Ben S Bernanke: Long-term fiscal challenges and the economy
Testimony by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal Reserve
System, before the Committee on the Budget, US House of Representatives, Washington DC,
28 February 2007.
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Chairman Spratt, Representative Ryan, and other members of the Committee, I am pleased to be here
to offer my views on the federal budget and related issues. At the outset, I should underscore that I
speak only for myself and not necessarily for my colleagues at the Federal Reserve.
My testimony will focus on the long-term budget outlook and will draw on the most recent set of
longterm budget projections from the Congressional Budget Office (CBO), issued in December 2005. The
CBO constructed its projections based on the assumptions that real gross domestic product (GDP)
would rise about 3-1/2 percent per year in 2005 and 2006 and at a rate of 2.9 per cent per annum from
2007 through 2015. The growth projections through 2015 were in turn based on the assumptions that
trend labor force growth will average 0.8 percent per year and that trend labor productivity growth in
the nonfarm business sector will average 2.4 percent per year. The CBO has since updated those
assumptions for the purposes of other analyses, but the revisions were not large enough to materially
alter the broad contours of the fiscal outlook.1 As for the longer-term outlook, the CBO assumed that
the growth rate of real GDP will average about 2 percent per year starting around 2020. While such
projections are subject to considerable uncertainty, the CBO's assumptions provide a sensible and
useful starting point for assessing the budget situation over the longer run.
Before discussing that longer-run outlook, I will comment on recent budget developments. As you
know, the deficit in the unified federal budget declined for a second year in fiscal year 2006, falling to
$248 billion from $318 billion in fiscal 2005. So far in fiscal 2007, solid growth in receipts, especially in
collections of personal and corporate income taxes, has held the deficit somewhat below year-earlier
levels. Of course, a good deal of uncertainty still surrounds the budget outcome for the year as a
whole. Federal government outlays in fiscal 2006 were 20.3 percent of nominal gross domestic
product (GDP), receipts were 18.4 percent of GDP, and the deficit (equal to the difference of the two)
was 1.9 percent of GDP. These percentages are close to their averages since 1960. The on-budget
deficit, which differs from the unified budget deficit primarily in excluding receipts and payments of the
Social Security system, was $434 billion, or 3.3 percent of GDP, in fiscal 2006.2 As of the end of fiscal
2006, federal government debt held by the public, which includes holdings by the Federal Reserve but
excludes those by the Social Security and other trust funds, amounted to 37 percent of one year's
GDP.
Official projections suggest that the unified budget deficit may stabilize or moderate further over the
next few years. Unfortunately, we are experiencing what seems likely to be the calm before the storm.
In particular, spending on entitlement programs will begin to climb quickly during the next decade. In
fiscal 2006, federal spending for Social Security, Medicare, and Medicaid together totaled about 40
percent of federal expenditures, or 8-1/2 percent of GDP.3 In the medium-term projections released by
the CBO in January, these outlays increase to 10-3/4 percent of GDP by 2017, an increase of about 2
percentage points of GDP in little more than a decade, and they will likely continue to rise sharply
relative to GDP in the years after that. As I will discuss, these rising entitlement obligations will put
enormous pressure on the federal budget in coming years.
The large projected increases in future entitlement spending have two principal sources. First, like
many other industrial countries, the United States has entered what is likely to be a long period of
demographic transition, the result both of the reduction in fertility that followed the post-World War II
baby boom and of ongoing increases in life expectancy. Longer life expectancies are certainly to be
welcomed. But they are likely to lead to longer periods of retirement in the future, even as the growth
rate of the workforce declines. As a consequence of the demographic trends, the number of people of
retirement age will grow relative both to the population as a whole and to the number of potential
workers. Currently, people 65 years and older make up about 12 percent of the U.S. population, and
there are about five people between the ages of 20 and 64 for each person 65 and older. According to
the intermediate projections of the Social Security Trustees, in 2030 Americans 65 and older will
constitute about 19 percent of the U.S. population, and the ratio of those between the ages of 20 and
64 to those 65 and older will have fallen to about 3.
