Janet L Yellen: Fiscal responsibility and global rebalancing
Speech by Ms Janet L Yellen, Vice Chair of the Board of Governors of the Federal Reserve
System, at the Committee for Economic Development 2010 International Counterparts
Conference, New York, 1 December 2010.
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Good morning. Thank you for inviting me to be with you today. The Committee for Economic
Development has a long and distinguished record in identifying and addressing crucial issues
related to our nation's economic growth and productivity. And today's conference on fiscal
sustainability and the global economy fits squarely within that tradition. My remarks will focus
on the challenges faced by U.S. policymakers as they confront the need to put fiscal policy
on a sustainable track in the long term while providing support to the economy in the near
term. I will also offer some thoughts on the recent actions undertaken by the Federal
Reserve and on the implications of our nation's fiscal and monetary policy choices for the
global economy.1
The challenge of achieving fiscal sustainability in the United States
Charting a sensible course for the federal budget is an essential but formidable task for U.S.
policymakers. Since the onset of the recent recession and financial crisis, the federal budget
deficit has soared as the weak economy has depressed revenues and pushed up
expenditures and as necessary policy actions have been taken to help ease the recession
and shore up the financial system. At 9 percent of gross domestic product (GDP), the budget
deficit in fiscal year 2010 was a little lower than it had been a year earlier, but it was still
considerably above the average of 2 percent of GDP during the pre-crisis period from fiscal
2005 to 2007. As a result of the recent deficits, federal debt held by the public has increased
to around 60 percent of GDP - a level not seen in 60 years.
For now, the budget deficit seems to have topped out. So long as the economy and financial
markets continue to recover, the deficit should narrow relative to GDP over the next few
years as a growing economy boosts revenues and reduces safety-net expenditures and as
the policies put in place to provide economic stimulus and promote financial stability wind
down. That said, the budget situation over the longer run presents some very difficult
challenges, in part because the aging of the U.S. population implies a sizable and sustained
increase in the share of the population receiving benefits from Social Security, Medicare, and
Medicaid. Currently, there are about five individuals between the ages of 20 and 64 for each
person aged 65 and older. This ratio is projected to decline to around three by the time most
of the baby boomers have retired in 2030, and further increases in average life expectancies
may push this ratio down a little more in the years after that. Moreover, the demographic
pressures on the budget appear likely to be compounded by continued large increases in per
capita spending on health care. Admittedly, the ability of budget analysts to forecast the
trajectory of health-care spending is limited, but it is prudent to assume that federal health
spending per beneficiary will continue to rise faster than per capita GDP for the foreseeable
future.
In a nutshell, the problem is that, in the absence of significant policy changes, and under
reasonable assumptions about economic growth, demographics, and medical costs, federal
spending will rise significantly faster than federal tax revenues in coming years. As a result, if
current policy settings are maintained, the budget will be on an unsustainable path, with the
ratio of federal debt held by the public to national income rising rapidly.
A failure to address these fiscal challenges would expose the United States to serious
economic costs and risks. A high and rising level of government debt relative to national
income is likely to eventually put upward pressure on interest rates, thereby restraining
capital formation, productivity, and economic growth. Indeed, once the economy has
recovered from its downturn, fiscal deficits will crowd out private spending. Large fiscal
deficits will also likely put upward pressure on our current account deficits with the rest of the
world; the associated greater reliance on borrowing from abroad means that an increasing
share of our future income will be required to make interest payments on federal debt held
abroad, thereby reducing the amount of income available for domestic spending and
investment. A large federal debt will also limit the ability and flexibility of policymakers to
address future economic stresses and other emergencies, a risk that is underscored by the
critical fiscal policy actions that were taken to buffer the effects of the recent recession and
stabilize financial markets in the wake of the crisis. And a prolonged failure by policymakers
to address America's fiscal challenges could eventually undermine confidence in U.S. economic
management.
I do not underestimate the difficulty of crafting a long-range budget plan that will both garner
sufficient political support and have sound economic foundations. The reactions to the
proposals offered by members of the President's National Commission on Fiscal
Responsibility and Reform, as well as to those offered by other prominent groups, provide
ample evidence of the differences that must be bridged. Nonetheless, I am encouraged that
the debate seems to be moving forward and is starting to touch on some broad principles
that - if followed - would improve economic growth and make achieving sustainable fiscal
policies at least somewhat easier. Perhaps the most fundamental question that must be
faced concerns the size and scope of the federal government - that is, how much of the
nation's economic resources we will devote to federal programs, including transfer programs
such as Social Security, Medicare, and Medicaid. Crucially, whatever size of government we
choose, taxes must ultimately be set at a level sufficient to achieve an appropriate balance of
spending and revenues.
We should not defer charting a course for fiscal consolidation. Timely enactment of a plan to
eliminate future unsustainable budget gaps will make it easier for individuals and businesses
to prepare for and adjust to the changes. Moreover, the sooner we start addressing the
longer-term budget problem, the less wrenching the adjustment will have to be and the more
control we - rather than market forces or international creditors - will have over the timing,
size, and composition of the necessary adjustments.
That said, it is important to recognize that fiscal tightening, were it to occur prematurely,
could retard an already tepid economic recovery. We need, and I believe there is scope for,
an approach to fiscal policy that puts in place a well-timed and credible plan to bring deficits
down to sustainable levels over the medium and long terms while also addressing the
economy's short-term needs.
Unfortunately, U.S. economic performance continues to be impaired by the lingering effects
of the financial crisis. The economy remains far from full employment even though a year
and a half has elapsed since the trough of the business cycle. Job gains have continued to
be subpar, and the unemployment rate remains near its highest level since the early 1980s;
moreover, given the slow pace of economic growth, unemployment is likely to remain high for
some time. Meanwhile, measures of underlying inflation have continued to trend lower and
are now below the levels the Federal Open Market Committee (FOMC) judges to be
consistent, over the longer run, with its statutory mandate of maximum employment and price
stability.
