Commentary Magazine


Our High-Tax, Low-Growth Future

Fed Chairman Bernanke, in Congressional testimony today: “Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth.”

This is worth parsing. Bernanke’s talking about deficits. Earlier in the same speech, he said that it’s “necessary and appropriate” to spend heavily in deficit today, because of the urgent need to stabilize both financial companies and the economy itself. But he’s issuing a strong warning that continued heavy borrowing will create problems ahead.

Bernanke is engaged in an effort to stimulate an economic recovery by using monetary tools to reduce the level of medium and long-term interest rates (“quantitative easing”). The Treasury is trying to add to the effort by using fiscal tools (Keynesian stimulus). What everyone hopes will happen is that the economy will pick up and start generating its own momentum, so that by the time interest rates start ticking up by themselves, we’ll be able to lay off both the quantitative easing and the stimulus spending.

The danger, however, is that expectations for economic recovery will cause investor dollars to flow away from Treasury debt and dollar-denominated investments altogether, before the job has been done. As medium and long-term interest rates rise, Bernanke finds himself under considerable pressure to expand the quantitative easing program, which he’s very reluctant to do because of the danger of runaway inflation.

That leaves the Treasury needing to keep borrowing gargantuan amounts of money for a long time to come, probably years. And that keeps steady upward pressure on interest rates in the economically-sensitive medium and long range segments of the yield curve.

As a side point, there is a lively debate among economists and policymakers about the scope and size of the Federal government. Left-leaning people like Paul Krugman and Jeffrey Sachs have long championed a much larger government, in terms of its share of the economy, primarily to fund social-policy objectives. In a perverse way, these people are not helped if the economy recovers strongly, because interest rates will rise and make it more difficult for the Treasury to keep borrowing at high levels.

What Bernanke worries about in the long term is that permanent high deficits are unsustainable. In today’s environment of low private demand for credit, government can keep borrowing at relatively low rates. If demand for credit never picks up, then heavy borrowing is sustainable, but the result will be permanent low growth. If demand does pick up and interest rates rise, then government borrowing will push them up even farther, endangering financial stability (and incidentally necessitating strong policy responses from the Fed). That’s the expanded form of the sentence from Bernanke that I quoted above.

At this point in his testimony, Bernanke stopped. What I wanted to hear him say was: “…and given the need for real fiscal discipline rather than the phony kind that the President has been talking about, here are your alternatives…”

Bernanke’s job is to make monetary policy, not fiscal policy or social policy, so I can see his reluctance to connect the dots. I, however, am not so constrained.

Since we must scale back fiscal borrowing as we move into the future, there are only two alternatives: to accept far higher levels of taxation, or to accept a U.S. economy that is significantly smaller and slower-growing than it would otherwise have been. (The consequences of the latter, of course,are high unemployment and less material well-being for individuals.)

What would be a logical way to navigate between those alternatives? Adopt a high-tax policy that does as little as possible to burden highly-productive individuals, businesses and capital, thus lessening the impact on the size and dynamism of the economy.

But we already know that the President wants to do exactly the opposite. Faced with an evil choice between much higher taxes and a smaller economy, Obama is on track to give us both.