Fed Chairman Calls Deficit Reduction "Very Important"

Washington, D.C. - Federal Reserve Chairman Ben Bernanke told Congressman Brad Sherman that a wave of baby boom retirements increases the importance of shrinking the federal budget deficit. The new Fed chairman also asserted, contrary to claims by the Bush administration and so-called supply-side economists, that "tax cuts do not wholly pay for themselves."

"I am heartened." Sherman said, "by the chairman's honesty about soaring budget deficits and the reality check he provides on Bush administration fantasies about the budgetary impact of tax cuts for the wealthy."

"The Fed chairman is above politics and he can speak his mind," Sherman added. "He can tell us what we should already realize, and that is that we have to cut spending if we can, and cannot continue to cut taxes on those at the very top if we are going to get rid of this federal budget deficit."

Bernanke's statements came in a letter to Sherman, a member of the House Financial Services Committee. The letter elaborated on issues raised during testimony to the committee last February 15 during the new chairman's first appearance before Congress.

Sherman asked Bernanke, "Can we count on your leadership, as the new chairman of the Federal Reserve, to have as one of your top priorities the reduction of the nation's budget deficit?" Bernanke replied:" ...­[R]educing the federal deficit is very important, especially in light of the need to prepare for the retirement of the baby-boom generation. I urge the Congress to proceed on that effort in a timely manner and to pay particular attention to how its decisions on spending and tax programs will affect the U.S. economy in the long run." He deferred to Congress regarding specific tax and spending programs.

Sherman also questioned Bernanke about tax policy. "I interpret your position to be that tax cuts do not pay for themselves, and that they do indeed reduce revenues," the congressman said. Bernanke said, "[U]nder normal conditions, tax cuts do not wholly pay for themselves."

Here is the text of the chairman's letter to Sherman:

BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON D.C. 20551

Ben S. Bernanke
CHAIRMAN

April 18, 2006

The Honorable Brad Sherman
House of Representatives
Washington, D.C. 20515

Dear Congressman:

I am pleased to enclose my responses to the additional questions you submitted in connection with the February 15, 2006, hearing before the Committee on Financial Services, I am also enclosing for your reference a copy of my March 21 letter to you with responses to the questions you asked during that hearing.

Please let me know if I can be of further assistance.

Sincerely,

Enclosures

Chairman Bernanke subsequently submitted the following in response to written questions received from Congressman Brad Sherman in connection with the February 15, 2006, hearing before the Committee on Financial Services:

1) The Deficit

Can we count on your leadership, as the new Chairman of the Federal Reserve, to have as one of your top priorities the reduction of the nation's budget deficits?
Further, in the pursuit of this policy, are you willing to seek restraints on unwise tax cuts, as well as restraints on federal spending?

As I stated in my hearing on the Monetary Policy report, I believe that reducing the federal deficit is very important, especially in the light of the need to prepare for the retirement of the baby-boom generation. I urge the Congress to proceed on that effort in a timely manner and to pay particular attention to how its decisions on spending and tax programs will affect the U.S. economy over the long run. However, I also believe that in my role as Chairman of the Federal Reserve, I should not be involved in making recommendations to the Congress regarding specific tax and spending programs. Those decisions are best made by elected officials.

From both your written and oral testimony before the Committee, I interpret your position to be that tax cuts do not pay for themselves, and that they do indeed reduce revenues. Is that indeed your position?

Tax cuts that reduce marginal tax rates will likely improve the efficiency of the economy and boost overall economic activity. Because they increase economic activity, cuts in marginal tax rates typically lead to revenue losses that are smaller than implied by so-called static analyses, which hold economic activity constant. However, under normal conditions, tax cuts do not wholly pay for themselves.

Tax cuts tend to boost both aggregate demand and aggregate supply. Aggregate demand may be stimulated by a tax cut, for example, if consumers spend a portion of the increase in their after-tax income. The demand side effects initially boost economic activity and revenues. But these effects dissipate over time as the economy's self-correcting forces and monetary policy work to bring the economy back to its sustainable potential.

Cuts in marginal tax rates may have important supply-side effects by altering the incentives to work, save, and invest. In contrast to the aggregate demand effects, the supply-side effects will tend to build over time as capital accumulates and the added labor supply is absorbed. The economic literature supports the idea that work effort, saving, and investment respond to tax incentives but the sizes of the responses are in some dispute.

