Deficit fears boxing in Bernanke and undermining recovery, economist says

Exclusive reporting for FinReg21 by Darrell Delamaide 

The government’s budget and long-term deficit projections are undermining the economic stimulus program and Federal Reserve chairman Ben Bernanke’s efforts to lower long-term interest rates, says economist Desmond Lachman at the American Enterprise Institute.

“Bernanke is in a box,” Lachman says, referring to the Fed chairman’s warning in congressional testimony this week about curbing fiscal deficits. Bernanke said that the deficits are not sustainable and that the Fed would not monetize them. 

But fears that the Fed is monetizing the debt with its current program to buy Treasuries with central bank money have already driven up yields on 10-year Treasuries to 3.8 percent, compared with less than 3 percent just months ago, Lachman notes. Unemployment figures released Friday briefly drove the 10-year rate to 3.89 percent.

“Bernanke knows this cannot be good for stabilizing the housing market,” Lachman says. “And yet that should be the government’s overriding priority now.” 

Mortgage rates have followed Treasury rates up, threatening to stifle any recovery in the housing market, Lachman says. But stabilizing the housing market is essential to any durable economic recovery. “It goes in exactly the opposite direction,” Lachman says. 

A short-term deficit to stimulate the economy was a good idea – though Lachman thinks the stimulus program actually passed is not very good at that, either. But putting out a budget with projected deficits above 80 percent of gross domestic product was “irresponsible” and “ridiculous,” Lachman says. 

“I truly can’t understand how Larry Summers can sign off on this,” Lachman says, referring to President Barack Obama’s chief economic adviser. Summers, a former Harvard professor considered one of the brightest economists of his generation, is director of the National Economic Council in the White House. 

The decision last month by Standard & Poor’s to put UK government debt on credit watch for possible downgrade from triple-A led to a sharp increase in Treasury yields because the Congressional Budget Office deficit projections forecast levels for the U.S. near the 100 percent of GDP that has the credit rating agency worried about the UK. 

“It’s not so much what S&P thinks, but what the market does right now,” Lachman says, “and they are putting two and two together.” 

Lachman thinks the administration should not have advanced its ambitious spending plans for policies like health care reform without having a way to pay for it. “If they can’t come up with a plan now to finance it, what makes you think they will be able to devise a plan a year from now?” he asks. 

But this think-tank economist does not believe the government will be able to retract its budget plans at this point. As a consequence, Bernanke will remain boxed in, unable to influence long-term interest rates by buying Treasuries or mortgage-backed securities because fears about long-term deficits will continue to drive up yields. 

And that could snuff out any incipient recovery or keep it so anemic that unemployment will rise above 10 percent and stay there for some time, Lachman fears. Also, it could create further pressure on the dollar that will bring higher oil prices and short-circuit a U.S.-led global economic recovery. 

The $100 billion the Fed has pledged to buy long-term securities will be swamped by investors fleeing Treasury debt, Lachman believes. Long-term rates will continue to rise, he fears, “And the Fed can’t do anything about it.”