Cato Calls for Leadership from Fiscal Authorities

Cato's Jagadeesh Gokhale speaks on the federal budget deficit in The Financial Times and he is not happy with the leadership he sees from the administration and congress on this issue.  The worry is that the fiscal deficit will eventually lead to debt monetization* by the Fed:

Only leadership can defuse US fiscal time-bomb, by Jagadeesh Gokhale, commentary, FT: Alan Greenspan recently warned that monetary policy “cannot ignore the potential inflationary risks inherent in our current fiscal outlook . . .” He also said: “I assume that [fiscal] imbalances will be resolved before stark choices again confront us and, if they are not, the Fed will resist any temptation to monetise fiscal deficits.” ... Unfortunately, the “stark choices” fiscal policymakers would face if they fail to resolve the growing fiscal imbalance will eventually confront the Fed. Why? Because continued high deficits and growing debt will drain the economy of investible resources. It will also reduce foreign lenders’ confidence in US ability to resist the temptation to inflate away the real value of growing federal debt – much of which is held abroad. That may lead them to divert their savings from US shores, further draining domestic investment.

If that happens, ... domestic unemployment will increase and political pressure on the Fed to stimulate economic activity will grow. Direct monetary stimulus entails purchasing more Treasury debt for cash to keep interest rates lower than would be consistent with an “inflation neutral” level – precisely the action Mr Greenspan abjures. So the question remains: how long can his successor continue serving the price-stability goal and ignore calls for direct action? ...

Managing the public’s inflation expectations has been Mr Greenspan’s quintessential skill. ... However, and here is the really hard question, does performing such a superb job of managing inflation expectations while maintaining price stability exacerbate the problem by allowing the nation’s fiscal imbalance to grow? ... By allowing fiscal policymakers to prolong their “no tax-hikes” versus “no-spending-cuts” ... Greater confidence in the ability of monetary policy to mop up problems created by fiscal profligacy may be enabling the very irresponsible fiscal policies ... Ultimately, defusing the fiscal time-bomb will require sustained leadership directly in federal fiscal management.

We've seen this game between the fiscal and monetary authorities before.  I’m sure I disagree with Cato as to how to solve the deficit problem, but that aside I too worry about the pressures to monetize the debt in coming years.  That’s why I think it is appropriate and necessary for the Fed chair to discuss the implications of budget deficits and this is another place where, in my opinion, more leadership is needed.

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*Debt monetization occurs when the Fed prints money and uses it to purchase government debt from the private sector.  It's equivalent to printing money to finance government expenditures.

Comments

[pgl]

But see my Angrybear comments (as well as Kevin Drum and Atrios) on what Tom DeLay said - which was the FEDs have cut all the fat out of government spending. Something tells me fiscal conservatives are shaking their heads in disbelief.

[anne]

Conservatives have just what they wished for and are pleased as punch, though they wish mightly they might undo Social Security and Medicare. There is a push to further undo Medicaid. Defense will not be cut, there will be aid for the Gulf Coast, taxes will not be raised. So conservatives will nibble away at social benefit progams and complain all the while but make sure they do all they can to keep control of Congress and the White House.

[anne]

Cato wishes only to set aside the New Deal legacy. When Cato complains the idea is to cut Social Security and Medicare benefits. Notice how impressed I am by such a hypocritical article. Of course, Cato could ask for a tax increase :) Imagine, the Democrats could fight a tax increase while the Republicans force an increase through Congress and the President signs :)

[jm]

But by providing a flood of liquidity to prevent the deflation which would otherwise have been a natural outcome of China's export drive, and preventing the collapse of US worker wages and decline of consumption that would have been the inevitable result of such deflation, the Fed has handed the Asians a huge quantity of dollars to invest in US government bonds. So in fact it has monetised the deficit, though indirectly.

[ken melvin]

Alas dear CATO, as you sow so shall you reap. Long long CATO has preached these inane, little more than Rand warmed up, policies that have brought us thus close to the brink.

[Shawn]

I don't see why anyone's worried. I mean, Tom DeLay has declared victory against government "fat." And he ALWAYS tells the truth.