Yellen: High Debt Could Undermine Flexibility

Feb 25, 2015 | Economics

Federal Reserve Chair Janet Yellen delivered testimony on the Semiannual Monetary Policy report to the Senate Banking Committee on Tuesday. Not surprisingly, the hearing focused on the economic outlook, the timing of an increase in the federal funds rate, and financial regulatory policy. But the topic of federal debt did come up, and Yellen corroborated our view on why debt should be put on a downward path.

In response to a question from Sen. Heidi Heitkamp (D-ND) about longer-term challenges facing the economy, Yellen responded that one was "longer-run issues with the federal budget."

I think Congress has made painful decisions that have now really stabilized, brought down the deficit very substantially and stabilized for a number of years the debt-to-GDP ratio. But eventually debt-to-GDP will begin to rise, and deficits will increase again as the population ages and Medicare, Medicaid, and Social Security get to be a larger share of GDP under current programs. And there are lots of ways in which these are problems we've known about for a long time.

Importantly, that rise in debt over the long term could mean that policymakers would have more limited options in needing to stimulate the economy if it fell into another deep recession.

I also worry that if we were to again be hit by an adverse shock, that there's not much scope to use fiscal policy. It was used in the early years after the financial crisis -- we ran large deficits -- but in the course of doing that, the debt-to-GDP ratio rose. And were another negative shock to come along, it's questionable how much scope we would now have to put in place even on a temporary multiyear basis expansionary fiscal policy, and I think it's important to deal with these issues -- for the Congress to do so.

This is a key point we have made as to why current projections are problematic and stabilizing debt is an insufficient goal. The high level of debt may constrain our ability to respond as necessary to emergencies, whether they be recessions, natural disasters, or conflicts. Lawmakers should not get complacent about debt stabilizing over the next few years as it could become a greater problem beyond then.