Here’s what we’re up against. The only thing between today’s economic catastrophe and unimaginable prosperity is the space between their ears, as we continue to lose the battle vs the demand leakages.

Fiscal Policy and Monetary Policy: Restoring the Boundaries

By Charles I. Plosser, President and Chief Executive Officer, Federal Reserve Bank of Philadelphia

Fiscal Imbalances

August 5 (Philadelphia Fed)&#8212 During the past several years, we have witnessed the ongoing saga of governments, both in Europe and in the U.S., struggling with large deficits and soaring public debt. For the most part, these challenges are self-inflicted. They are the result of governments choosing fiscal policies that they knew would be unsustainable in the long run. Financial market participants remain skeptical about whether the political process can come to grips with the problems.

So far, this skepticism appears to be wholly justified. Neither the European nor the American political process has developed credible and sustainable plans to finance public spending. Instead, politicians continue to engage in protracted debates over who will bear the burden of the substantial adjustments needed to put fiscal policies back on a sustainable path. In my view, these prolonged debates impede economic growth, in part, due to the uncertainty they impose on consumers and businesses. Moreover, the longer the delay in developing credible plans, the more costly it becomes for the respective economies.

Given the magnitude of the fiscal shortfalls, the way in which the political process restores fiscal discipline will have profound implications for years to come. Will there be higher taxes on investments by the private sector that risk reducing productive capacity and output in the future? Will there be higher taxes on labor that discourage work effort or hiring? Will there be cutbacks in government expenditures on defense or basic research that might force significant resource reallocations and affect a wide array of industry sectors? Will there be cutbacks on entitlements that could affect health care, social insurance, and other aspects of our safety net? Or will a viable fiscal plan combine various types of tax increases and spending cuts?

These are important questions that involve hard choices and trade-offs between efficiency and equity. Yet, until fiscal authorities choose a path, uncertainty encourages firms to defer hiring and investment decisions and complicates the financial planning of individuals and businesses. The longer it takes to reach a resolution on a credible, sustainable plan to reduce future deficits and limit the ratio of public debt to gross domestic product, or GDP, the more damage is done to the economy in the near term.

Some observers say cyclical factors and the magnitude of the recent global recession caused the current fiscal crisis. It is certainly true that the policy choices made by governments to deal with the financial crisis and ensuing recession have caused a significant deterioration in fiscal balances and debt levels in many countries. However, the underlying trends that are at the root of unsustainable fiscal deficits in many countries, including the U.S., have been in place and known for some time. In the U.S., for example, the major long-run drivers of the structural deficit at the federal level are entitlements such as health care and Social Security.[2]

Thus, even after cyclical effects play out, many countries will continue to have large structural budget deficits. In this sense, the financial crisis and recession have simply exacerbated the underlying problems and perhaps moved up the day of reckoning. In some cases, such as Greece, that day has come. In light of these realities, market participants have begun to question the solvency of governments and their ability to honor their sovereign debt obligations in the absence of deep structural reforms. In Europe, the doubts have greatly complicated the political problems as various countries debate the question of “who pays” for the anticipated bad debts of individual countries. Here, too, the protracted nature of the political debate creates uncertainty, which undermines economic growth and exacerbates the crisis.