Sebastien Buttet is an adjunct professor at LIU Post and Panos Mourdoukoutas is a professor of economics at LIU Post.
Chairman of the Federal Reserve Ben Bernanke sent critical warnings to lawmakers about fiscal deficit, interest rates and the economy in his testimony before the Senate Budget Committee Tuesday. Setting U.S. fiscal policy on a sustainable path remains a top priority. Ensuring that the debt declines relative to national income -- or at least remains stable -- is of equal importance. Bernanke again cautioned that interest rates could "soar quickly if investors lose confidence in the ability of a government to manage its fiscal policy."
By pledging to keep interest rates at ultralow levels until the latter part of 2014, however, the Fed's policy undermines the economic stimulus provided by the federal government as of late, such as the rollover in payroll-tax cuts, extension of unemployment benefits and increased spending on infrastructure.
In normal times, monetary and fiscal policies work in tandem to fight recessions: When the economy is weak, the Fed cuts interest rates and the Treasury runs deficits. After the stimulus takes effect and the economy is back on track, growth resumes, and unemployment converges to its natural rate.
This happy cocktail of monetary and fiscal policy works well when interest rates decline from high levels and when the Treasury runs a balanced budget or small deficits. The two-decade-long expansion that started in the 1980s under president Ronald Reagan and lasted until the collapse of the Internet bubble attests to the power of monetary and fiscal policy cooperation.
Today, the U.S. economy is in a very different state. Both monetary policies and fiscal ones are "maxed out." Interest rates are at rock bottom, while the national debt is almost as high as the gross domestic product. In this environment, monetary policy bumps against fiscal policy.
Keeping interest rates at ultralow levels runs against the benefits of an expansionary fiscal policy for three reasons. First, ultralow interest rates discourage lending by banks and other financial institutions, and that hurts economic growth and tax receipts. With the prime-lending rate as low as 3.25 percent, the interest rate risk of a 30-year, fixed-rate mortgage to banks is substantial. Even if banks don't keep the loans on their books, securitization profits are meager when interest rates are so low.
Second, interest rates provide a benchmark for pension fund returns. When rates stay too low for too long, they create unfunded liabilities for the pension funds that guarantee benefits or a minimum rate of return, which sometimes is as high as 8 percent. If a low-interest-rate environment persists for a long period, the underfunding of pension plans will become severe, especially with baby boomers retiring. This is becoming a real problem on Long Island.
Ultimately, a bailout of pension funds and insurance companies might be necessary. Higher taxes or more borrowing seems inevitable to address pension underfunding. The former is deflationary, while the latter might end up very costly if investors start asking for higher interest rates.
Finally, ultralow interest rates are a form of financial repression that "steals" income from savers. In turn, lower income from saving leads to lower aggregate spending and tax collections, which makes the deficit situation worse.
Time is not on the Fed's side. There's an adage on Wall Street: "Don't fight the Fed." In this case, though, the Treasury market is so large that the Fed lacks the necessary firepower to fight bond vigilantes who might demand higher interest rates.
Congress and the White House should address the fiscal deficit before a sovereign debt crisis emerges. And for its part, the Fed should reconsider whether its ultralow interest rates policy may hurt more than help the U.S. economy.
This is a corrected version of the essay. An earlier version overstated the prime-lending rate.