Bernanke Gives Federal Deficit Lip Service; Is a Day of Reckoning Coming?

June 3, 2009 2:52 PM EDT

In his speech to Congress today, Federal Reserve Chairman Ben Bernanke warned about the U.S.'s massive current and forecasted federal deficit, which is growing to an alarming percentage of GDP. Bernanke warned that unless the government demonstrates a strong commitment to fiscal sustainability in the longer term, "we will have neither financial stability nor healthy economic growth."

Bernanke confirmed what the market already knows - that the recent uptick in Treasury securities and fixed-rate mortgages is in part related to fears about large federal deficits.

The deficit rhetoric from Bernanke and others in the government follows a "shot across the bow" from the rating agencies, which recently moved the U.K.'s sovereign rating outlook to Negative, citing a debt burden that could approach 100% of GDP. Many, including the bond-king Bill Gross, view the U.S. and the U.K. as "relative twins." While the U.S.'s forecasted federal deficit is still at a low % of GDP, versus the U.K., it is expected to swell and get closer and closer to the 100% mark, which will nearly guarantee a downgrade. While the rating agencies have little credibility at this point, due to the credit meltdown, a AAA sovereign rating still carries some weight and a downgrade would have horrible consequences.

Right now, rightly or wrongly, the U.S. government is basically just giving "lip-service" to the deficit problem. This is simply because they need to address the issue to appease foreign and other investors that are supporting our deficit by buying bond. Should this change, and investors start shying away from our auctions, the U.S. will be forced to handle the massive problem.

The government has a few ways to fix the deficit situation. None of them being really good:

1. Fix number one is based on the denial approach. The government can hope that because economic activity increases, tax revenues will rise and the projected deficits will turn out to be too high.

2. Raising taxes would be the second option. There has been talk recently of a national sales taxes. This would fix the deficit problem, but would create an uproar and kill consumer spending.

3. Devaluing the currency. In banana republics, to get out of debt problems, they simply print more money. You owe someone 1 Trillion yanks (a made up currency), just print it up and pay them. Well this creates a little problem, known as hyperinflation. In a situation like this chaos takes over. Bread is 2 yanks one day and 200 yanks the next. Complete chaos. The U.S. is no banana republic - right!. You can't just print money out of thin air and pay someone, right?

The U.S. situation is a little more complicated, because we are considered the world currency, we need to do it more strategically. But to some extent it is already happening here. The Federal Reserve's balance sheet has swelled and the Federal Reserve is buying government bonds from Treasury, effectively monetizing the national debt. What one hand needs, the other "with the printing press" can deliver. In addition, it is only because of the Fed that many debt markets are functional at all.

While the fed activity has yet to cause inflation, many believe sooner or later it will come. Because of this, Gold (NYSE: GLD) and other commodities, like Oil (NYSE: OIH), have been rising. Remember, it is NOT HARD TO CREATE INFLATION. The fed can come out tomorrow and say "we are executing a 2-for-1 split of the dollar." For every $1 in your bank account you now have $2! You make $50K a year, now you make $100K! Your $200K house has just doubled to $400K, but your mortgage stayed the same at $200K! This sounds great, right? Well one problem is that everything now costs double. That $1 hamburger now costs $2, so you gain nothing but more paper. It works out great for those that owe money; to have your house double overnight but your mortgage stay the same! But in a situation like this, who would loan money to anyone in the future? As a lender, if you knew the $200K you just lent out is now worth half, how could you make any money unless you charged much higher interest. Now magnify this by 1000 for the treasury market. What foreign investor would put in another dime if they just saw the currency cut in half? Economic activity would come to a stand still.

Pretty soon the government will be forced to address the deficit situation, not with 'lip service' but with action. I fear that day.

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• William H. Gross
• Ben S. Bernanke
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