In a deposition before the Senate Budget Committee, Federal Reserve Chief Ben Bernanke expressed concern over long-term fiscal challenges facing the United States in the form of the federal deficit, claiming that recent drops in the deficit are merely "the calm before the storm."
Over the course of 2006, the federal deficit fell to $248 billion from $319 billion in 2005, which Bernanke attributed to a solid increase in tax receipts and especially collections of personal and corporate income taxes. "Federal outlays in fiscal 2006 were 20.3% of nominal gross domestic product (GDP), receipts were 18.4% of GDP," said Bernanke. The deficit is, of course, the difference of these two and totals 1.9% of the U.S. GDP.
However, Bernanke cited projections by the Congressional Budget Office (CBO) that suggested that the baby boomer generation, which will soon reach retirement age, rising life expectancies and a continuing increase in medical costs will cause the deficit’s percentage of GDP to rise drastically. "The outcomes that appear most likely, in the absence of policy changes, involve rising budget deficits and increases in the amount of federal debt outstanding to unprecedented levels," said Bernanke. Under the assumption that federal retirement and health spending follow projections, defense spending decreases over time, non-interest spending grows proportional to the GDP and federal revenues remain close to their current levels, the CBO calculated that by 2030, the deficit will approach 9% of GDP, which is more than four times the current level.
Bernanke added that, should the deficit grow as high as predicted, the effects on the U.S. economy would be severe. "High rates of government borrowing would drain funds away from private capital formation and thus slow the growth of real incomes and living standards over time," said Bernanke. "Uncertainty about the ultimate resolution of the fiscal imbalances would reduce the confidence of consumers, businesses and investors in the U.S. economy, with adverse implications for investment and growth."
The fed chief suggested that, in a dire situation, a fraction of additional U.S. debt could be financed abroad but this would only be a short-term fix. "The necessity of paying interest on the foreign-held debt would leave a smaller portion of our nation’s future output available for domestic consumption," he warned.
According to the same CBO projection, Bernanke said that interest payments on government debt could total 4.5% of GDP by 2030, which is nearly three times the current size. "Under this scenario, the ratio of federal debt held by the public to GDP would climb from 37% to roughly 100% in 2030 and would continue to grow exponentially after that." The only other time that the debt-to-GDP ratio has come close to 100% was during World War II, when it spiked over the course of 1941-1945 and fell dramatically afterward. "In contrast," he added, "under the scenario I have been discussing, the debt-to-GDP ratio would rise far into the future."
"Ultimately, this expansion of debt would spark a fiscal crisis," said Bernanke, "which could be addressed only by very sharp spending cuts or tax increases, or both."
Source: Jacob Barron, NACM Staff Writer, and the Federal Reserve