In this context, the Federal Reserve decided at its November meeting to undertake additional
monetary policy actions to satisfy its dual mandate. After weighing carefully the uncertainties
and risks, the FOMC decided to further expand the Federal Reserve's holdings of
longerterm Treasury securities. The objective of this action is to reduce longer-term interest rates,
thereby promoting a stronger pace of economic growth. The purchase of longer-term
securities, while in some ways "unconventional," is actually quite similar to the Fed's
traditional approach to monetary policy, which involves lowering the overnight federal funds
rate by increasing the supply of reserve balances. With the federal funds rate now effectively
pinned at zero, purchases of longer-term securities are intended to push down rates further
out the yield curve. By bolstering activity in the United States and mitigating risks that could
threaten the recovery, this policy should also provide support for a sustained expansion of
the global economy.
In announcing its intention to purchase an additional $600 billion of longer-term Treasury
securities, the FOMC committed to review the purchase program regularly in light of
incoming information and to make adjustments as needed to meet our objectives. The
Committee, of course, recognizes that at the appropriate time, as the economy more fully
recovers, the Federal Reserve will need to remove this extraordinary monetary
accommodation in order to maintain price stability and keep inflation expectations well
anchored. I am confident that the Federal Reserve has both the commitment and the tools to
achieve this unwinding.
I strongly supported the Federal Reserve's recent action because I believe it will be helpful in
strengthening the recovery. But it is hardly a panacea. Thus, a fiscal program that combines
a focus on pro-growth policies in the near term with concrete steps to reduce longer-term
budget deficits could be a valuable complement to our efforts. Indeed, some budget experts
are exploring the idea of explicitly coupling fiscal stimulus in the near term, when
unemployment is high and resource utilization is low, with specific deficit-reducing actions
that take effect at scheduled future times, when output and employment are expected to
have moved closer to their potential. Although a plan of this type might be challenging to
develop and implement, it could provide an effective means to support economic activity in
the short run while moving toward fiscal sustainability over time.
International implications of US policy choices
Because the focus of this conference is on fiscal adjustments and the global economy, let me
now try to place this discussion of U.S. fiscal and monetary policies into the current
international context. The process of long-run fiscal consolidation in the United States would
likely entail higher national saving relative to investment, which should have the direct effect
of restraining U.S. imports and shrinking the U.S. trade deficit. More generally, by lowering
interest rates, fiscal consolidation should diminish net capital inflows into the United States,
thereby reducing the current account deficit in this country and current account surpluses
elsewhere. The resulting pattern of international debt accumulation and capital flows would
be more balanced than at present, promoting a more sustainable pattern of growth in the
global economy. Indeed, such a rebalancing program was strongly endorsed by the leaders
of the Group of Twenty at their recent meeting in Seoul.
Although the fiscal consolidation process is just beginning, the weakness of private demand
in the United States and other advanced economies, combined with robust growth in the
emerging market economies, has led to a two-speed global recovery that already is creating
pressures toward rebalancing. The advanced economies started their recoveries in 2009, but
economic growth has barely exceeded the growth rate of potential output; as a result, the
level of output in most advanced economies, including the United States, is still well below its
potential. Forecasts suggest that growth and resource utilization will remain lackluster in the
advanced economies for some time. Furthermore, inflation pressures in most other advanced
countries, as in the United States, remain quite low, reflecting the existence of substantial
economic slack.
In contrast to the subdued pace of recovery in the advanced economies, economic activity in
the emerging market economies has rebounded sharply, and the level of output in most of
those economies now well exceeds pre-crisis levels. The consequence is that policymakers
in emerging market countries have turned their attention to the threat of rising inflation and
have begun tightening monetary policy.
The stronger growth prospects in the emerging market economies, coupled with the
tightening stance of their monetary policies, appear to be contributing to a resurgence of
capital inflows to these economies. Sizeable differentials in expected returns between
advanced and emerging market economies also seem to be reinforcing these flows and
causing emerging market currencies to rise. In light of their increasing concerns about
inflation, a case can be made that emerging market policymakers should welcome currency
appreciation because it reduces inflation pressures and, over time, aids global rebalancing.
However, some of them have argued that unduly large and rapid capital inflows may lead to
asset-price bubbles and expose the financial sectors in their economies to a subsequent
reversal of these flows, while rapid currency appreciation could derail the growth of their
export sectors. A number of emerging market economies have accordingly attempted to
counter the effects of financial inflows through a range of policies, including foreign exchange
intervention and capital controls.
The U.S. fiscal program that I discussed earlier might also moderate the pressures emerging
market economies are experiencing at present. Stronger U.S. growth would boost our
demand for foreign goods and reduce the incentives for capital flows to emerging markets,
thereby diminishing some of the upward pressure on emerging market currencies. Thus, the
U.S. fiscal program would lessen for a time the natural mechanisms pushing the emerging
markets to rebalance their economies toward domestic demand, even as it helped put the
global economy as a whole on a more solid footing. However, such developments would in
no way diminish the need for such rebalancing in the medium term. It is also important for
both advanced and emerging market economies to begin planning now for the structural
reforms that will eventually be needed to promote rebalancing.
Conclusion
As I hope I've made clear, the challenge for U.S. policymakers will be to craft a strategy that
puts our fiscal policy on a sustainable path in the longer term while helping support the
recovery in economic activity in the near term. These goals are challenging to achieve but
not inconsistent. Moreover, making progress on them would not only provide important
benefits to the United States; it would also help foster a stronger world economy in the near
term and a better global balance in spending, production, saving, and borrowing over time.