Bernanke Warns of Fiscal Cliff, Reminds of Debt Limit

As fiscal policymakers face these critical decisions, they should keep two objectives in mind. First, as I think is widely appreciated by now, the federal budget is on an unsustainable path. The budget deficit, which peaked at about 10 percent of GDP in 2009 and now stands at about 7 percent of GDP, is expected to narrow further in the coming years as the economy continues to recover. However, the CBO projects that, under a plausible set of policy assumptions, the budget deficit would still be greater than 4 percent of GDP in 2018, assuming the economy has returned to its potential by then. Moreover, under the CBO projection, the deficit and the ratio of federal debt to GDP would subsequently return to an upward trend.9 Of course, we should all understand that long-term projections of ever-increasing deficits will never actually come to pass, because the willingness of lenders to continue to fund the government can only be sustained by responsible fiscal plans and actions. A credible framework to set federal fiscal policy on a stable path--for example, one on which the ratio of federal debt to GDP eventually stabilizes or declines--is thus urgently needed to ensure longer-term economic growth and stability.

Even as fiscal policymakers address the urgent issue of longer-run fiscal sustainability, they should not ignore a second key objective: to avoid unnecessarily adding to the headwinds that are already holding back the economic recovery. Fortunately, the two objectives are fully compatible and mutually reinforcing. Preventing a sudden and severe contraction in fiscal policy early next year will support the transition of the economy back to full employment; a stronger economy will in turn reduce the deficit and contribute to achieving long-term fiscal sustainability. At the same time, a credible plan to put the federal budget on a path that will be sustainable in the long run could help keep longer-term interest rates low and boost household and business confidence, thereby supporting economic growth today.

Coming together to find fiscal solutions will not be easy, but the stakes are high. Uncertainty about how the fiscal cliff, the raising of the debt limit, and the longer-term budget situation will be addressed appears already to be affecting private spending and investment decisions and may be contributing to an increased sense of caution in financial markets, with adverse effects on the economy. Continuing to push off difficult policy choices will only prolong and intensify these uncertainties. Moreover, while the details of whatever agreement is reached to resolve the fiscal cliff are important, the economic confidence of both market participants and the general public likely will also be influenced by the extent to which our political system proves able to deliver a reasonable solution with a minimum of uncertainty and delay. Finding long-term solutions that can win sufficient political support to be enacted may take some time, but meaningful progress toward this end can be achieved now if policymakers are willing to think creatively and work together constructively.