Bernanke’s testimony prepared
Thursday for the House Budget Committee:

Fiscal Policy Challenges

In the remainder of my remarks, I would like to briefly discuss the
fiscal challenges facing your Committee and the country. The federal
budget deficit widened appreciably with the onset of the recent
recession, and it has averaged around 9 percent of gross domestic
product (GDP) over the past three fiscal years. This exceptional
increase in the deficit has mostly reflected the automatic cyclical
response of revenues and spending to a weak economy as well as the
fiscal actions taken to ease the recession and aid the recovery. As the
economy continues to expand and stimulus policies are phased out, the
budget deficit should narrow over the next few years.

Unfortunately, even after economic conditions have returned to
normal, the nation will still face a sizable structural budget gap if
current budget policies continue. Using information from the recent
budget outlook by the Congressional Budget Office, one can construct a
projection for the federal deficit assuming that most expiring tax
provisions are extended and that Medicare’s physician payment rates are
held at their current level. Under these assumptions, the budget deficit
would be more than 4 percent of GDP in fiscal year 2017, assuming that
the economy is then close to full employment.2 Of even greater concern
is that longer-run projections, based on plausible assumptions about the
evolution of the economy and budget under current policies, show the
structural budget gap increasing significantly further over time and the
ratio of outstanding federal debt to GDP rising rapidly. This dynamic is
clearly unsustainable.

These structural fiscal imbalances did not emerge overnight. To a
significant extent, they are the result of an aging population and,
especially, fast-rising health-care costs, both of which have been
predicted for decades. Notably, the Congressional Budget Office projects
that net federal outlays for health-care entitlements–which were about
5 percent of GDP in fiscal 2011– could rise to more than 9 percent of
GDP by 2035. 3 Although we have been warned about such developments for
many years, the time when projections become reality is coming closer.
Having a large and increasing level of government debt relative to
national income runs the risk of serious economic consequences. Over the
longer term, the current trajectory of federal debt threatens to crowd
out private capital formation and thus reduce productivity growth. To
the extent that increasing debt is financed by borrowing from abroad, a
growing share of our future income would be devoted to interest payments
on foreign-held federal debt. High levels of debt also impair the
ability of policymakers to respond effectively to future economic shocks
and other adverse events.

Even the prospect of unsustainable deficits has costs, including an
increased possibility of a sudden fiscal crisis. As we have seen in a
number of countries recently, interest rates can soar quickly if
investors lose confidence in the ability of a government to manage its
fiscal policy. Although historical experience and economic theory do not
indicate the exact threshold at which the perceived risks associated
with the U.S. public debt would increase markedly, we can be sure that,
without corrective action, our fiscal trajectory will move the nation
ever closer to that point.

To achieve economic and financial stability, U.S. fiscal policy
must be placed on a sustainable path that ensures that debt relative to
national income is at least stable or, preferably, declining over time.
Attaining this goal should be a top priority.

Even as fiscal policymakers address the urgent issue of fiscal
sustainability, they should take care not to unnecessarily impede the
current economic recovery. Fortunately, the two goals of achieving
long-term fiscal sustainability and avoiding additional fiscal headwinds
for the current recovery are fully compatible–indeed, they are mutually
reinforcing. On the one hand, a more robust recovery will lead to lower
deficits and debt in coming years. On the other hand, a plan that
clearly and credibly puts fiscal policy on a path to sustainability
could help keep longerterm interest rates low and improve household and
business confidence, thereby supporting improved economic performance
today.

Fiscal policymakers can also promote stronger economic performance
in the medium term through the careful design of tax policies and
spending programs. To the fullest extent possible, our nation’s tax and
spending policies should increase incentives to work and save, encourage
investments in the skills of our workforce, stimulate private capital
formation, promote research and development, and provide necessary
public infrastructure. Although we cannot expect our economy to grow its
way out of our fiscal imbalances, a more productive economy will ease
the tradeoffs that we face and increase the likelihood that we leave a
healthy economy to our children and grandchildren.

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** Market News International Washington Bureau: 202-371-2121 **

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