Although the retirement of the baby boomers will be an important milestone in the demographic
transition - the oldest baby boomers will be eligible for Social Security benefits starting next year - the
change in the nation's demographic structure is not just a temporary phenomenon related to the large
relative size of the baby-boom generation. Rather, if the U.S. fertility rate remains close to current
levels and life expectancies continue to rise, as demographers generally expect, the U.S. population
will continue to grow older, even after the baby-boom generation has passed from the scene. If current
law is maintained, that aging of the U.S. population will lead to sustained increases in federal
entitlement spending on programs that benefit older Americans, such as Social Security and Medicare.
The second cause of rising entitlement spending is the expected continued increase in medical costs
per beneficiary. Projections of future medical costs are fraught with uncertainty, but history suggests
that - without significant changes in policy - these costs are likely to continue to rise more quickly than
incomes, at least for the foreseeable future. Together with the aging of the population, ongoing
increases in medical costs will lead to a rapid expansion of Medicare and Medicaid expenditures.
Long-range projections prepared by the CBO vividly portray the potential effects on the budget of an
aging population and rapidly rising health care costs. The CBO has developed projections for a variety
of alternative scenarios, based on different assumptions about the evolution of spending and taxes.
The scenarios produce a wide range of possible budget outcomes, reflecting the substantial
uncertainty that attends long-range budget projections.4 However, 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. For example, one plausible scenario is based on the
assumptions that (1) federal retirement and health spending will follow the CBO's intermediate
projection; (2) defense spending will drift down over time as a percentage of GDP; (3) other
noninterest spending will grow roughly in line with GDP; and (4) federal revenues will remain close to their
historical share of GDP - that is, about where they are today.5 Under these assumptions, the CBO
calculates that, by 2030, the federal budget deficit will approach 9 percent of GDP - more than four
times greater as a share of GDP than the deficit in fiscal year 2006.
A particularly worrisome aspect of this projection and similar ones is the implied evolution of the
national debt and the associated interest payments to government bondholders. Minor details aside,
the federal debt held by the public increases each year by the amount of that year's unified deficit.
Consequently, scenarios that project large deficits also project rapid growth in the outstanding
government debt. The higher levels of debt in turn imply increased expenditures on interest payments
to bondholders, which exacerbate the deficit problem still further. Thus, a vicious cycle may develop in
which large deficits lead to rapid growth in debt and interest payments, which in turn adds to
subsequent deficits. According to the CBO projection that I have been discussing, interest payments
on the government's debt will reach 4-1/2 percent of GDP in 2030, nearly three times their current size
relative to national output. Under this scenario, the ratio of federal debt held by the public to GDP
would climb from 37 percent currently to roughly 100 percent in 2030 and would continue to grow
exponentially after that. The only time in U.S. history that the debt-to-GDP ratio has been in the
neighborhood of 100 percent was during World War II. People at that time understood the situation to
be temporary and expected deficits and the debt-to-GDP ratio to fall rapidly after the war, as in fact
they did. In contrast, under the scenario I have been discussing, the debt-to-GDP ratio would rise far
into the future at an accelerating rate. Ultimately, this expansion of debt would spark a fiscal crisis,
which could be addressed only by very sharp spending cuts or tax increases, or both.6
The CBO projections, by design, ignore the adverse effects that such high deficits would likely have on
economic growth. But if government debt and deficits were actually to grow at the pace envisioned by
the CBO's scenario, 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. Some fraction of the additional debt would likely be financed
abroad, which would lessen the negative influence on domestic investment; however, 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. Moreover, 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.
