Bernanke Warns of Dire Effect of Unsustainable Deficit
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Bernanke Warns of Dire Effect of Unsustainable Deficit

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Federal Reserve Board chairman Ben Bernanke managed to antagonize most of his critics in his latest testimony on Capitol Hill as he argued for continued government efforts to boost a weak economy, but offered no help for struggling states.

While many Republican leaders in the new Congress are demanding deep spending cuts to contain the deficit, Bernanke told members of the Senate Budget Committee Friday that large cutbacks in federal spending now would be premature. The economy is still generating far too few jobs to substantially bring down the jobless rate, which fell last month to 9.4 percent only because more than a quarter million people dropped out of the labor force. “Fiscal policymakers will need to continue to take into account the low level of economic activity and the still-fragile nature of the economy recovery,” he said.

At the same time, he dismissed inflation fears of critics upset with the Fed’s second round of buying government debt – so-called quantitative easing – which is designed to shore-up bank balance sheets and stimulate lending. Bernanke pointed out that inflation remains below 1 percent and shows no signs of reappearing, even though gas prices are once again on the rise.

In fact, the Fed believes inflation will “be at historically low levels for some time,” he said. “Low inflation increases the risk that new adverse shocks could push the economy into deflation,” which makes business reluctant to hire new workers. “It is important to recognize that periods of very low inflation generally involve very slow growth in nominal wages and incomes as well as in prices,” he said.

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. 

Bernanke's performance Friday suggests the academic-turned-central banker has clearly established room to maneuver on policy issues, and to speak his mind on Capitol Hill. Having brought the U.S. economy through the worst economic downturn since the Great Depression, Bernanke’s aggressive defense of his quantitative easing policy shows he’s consolidated his power over internal critics at the Fed, who would prefer a tougher stance on inflation and less attention to job creation. One of his chief critics on the Fed board, Thomas Hoenig of the Kansas City Fed, rotates off the Federal Open Markets Committee this month.

While Senate Budget Committee Chairman Kent Conrad, D-N.D., and other majority Democrats on the panel focused on the need for a long-term deficit reduction plan, Republicans took aim at Bernanke’s unwillingness to endorse short-run budget cuts, which the Republican-led House will be sending over to the Senate in the coming months.

“Is it premature to start reducing spending,” asked Sen. Jeff Sessions, R-Ala., the new ranking member of the committee. “The Brits don’t seem to think so. They’re cutting now,” referring to the British government’s draconian budget cuts and reduction in services in response to a mounting debt crisis.

“It’s a long-run issue,” Bernanke responded. “It’s not too soon to have a strong set of measures that bring deficits down over a long period of time ... but you’re not going to solve the [deficit]  problem by making cuts in this year’s budget.”

Analysts expressed surprise at the vehemence with which Bernanke defended his recent policies. “Inflation is too low and the risk of deflation is too great,” said Diane Swonk, chief economist at Mesirow Financial in Chicago. “Plus, unemployment is too high for the Fed not to easy further ... and the only way to do that is to buy Treasury bonds.”

On a separate issue, the fiscal crisis roiling many states became a major focus of attention during the session when newly elected Sen. Joseph Manchin, D-W.Va., a former governor making his first appearance at a committee hearing, predicted dozens of states will soon be besieging Capitol Hill with pleas for  another federal bailout.

The states’ collective deficit for the next fiscal year has been variously estimated at $97 billion to $140 billion. Sales and income taxes, while recovering, remain depressed, and federal aid from the 2009 stimulus act expires in June. Some analysts are predicting that as many as 50 municipalities may default on their debts this year, and one or two states are flirting with bankruptcy, with President Obama’s home state of Illinois at the head of the pack.

“They’re making draconian cuts,” Manchin said. “Is there any plan that might be available to help the states to prevent this from happening?”

Bernanke said the Fed was monitoring state and municipal bond markets closely and as yet saw no reason for alarm. However, given the Fed’s poor performance in anticipating the mortgage bond crisis suggests, that may not have been reassuring to Manchin and other lawmakers. 

Nor did Bernanke see any reason to help states avoid budget cuts, which if they are as large as anticipated this year and next, will largely offset the stimulus provided by the federal payroll tax cut enacted in December. “I don’t think the Federal Reserve has the authority nor would it be appropriate for us to do that,” Bernanke said. There is “plenty of time for Congress and the state to look for alternative solutions. This is a political and fiscal issue.”

That sentiment drew bipartisan support from senior members of the budget committee. “States need to get their house in order,” said Sessions. “They shouldn’t expect low interest loans from the Fed if they get in trouble.”

“I don’t think there’s going to be any appetite here to send truckloads of money to states,” agreed Conrad.