Bernanke Calls For New Debt Limit

• I was pleased that Bernanke called for a debt-to-GDP limit.  He is correct in criticizing the current unworkable debt limit and the delay in dealing with the problem.  However, his speech didn’t make any distinction between spending cuts and tax increases.  To get the private sector to invest and hire, it’s critical that Washington cut both spending and tax rates (broader base, lower rates).  Unfortunately, Bernanke ducked on this issue, leaving the impression that the Fed, like CBO is bound by an economic model in which the GDP growth rate is unaffected by the size of government and taxes. 

• Bernanke said: “Fiscal policymakers could look now to find substantial savings in the 10-year budget window, enforced by well-designed budget rules, while simultaneously undertaking additional reforms to address the long-term sustainability of entitlement programs. Such a framework could include a commitment to make a down payment on fiscal consolidation by enacting legislation to reduce the structural deficit over the next several years.”  This recommendation could be used to advocate a giant consumption tax or a lifting of the wage cap on social security taxes. To the extent that the Fed comments on fiscal policy, it should distinguish between spending and taxes in order to be helpful to the growth outlook. 

• The debt limit by itself isn’t a strong legislative vehicle.  It is a “must pass” bill, but the Administration drives a Mack truck in the negotiations with fiscal conservatives because it can orchestrate the shut-down of critical programs.  Bernanke articulated clearly the tools available to Treasury as it “prioritizes and withholds critical disbursements.”

• In the end, we expect ultra-loose fiscal and monetary policy to continue. Republicans will have to claim victory with only limited spending cuts.  As with the continuing resolution in the spring, we expect both sides to claim a large number ($1 trillion or $2 trillion in reductions) but without actually cutting any programs or spending. 

• The debt limit is not an effective check and balance.  It is written in a harmful way.  The money has already been spent. Since the federal budget is cash basis, a limit doesn’t work because much of the spending is already in the pipeline by the time the limit is hit.  The limit stated in nominal dollar terms and can be exceeded by the non-cash contributions to social security and medicare trust funds.

• I expect the Administration to turn up the heat on the Republicans week by week.  This is a great political issue for the President because he can call the Republicans irresponsible while at the same time making himself look fiscally responsible by offering future reductions in spending growth.  The longer the Congressional delay in passing the debt limit, the more broadsides I expect from the Fed, the Administration, bond rating agencies and foreign bond buyers like China. 

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