Mohamed El-Erian on Bernanke

Mohamed El-Erian points out that there are good reasons for Bernanke to be worried about the future with regards to fiscal policy.

Mr Bernanke acknowledges that, despite the “green shoots”, there are still question mark over which components of demand will kick into gear once the cyclical inventory pick-up runs its course, as it will inevitably do so over the next few months. Indeed, the chairman notes that “businesses remain very cautious and continue to reduce their workforces and capital investments.”

Concerns about a sustainable recovery are not limited to the dynamics of the immediate cyclical recovery. Mr Bernanke also notes that “even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilisation will increase further.”

Yet he stops short of addressing what, increasingly, will be on many people’s minds going forward. Specifically, the longer-term question goes well beyond the notion of a prolonged period of below-potential growth. The level of potential growth itself is likely to decline. Indeed, this is a central element of what we, at Pimco, call the “new normal”.

The “New Normal” refers to lower potential growth due to constraints from the increased national debt.

When it comes to fiscal issues, the chairman is not timid about worrying about longer-term questions — and rightly so. He is explicit about the need for greater clarity on how fiscal sustainability will be restored after this period of emergency policy actions.

Mr Bernanke states that “even as we take steps to address the recession and threats to financial stability, maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby-boom generation and continued increases in medical costs.”

He does not stop here. He goes on to warn that “near-term challenges must not be allowed to hinder timely consideration of the steps needed to address fiscal imbalances. Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth.”

Almost all projections show the U.S. national debt doubling by 2019 and that the outlook in terms of deficits goes from declining as a percentage of GDP to increasing after 2013. Significant parts of the problem are the fiscal imbalances caused by Social Security and Medicare with Medicare being the much larger contributor. And there is nothing even hinting at how these issues will be handled. The claim that President Obama is going to reduce the deficit by half by the end of his first term is offset by the worsening fiscal projections after that.

The chairman’s challenges on this count are neither easy nor amenable to quick solutions. Moreover, as markets increasingly look into the underlying factors, as inevitably they will, they will recognise the difficulty that the government faces in credibly committing to the needed primary fiscal adjustment in the absence of high economic growth.

The bottom line is that we should come away from Mr Bernanke’s testimony with at least two conclusions: the chairman seems more cautious about the growth outlook when compared with other recent public statements; and he wants to push fiscal sustainability issues clearly away from the Fed’s domain and back where they belong, with Congress and the administration.

Indeed, there is little the Fed Chairman can do regarding the fiscal situation. If the Congress and the Administration do not step up and start to show some signs of moving towards a sustainable fiscal policy economic growth could be considerably lower for quite some time.

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Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.


  1. odograph says:

    It’s actually interesting. Bill Gross writes about “the new normal” in his monthly letter as well … and it sounds like nothing so much as the Butler Creek world described in his 1998 book.

    He predicted the same “new normal” then, but it was put off by two stock bubbles.

    Here’s the google books link, where you can read the introduction about a lower return world, and Butler Creek. That’s a long crazy URL. If it doesn’t work, there’s always Amazon and their ‘look inside’.

    The commonality I see between the old and new view is that the “supply side” for investment is still there with crazy-high Asian saving … and now we are saving too. The difference now is that we are all also risk-adverse. The willingness to take risk was what made “Butler Creek” miss the first time around.

  2. odograph says:

    (The subtext of course is that Gross was totally wrong to call “the new normal” in 1998. He may be right this time, or something else crazy may happen. Heck, maybe the world is still so frothy that we will get another bubble.)

  3. odograph says:

    Oh, (classic triple post) also note that some people have started graphing the decline in consumer debt (as people deleverage) on the same page as rising government debt.

    If “we are all savers now“, and we are still risk adverse, we’ll be going for those boring bonds.

  4. Drew says:

    Sing along with me Christmas fans…….

    It’s beginning to look alot like Ja-pan, everywhere you go…..