Kansas City Federal Reserve President Thomas M. Hoenig has been a voice in the wilderness for some time. Mr. Hoenig was the only dissenter of the policy action at the January meeting of the Federal Open Market Committee because he believes that economic and financial conditions no longer warrant the Federal Reserve’s commitment to keep the federal funds rate at “exceptionally low” levels for an extended period of time. Last year, Mr. Hoenig gave a speech outlining alternatives to the “too big to fail” doctrine that has become conventional wisdom in Washington.
In a speech in Washington yesterday, Mr. Hoenig argues that there are only three options for dealing with the unsustainable fiscal situation: Have the Federal Reserve print money to monetize the national debt; do nothing as long as markets are willing to fund borrowing at inevitably higher interest rates; or act now to implement programs that restore balance to fiscal policy. A few excerpts from the speech are provided below.
Fiscal Irresponsibility Threatens Fed Independence
The question of what combination of spending and revenue actions the country might choose is the purview of Congress and the executive branch. As a central banker, it is my responsibility to anticipate and avoid the consequences that an unchecked expansion of the debt may have on monetary policy. It is a fact that the current outlook for fiscal policy poses a threat to the Federal Reserve’s ability to achieve its dual objectives of price stability and maximum sustainable long-term growth, and therefore is a threat to its independence as well.
The founders of the Federal Reserve understood this conflict. They understood that placing the printing press with the power to spend was a formula for fiscal and financial disaster. Aware of this danger, they designed our central bank to be responsible for stable prices and long term growth, and they gave it a degree of independence so that it could carry out this mandate.
Unprecedented Mountain of Debt
The immediate concern is the size of the deficit. The CBO projects the deficit was almost 12 percent of GDP in fiscal year 2009 and will be almost 8 percent in the current fiscal year—extraordinarily high levels by historical standards. In the entire history of the United 6 States, the government has run deficits over 10 percent of GDP in only a few instances, and usually only during or immediately following a major war.
As troubling as these deficits appear, even more disconcerting is the longer-term outlook for the federal debt caused by the accumulation of these deficits over time. The CBO’s long term debt projections clearly show that current fiscal policies are unsustainable. In one scenario, the liftoff point for federal debt—that is, the time when debt starts rising without any sign of stabilizing—occurs shortly after 2020. By 2035, federal debt held by the public reaches 80 percent of GDP—a level only exceeded during and just after World War II. In another, more pessimistic scenario, the liftoff in debt has already begun, with federal debt held by the public reaching 181 percent of GDP in 2035, easily exceeding the peak debt to GDP ratio of 113 percent that occurred at the end of World War II.
Importance of Maintaining Fed Independence
In the United States, the Federal Reserve’s policies in the early 1980s provide a vivid example of the benefits that arise from the exercise of central bank independence. During this time, high interest rate policies designed to lower inflation were deeply unpopular both among elected leaders and the broad public. But the Federal Reserve was able to exercise its independence and pursue long-term goals which systematically reduced inflation and changed the psychology of the nation regarding its expectation about inflation’s path. As a result, the United States has had nearly three decades of low inflation.
Will Corrective Action Occur Before or After a Profound Crisis?
Unfortunately, nations often must experience a profound crisis to focus the government’s attention on taking corrective action. Usually it is at this point that governments reestablish fiscal discipline and renew their commitment to an independent central bank. Ironically, however, these generally are precisely the reforms that would have prevented a crisis in the first place. The only difference between countries that experience a fiscal crisis and those that don’t is the foresight to take corrective action before circumstance and markets harshly impose it upon them. In time, significant and permanent fiscal reforms must occur in the United States. I much prefer this be done well before anyone feels an irresistible impulse to knock on this central bank’s door.