Deficit must fall to prevent economic crisis, Bernanke warns

By Neil Irwin
Washington Post Staff Writer
Friday, January 7, 2011; 3:52 PM

Federal Reserve Chairman Ben S. Bernanke laid out a dire scenario on Friday of what could happen to the U.S. economy if the government cannot develop a plan to bring down the budget deficit in the years ahead, even as he said that the economic recovery appears to be gaining momentum.

Bernanke began his testimony before the Senate Budget Committee just an hour after the Labor Department reported that the unemployment rate fell to 9.4 percent in December - its lowest level since May 2009 - from the previous month's 9.8 percent. The surprising decrease was tempered by news from employers that showed weaker-than-expected job growth. Still, the sharp drop in unemployment revealed a growing confidence in the nation's economic outlook.

"We have seen increased evidence that a self-sustaining recovery in consumer and business spending may be taking hold," Bernanke said, according to prepared testimony. "Overall, the pace of economic recovery seems likely to be moderately stronger in 2011 than it was in 2010."

But Bernanke also offered his strongest warning yet over the nation's high deficit. If the United States does not set a fiscal course that is more sustainable, "the economic and financial effects would be severe," he said.

If federal debt were to rise at the pace assumed in a plausible scenario analyzed by the Congressional Budget Office - such as extending most of the 2001 and 2003 tax cuts as spending rises at a steady rate - "diminishing confidence on the part of investors that deficits will be brought under control would likely lead to sharply rising interest rates on government debt and, potentially, to broader financial turmoil," Bernanke said. He added that the high borrowing rate would limit private investment and push up the nation's foreign debt, hurting U.S. incomes and standards of living.

"Prompt adoption" of a plan to bring deficits down in future years could improve the economic outlook today, Bernanke argued, by helping keep interest rates low and increasing business confidence.

Bernanke's warning comes after remarks by Treasury Secretary Timothy F. Geithner on Thursday about the rising national debt, which he said would reach its limit of $14.3 trillion this spring. Geithner urged Congress to raise the debt limit, saying that failure to do so could cost jobs and push up interest rates.

Bernanke's testimony was prepared before the Friday morning jobs report, and while he indicated greater confidence in the state of the economy than he had in recent speeches, his enthusiasm remained measured.

"With output growth likely to be moderate in the next few quarters and employers reportedly reluctant to add to payrolls," it will take five years before the unemployment rate has returned to a more normal level, he said.

The Fed chairman also offered his first public defense to Congress of the central bank's program to buy $600 billion in Treasury bonds in an effort to prop up growth. The program was announced Nov. 3, and Bernanke has discussed it in several public settings and in private meetings with lawmakers. But Friday's hearing was his first chance to defend the decision publicly against congressional questioning.

He emphasized that the bond purchases are a form of monetary policy, not government spending.

"Although longer-term securities purchases are a different tool for conducting monetary policy than the more familiar approach of managing the overnight interest rate, the goals and transmission mechanisms are similar," Bernanke said. "It is worth emphasizing that the Fed's purchases of longer-term securities are not comparable to ordinary spending."

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