Italian Lessons for Bernanke
In his testimony before Congress on Thursday, Federal Reserve (FED) Chairman Ben Bernanke issued a stern warning to Congress and the US Government. What worries him the most is the fiscal trajectory of the country. He called the dynamic “clearly unsustainable.” He reminded politicians that monetary policies alone cannot offset political gridlock.
Bernanke’s fiscal nightmares can be summarized by the following assessment, “the current trajectory of federal debt threatens to crowd out private capital formation and thus reduce productivity growth.” In his words, in the coming years, a “growing share of income would be devoted to interest payments on (…) federal debt.” Sounds familiar? That is exactly what happened to a number of euro zone countries, such as Italy. In the wake of the financial crisis of 2008, Rome could not offset the collapse in economic activity by using aggressive Keynesian fiscal tools, because the government’s maneuvering room had been depleted by its overall debt burden. Relying on stimulus packages implemented in other countries proved insufficient to boost the Italian economy. Furthermore, Italy’s economy had been plagued by falling productivity for a decade, thanks in part to the high public debt burden. Is Rome’s experience suddenly becoming the blueprint for the U.S.? Bernanke’s reasoning suggests that it could.
In fact, Bernanke warned politicians against kicking the can down the road for too much longer, since “(..) the prospect of unsustainable deficits has costs, including an increased risk of a sudden fiscal crisis. As we have seen in a number of countries recently [i.e. Europe], interest rates can soar quickly if investors lose confidence in the ability of the government to manage its fiscal policy.” Even more worryingly, Bernanke admits that “historical experience and economic theory do not indicate the exact threshold at which the perceived risk (…) would increase markedly.” In other words, a sudden loss in investors’ confidence could happen anytime. While Greece was already in the tight grip of its sovereign debt crisis, Italy went from a safe bond market to a country with a liquidity problem, and finally, to a candidate for insolvency − it all happened in the space of six months. During this period of time, Italy’s fundamentals had not changed.
But why is Chairman Bernanke choosing this particular moment to remind Congress and the White House of its duties? After all, the analysis is not new, and fears that a downgrade of the country by one or more rating agencies would put U.S. treasuries under pressure have been proven wrong. Furthermore, aren’t commentators relentlessly reminding us that the U.S. is different from Europe because of its federal structure and the presence of a lender of last resort, the FED? Bernanke does not seem to be so sure that the institutional differences outweigh the potential disruptions that a fiscal crisis can cause. His is a note of caution to all those on both sides of the political spectrum in Washington who too readily paint Europe as a lost cause and argue that its situation is not replicable in the U.S.
In fact, if it is true that Europeans are finally getting a tighter grip on their more urgent problems and the pressure on most of their sovereign bonds is somewhat abating, the moment of reckoning for the U.S. could come much faster than is commonly assumed.
Europe was and still is a convenient diversion. But it has only bought time. Unfortunately, the gridlock in Washington has made it impossible to use this precious window of opportunity to start to fundamentally correct the country’ s fiscal trajectory. FED Chairman Bernanke is trying to remind everybody that time could very well be running out. No wonder his outlook on the U.S. economy is still so gloomy.