Fed Vice Chair Yellen on Fiscal Responsibility

As they read over the draft Fiscal Commission plan released today, many politicians will wonder why in the world should they agree on a plan – any plan - that contains so many features they don't like and which would more than likely set in motion painful adjustments for their constituents?

To better understand that the economic - and political - costs of doing nothing might be even higher than the costs of taking fiscal action, take a close look at Fed Vice Chair Janet Yellen’s timely speech today on “Fiscal Responsibility and Global Rebalancing”. In her words:

... the problem is that, in the absence of significant policy changes, and under reasonable assumptions about economic growth, demographics, and medical costs, federal spending will rise significantly faster than federal tax revenues in coming years. As a result, if current policy settings are maintained, the budget will be on an unsustainable path, with the ratio of federal debt held by the public to national income rising rapidly.

A failure to address these fiscal challenges would expose the United States to serious economic costs and risks. A high and rising level of government debt relative to national income is likely to eventually put upward pressure on interest rates, thereby restraining capital formation, productivity, and economic growth. Indeed, once the economy has recovered from its downturn, fiscal deficits will crowd out private spending. Large fiscal deficits will also likely put upward pressure on our current account deficits with the rest of the world; the associated greater reliance on borrowing from abroad means that an increasing share of our future income will be required to make interest payments on federal debt held abroad, thereby reducing the amount of income available for domestic spending and investment. A large federal debt will also limit the ability and flexibility of policymakers to address future economic stresses and other emergencies, a risk that is underscored by the critical fiscal policy actions that were taken to buffer the effects of the recent recession and stabilize financial markets in the wake of the crisis. And a prolonged failure by policymakers to address America's fiscal challenges could eventually undermine confidence in U.S. economic management.

We should not defer charting a course for fiscal consolidation. Timely enactment of a plan to eliminate future unsustainable budget gaps will make it easier for individuals and businesses to prepare for and adjust to the changes. Moreover, the sooner we start addressing the longer-term budget problem, the less wrenching the adjustment will have to be and the more control we--rather than market forces or international creditors--will have over the timing, size, and composition of the necessary adjustments.

She also made an observation that might even help bridge a political divide in the lame duck session: in her view, there may be scope for fiscal policy to address the continuing weakness of the economy now but in the context of a "well-timed and credible plan to bring deficits down to sustainable levels over the medium and long terms".