Supply-Side Forum Archives

Response to Federal Reserve Chairman Ben Bernanke

Ed Rombach, October 12, 2006

Federal Reserve Chairman Ben Bernanke recently delivered an address to the Economic Club of Washington entitled “The Coming Demographic Transition: Will We Treat Future Generations Fairly?

Bernanke has been winning applause lately from financial market participants who are increasingly persuaded that the Fed may succeed in engineering a soft economic landing and revive the “Goldilocks Economy”. Bernanke’s address, side stepped monetary policy issues, although during the Q&A session he characterized the ongoing correction in the housing market as "substantial" with potential to trim GDP by as much as 1% in the second half of this year. Thus he introduced a new metric for gauging spillover from the slowing housing sector onto the rest of the economy.

Aside from that, in a nutshell the challenge of the coming demographic transition is all about how to pay for Social Security, Medicare and other government entitlement obligations for aging and retiring baby boomers in the years ahead, and in this regard Bernanke missed an important opportunity.

He stated that, “Although some adverse effect of population aging on future per capita output and consumption is probably inevitable, actions that we take today, in both the public and the private spheres, have the potential to mitigate those effects. One such action would be to find ways to increase our national saving rate. If the extra savings were used to increase the nation’s capital stock--the quantity of plant and equipment available for use by workers--then future workers would be more productive, ameliorating the anticipated effects on per capita output and consumption. Alternatively, using extra saving to acquire financial assets abroad (or to reduce foreign obligations) would also increase the resources available in the future.”

That would have been a golden opportunity to introduce reductions in the capital gains tax as a policy tool to meet the challenge of a demographically aging population. The problem is that in the macro picture it currently takes about three employed workers to provide the resources to pay for current entitlement benefits for retired workers, and that in 15 years there will only be about two workers available to pay for entitlement benefits for retired baby boomers. The solution is to structure policy so that 15 years from now two workers will be as productive as three workers are today. The way to make workers more productive is to apply more capital to their efforts, and the way to make capital more abundant is to increase the after tax return on capital by reducing or eliminating the capital gains tax. Bernanke did make the observation that, “If current trends continue, the typical U.S. worker will be considerably more productive several decades from now.”

Bernanke even sounded like a quintessential supply-sider in his address when he said, “A large increase in tax rates would surely have adverse effects on a wide range of economic incentives, including the incentives to work and save, which would hamper economic performance.”

However he sounded like a fiscal drag queen from the green eyeshade wing of the Republican Party when he argued that “Perhaps the most straightforward way to raise national saving--although not a politically easy one--is to reduce the government’s current and projected budget deficits.”

He goes on to say that the negative impact of the aging population on future generations can only be offset by foregoing consumption or leisure today, i.e. by increasing the national savings rate. Bernanke pointed out that private savings consists of both the domestic corporate and household sector, (he didn’t mention foreign savers), and while corporate saving, in the form of retained earnings, is currently at relatively high levels, household saving rates are exceptionally low.

However his argument becomes something of a contradiction (conundrum?), because he states that a reduction in government borrowing would facilitate more private saving that could be used for capital formation to enhance U.S. output and income in order to pay for the burdens associated with a population that is demographically aging. On the contrary, a mounting pile of evidence suggests just the opposite; that a reduction in government borrowing is associated with an increase in private sector borrowing, which translates into a decrease in net private sector savings.

In connection with this, the chart below features the federal budget deficit / surplus as a percentage of gross domestic product, (GDP) in contrast with private savings as percentage of personal disposable income. The chart clearly illustrates that from 1997 to 2001 during the years when the government was running a budget surplus, (i.e. government savings), individuals for some reason found it increasingly difficult to save. In other words, the chart suggests an inverse relationship between the personal savings rate and the government savings rate. However, the chart also shows that the decline in the personal savings rate stabilized for a while with the return of government budget deficits before proceeding to decline again and slipping into negative territory as the budget deficit began to shrink again over the past two years as a consequence of tax collections outpacing the rate of government spending. Whatever one may think about what the chart shows, it definitely does not show that reduced government borrowing facilitates more private saving.

Ben Bernanke needs to go back to the drawing board and re-think the appropriate mix of fiscal policies that will provide individuals with the incentives to work, save and invest because the track record of smaller federal budget deficits, and/or outright budget surpluses, is not a good one.

While at the drawing board, it might be time profitably spent for Bernanke to contemplate the following exchange between Congressman Paul Ryan (R - WI) and the former Fed Chairman during the question and answer session of his semi-annual Congressional testimony in February of 2004:

RYAN: "Do you believe that personal retirement accounts can help us achieve solvency for the system and make those future retiree benefits more secure?"

GREENSPAN: "Well, I wouldn't say that the pay-as-you-go benefits are insecure, in the sense that there's nothing to prevent the federal government from creating as much money as it wants and paying it to somebody. The question is, how do you set up a system which assures that the real assets are created which those benefits are employed to purchase."