Federal Reserve Chairman Ben Bernanke should win a prize for the tone of his recent remarks to Congress. For telling both representatives and senators that the country was approaching a “massive fiscal cliff,” he surely deserves the melodrama-in-everyday-life award. But if Bernanke chose unusually dramatic language to make his point, he had one nonetheless, and maybe the shock value was worth it.
His remarkable phrase refers specifically to the economic danger of the fiscal restraint already scheduled to take effect on Jan. 1, 2013. A sudden cut in spending and a sudden rise in taxes, as will occur in 2013, when the Bush tax cuts are set to expire, could cripple an already subpar recovery and inadvertently compound budget problems. More significant, however, is the chairman’s implicit reminder in these remarks that for all the need to control deficits and the budget, policy makers must also consider how tax and spending decisions impact the economy, immediately and over the long run. Deficits and budget reform are more complex matters than many on both sides of Washington’s political divide seem to believe. His remark also served as a reminder to politicians, and, through them, to the public generally, that there is only so much the Fed can do.
Basically Bernanke’s comments referenced a fundamental aspect of public finance. However much politicians like to draw parallels to corporate or personal finances, the federal budget is fundamentally unlike them. What is prudent and sane for companies and individuals can be very dangerous for governments. With a company or a household, red ink demands an immediate cut in outlays and efforts to increase income. A firm produces more goods and prices for sale, while at the same time searches for ways to cut costs. Every success on either side of this equation addresses the deficit problem. Household members work longer hours and spend less on themselves to the same effect. But for governments, spending cuts, if done bluntly or too suddenly, can so hurt certain segments of the population that the resulting economic shortfalls cut into tax revenues and only make deficits worse.
Similarly, on the revenue side, the differences are fundamental and probably even more profound. Businesses and households gain revenue by selling something—products, talent or labor. Governments sell nothing. Their revenue comes from taxing, that is, confiscating monies from individuals and companies. The funds taken from firms and households might constrain their spending and are equally likely to constrain economic activity, and make the budget situation worse, especially if the government grabs for the revenues in a ham-handed way. Bernanke’s “cliff” remarks were clearly meant to remind lawmakers of these fundamental facts of life.
In the context of the rest of Bernanke’s testimony, his fiscal warnings also speak to the limits of monetary policy. He reminded lawmakers in both houses of Congress how the Fed, to spur the economy and quiet financial turmoil, has kept interest rates low and purchased large amounts of private and government bonds. The Fed has purchased most, if not all, of the federal debt issued to cover the huge budget deficits of the past two-plus years. He noted how the efforts have more than doubled the size of the Fed’s balance sheet, to almost $3 trillion. In recounting this record, Bernanke also pointedly alluded to the link between the Fed’s balance sheet and inflation, implicitly warning of longer-term dangers and the Fed’s ultimate need to halt its recent behavior and shrink its bloated balance sheet back to a more normal relationship to the economy. Since the Fed cannot begin this remedial process until Washington begins to get a handle on fiscal policy, he made clear to all how critical it was for them to address budget matters in ways that spared the economy.
Bernanke has shown clearly that all policy—fiscal and monetary—faces quite a balancing act. The Fed, which has already done a great deal to support financial markets and the economic recovery, has reason to worry about longer-term inflationary pressures. But it cannot remedy matters if the federal government fails to do its job of fiscal reform while protecting the economic recovery. Bernanke has made it clear that there are no easy answers because all the pieces of the puzzle—economic growth, inflation, monetary policy, and fiscal policy—depend on each other.