February 16, 2010

A Lone Voice

Today, Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, gave what I believe we will look back and see as an imminently important speech:

In managing our nation’s debt going forward, it strikes me that we have only three options. First, the worst choice for our long-term stability, but perhaps the easiest option in the face of short-term political pressures: We can knock on the central bank’s door and request or demand that it “print” money to buy the swelling amounts of government debt. Second, perhaps more tolerable politically, although damaging to our economy: We can do nothing so long as domestic and foreign markets are willing to fund our borrowing needs at inevitably higher interest rates. Or third, the most difficult and probably the least palatable politically: We can act now to implement programs that reduce spending and increase revenues to a more sustainable level.

I recognize that this last option involves hard choices and short-term pain. However, in my view it is the responsible path to sustainable economic growth with price stability. The alternative options inevitably lead to financial crisis and greater long-run losses in national income and wealth.

The question of what combination of spending and revenue actions the country might choose is the purview of Congress and the executive branch. As a central banker, it is my responsibility to anticipate and avoid the consequences that an unchecked expansion of the debt may have on monetary policy. It is a fact that the current outlook for fiscal policy poses a threat to the Federal Reserve’s ability to achieve its dual objectives of price stability and maximum sustainable long term growth, and therefore is a threat to its independence as well.

..........Throughout history, there are many examples of severe fiscal strains leading to major inflation. It seems inevitable that a government turns to its central bank to bridge budget shortfalls, with the result being too-rapid money creation and eventually, not immediately, high inflation. Such outcomes require either a cooperative central bank or an infringement on its independence. While many, perhaps most, nations assert the importance and benefits of an independent central bank, the pressures of the “immediate” over the goals of the long run makes this principle all too expedient to forgo when budget pressures mount.

German hyperinflation is one classic and often-cited example, and with good reason. When I was named president of the Federal Reserve Bank of Kansas City in 1991, my 85-year old neighbor gave me a 500,000 Mark German note. He had been in Germany during its hyperinflation and told me that in 1921, the note would have bought a house. In 1923, it would not even buy a loaf of bread. He said, “I want you to have this note as a reminder. Your duty is to protect the value of the currency.” That note is framed and hanging in my office.

Someone recently wrote that I evoked “hyperinflation” for effect. Many say it could never happen here in the U.S. To them I ask, “Would anyone have believed three years ago that the Federal Reserve would have $1¼ trillion in mortgage back securities on its books today”. Not likely. So I ask your indulgence in reminding all that the unthinkable becomes possible when the economy is under severe stress.

.........The immediate concern is the size of the deficit. The CBO projects the deficit was almost 12 percent of GDP in fiscal year 2009 and will be almost 8 percent in the current fiscal year—extraordinarily high levels by historical standards. In the entire history of the United States, the government has run deficits over 10 percent of GDP in only a few instances, and usually only during or immediately following a major war.

.......A key part of the problem stems from rapid growth in entitlement spending, including spending on Social Security and, especially, Medicare. Over the next 30 years, the Government Accountability Office (GAO) estimates that the present value of future expenditures on all social insurance programs exceeds future revenue by over $50 trillion. That is nearly four times the size of GDP and clearly unsustainable.

........the plan must be seen as fair, in which there is a sense of shared sacrifice across all segments of the economy. Without being specific, these requirements suggest an approach in which we are willing to disappoint a host of special interests. It means, for example, controlling budget earmarks, trimming subsidies to numerous economic sectors, and resolving our banking problems and the perception that Wall Street is favored over Main Street, all of which would otherwise foster mistrust and cynicism among the public. Leaving these issues unaddressed will undermine the essential popular support required for the tough decisions needed to bring our federal budget into balance.

Finally, there are no short-cuts. We currently must adjust from a misallocation of resources. There is no way to avoid some short-term pain in fixing the fundamentals in our economy. It is inconvenient for the election cycle, and it is undeniably terrible to have at least 10 percent of the labor force out of work. But short cuts now mean people out of work again in only a few years because we again try and avoid difficult adjustments. Outlining a credible course for managing our debt for the future will accelerate the restoration of confidence in our economy and contribute importantly to sustainable capital investment and job growth.

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