One principle that economists generally agree upon is that the higher the initial level of the tax, the greater the economic benefit of a marginal tax rate reduction. Together, the demand-side and the supply-side impacts of a tax cut on activity imply that some portion of the initial drop in revenues following a tax cut will be offset, though the degree of offset depends critically on the nature of the tax cut and the behavioral responses that it induces.

2) Currency Values--Emergency planning

In light of the fact that the United States consistently runs an enormous trade deficit, one would expect the inevitability of an eventual realignment in the value of the dollar in relation to other currencies. The reevaluation will have major impacts on our economy and, if this realignment does not occur smoothly and gradually, it is likely to have disastrous consequences both at home and abroad. While recognizing the Treasury's primary role in currency valuation, could you please address the following questions:

• What mechanisms can be established by the United States, and our trading partners, to react in a timely manner to address a sudden and precipitous decline in the value of the dollar?
  
• Would you envision such a response plan to mirror the "circuit breakers" that various securities and commodities markets currently employ when there is a sharp decline in the value of a particular security or commodity?
  
• What effect would a dramatic drop in the value of the dollar likely have on interest rates and the rate of inflation, both short- and long-term?
  
• Is the Federal Reserve prepared to react quickly and take those steps necessary to protect the U.S. economy -to the extent possible and practicable--in the event of a precipitous decline in the value of the dollar?
  
• Are we currently working with our trading partners to assure that there is indeed a smooth currency realignment and not a crash of the dollar?
  
• Has the Federal Reserve taken any steps to analyze what can be done in the event of a collapse of the dollar?
  
• Finally, those concerned with the U.S. trade deficit urge that the U.S. balance the Federal budget, encourage private saving, and seek to eliminate barriers to export. What other steps do you believe the United States can do to reduce our trade deficit?

As I noted previously, current U.S. policy is to let markets determine the exchange value of the dollar. This is consistent with the general view that the economy performs best when markets are allowed to freely set prices of goods, services, and assets. It is very difficult to gauge the appropriate level of the foreign exchange value of the dollar and, accordingly, it is difficult to determine whether movements in the dollar are inconsistent with market fundamentals and/or pose concerns for the smooth operation of our nation's economy.

For these reasons, stated U.S. policy has been generally not to intervene in currency markets except to counter disorderly market conditions. On occasions in the past, the United States has coordinated intervention with foreign governments, and such operations could be undertaken in the future if circumstances merited such actions. Officials in the Treasury Department and the Federal Reserve maintain close and frequent contact with their counterparts abroad.

Additionally, issues of global imbalances, external adjustment, and currency movements often have been discussed at international meetings of policymakers. Several measures have been identified which could contribute to the smooth adjustment of external imbalances, including increases in household and public saving rates in the United States, growth-enhancing structural reform in some of our industrial-country trading partners, greater reliance by emerging-market economies on domestic spending rather than exports as a source of growth, and increased flexibility of exchange rates in countries where such flexibility is lacking. Dismantling barriers to trade, and, more generally, keeping protectionism in check, would also be valuable. Such measures would be helpful, especially if the shift the relative attractiveness of U.S. and foreign assets in the eyes of global investors.

Although U.S. trade deficits cannot continue to widen forever, these deficits need not engender a precipitous decline in the dollar, nor should such a decline, were it to occur, necessarily disrupt financial markets, production, or employment. The dollar fell sharply in the mid-1980s without triggering substantial economic dislocations. More generally, research by Federal Reserve staff has indicated that, historically, significant declines in currency values have not led to material increases in interest rates and inflation, nor to sharp declines in economic activity, in industrial economies.

However, the possibility of a future disruptive correction of the U.S. trade deficit cannot be ruled out. The best way to protect the U.S. economy from such an event is to continue policies designed to maintain the stability of the financial system and the flexibility and resilience of the economy. Regardless of the future evolution of the trade balance, the Federal Reserve will work to ensure that prices remain stable and employment remains close to its maximum sustainable level. In the past, the Federal Reserve has reacted quickly to events that threatened those objectives, and it is prepared to [do] so in the future as well.