To some extent, strong economic growth can help to mitigate budgetary pressures, and all else being
equal, fiscal policies that are supportive of growth would be beneficial. Unfortunately, economic growth
alone is unlikely to solve the nation's impending fiscal problems. Economic growth leads to higher
wages and profits and thus increases tax receipts, but higher wages also imply increased Social
Security benefits, as those benefits are tied to wages. Higher incomes also tend to increase the
demand for medical services so that, indirectly, higher incomes may also increase federal health
expenditures. Increased rates of immigration could raise growth by raising the growth rate of the labor
force. However, economists who have looked at the issue have found that even a doubling in the rate
of immigration to the United States, from about 1 million to 2 million immigrants per year, would not
significantly reduce the federal government's fiscal imbalance.7
The prospect of growing fiscal imbalances and their economic consequences also raises essential
questions of intergenerational fairness.8 As I have noted, because of increasing life expectancy and
the decline in fertility, the number of retirees that each worker will have to support in the future - either
directly or indirectly through taxes paid to support government programs - will rise significantly. To the
extent that federal budgetary policies inhibit capital formation and increase our net liabilities to
foreigners, future generations of Americans will bear a growing burden of the debt and experience
slower growth in per-capita incomes than would otherwise have been the case.
An important element in ensuring that we leave behind a stronger economy than we inherited, as did
virtually all previous generations in this country, will be to move over time toward fiscal policies that are
sustainable, efficient, and equitable across generations. Policies that promote private as well as public
saving would also help us leave a more productive economy to our children and grandchildren. In
addition, we should explore ways to make the labor market as accommodating as possible to older
people who wish to continue working, as many will as longevity increases and health improves.
Addressing the country's fiscal problems will take persistence and a willingness to make difficult
choices. In the end, the fundamental decision that the Congress, the Administration, and the American
people must confront is how large a share of the nation's economic resources to devote to federal
government programs, including transfer programs such as Social Security, Medicare, and Medicaid.
Crucially, whatever size of government is chosen, tax rates must ultimately be set at a level sufficient
to achieve an appropriate balance of spending and revenues in the long run. Thus, members of the
Congress who put special emphasis on keeping tax rates low must accept that low tax rates can be
sustained only if outlays, including those on entitlements, are kept low as well. Likewise, members
who favor a more expansive role of the government, including relatively more-generous benefits
payments, must recognize the burden imposed by the additional taxes needed to pay for the higher
spending, a burden that includes not only the resources transferred from the private sector but also
any adverse economic incentives associated with higher tax rates.
Achieving fiscal sustainability will require sustained efforts and attention over many years. As an aid in
charting the way forward, the Congress may find it useful to set some benchmarks against which to
gauge progress toward key budgetary objectives. Because no single statistic fully describes the fiscal
situation, the most effective approach would likely involve monitoring a number of fiscal indicators,
each of which captures a different aspect of the budget and its economic impact. The unified budget
deficit, projected forward a certain number of years, is an important measure that is already included in
the congressional budgeting process. However, the unified budget deficit does not fully capture the
fiscal situation and its effect on the economy, for at least two reasons.
First, the budget deficit by itself does not measure the quantity of resources that the government is
taking from the private sector. An economy in which the government budget is balanced but in which
government spending equals 20 percent of GDP is very different from one in which the government's
budget is balanced but its spending is 40 percent of GDP, as the latter economy has both higher tax
rates and a greater role for the government. Monitoring current and prospective levels of total
government outlays relative to GDP or a similar indicator would help the Congress ensure that the
overall size of the government relative to the economy is consistent with members' views and
preferences.
Second, the annual budget deficit reflects only near-term financing needs and does not capture
longterm fiscal imbalances. As the most difficult long-term budgetary issues are associated with the growth
of entitlement spending, a comprehensive approach to budgeting would include close attention to
measures of the long-term solvency of entitlement programs, such as long-horizon present values of
unfunded liabilities for Social Security and Medicare.
To summarize, because of demographic changes and rising medical costs, federal expenditures for
entitlement programs are projected to rise sharply over the next few decades. Dealing with the
resulting fiscal strains will pose difficult choices for the Congress, the Administration, and the American
people. However, if early and meaningful action is not taken, the U.S. economy could be seriously
weakened, with future generations bearing much of the cost. The decisions the Congress will face will
not be easy or simple, but the benefits of placing the budget on a path that is both sustainable and
meets the nation's long-run needs would be substantial.
Thank you again for allowing me to comment on these important issues. I would be glad to take your
questions.