It’s a message that should be heeded in Canberra, once the high fives and back slapping finish about the first quarter growth figures.

Fed chairman Ben Bernanke has shown his true colours: fresh from steadying the global economy by throwing trillions of dollars at it and America’s dodgiest financial groups, he has now laid out the challenge for the Congress. Cut the debt and cut spending and do it quickly because the Fed won’t do it for you by monetising the debt.

Whether they do is another thing; the 530 or so members of the US House of Reps and the Senate have shown in the past 20 years that while they love spending money, and love talking about cutting spending and lowering taxes, they will do nothing to make themselves unpopular.

The Fed chairman knows that, and you can only imagine what went through his mind as he sat in front of a bunch of people whom he knows have no intention of doing what he says has to be done to rein in the US deficit ($US1.8 trillion this year) and borrowing ($US2 trillion) and debt (approaching $US12 trillion for the Government).

But he has at least told them that the Fed won’t save them by monetising that growing debt pile by allowing inflation to get away. The obvious follow up to his comment is that the Fed will remove its spending and support from the economy very quickly and drive up interest rates (if that’s also needed) to stop inflation rising and getting Congress off the hook.

The Fed chairman’s message applies to Europe, Japan and the UK which find themselves in similar predicaments to the US: crippled banks, intense recessions rising budget deficits and national debts that will rise sharply in the next five years, plus rising unemployment.

Australia is nowhere near the jam that these bigger economies find themselves in: even if unemployment worsens in the next year and the recession finally emerges from hiding, we have strong banks, low debt and low deficits. But at some stage they will have to be attacked, so the Fed chairman’s words have meaning here.

US politicians have been warned now: cut debt, cut spending or risk a surge in inflation and the economy blowing up once again.

Mr Bernanke told Congress (and the US people) overnight they have to slash debt by either cutting spending or lifting taxes: it’s a challenge because American politicians have had over a decade of trying to do it under a lazy Republican Administration that spent rather than saved.

Now both sides of Congress have been warned of the consequences of not cutting debt and controlling spending: doing nothing won’t be acceptable to financial markets which will set interest rates accordingly, which in turn could threaten economic recovery.

Mr Bernanke told Congress in testimony overnight that budget deficits threaten financial stability and the government can’t continue indefinitely to borrow at the current rate to finance the shortfall.

“Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth,” Bernanke said in his appearance on Capitol Hill in Washington. “Maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance.”

Bernanke’s comments signal that the central bank sees risks of a relapse into financial turmoil even as credit markets show signs of stability. He said the Fed won’t finance government spending over the long term, while warning that the financial industry remains under stress and the credit crunch continues to limit spending.

Mr Bernanke said large deficit-funded actions to fight the crisis were “necessary and appropriate.” But he said “near term challenges must not be allowed to hinder timely consideration of the steps needed to address fiscal imbalances.”

The Fed chief’s warning came as he reiterated his view that he expects to see growth “later this year” with “some stabilisation in final demand including consumer spending.” However, he remained cautious with numerous caveats.

“Even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly.

“In particular, businesses are likely to be cautious about hiring, and the unemployment rate is likely to rise for a time, even after economic growth resumes.”

(And that’s another warning from Mr Bernanke: he is telling politicians not to expect a sharp recovery, which would in turn lead to an improvement in tax revenues. It won’t come, especially with unemployment to remain high and the core of long term unemployed to grow).

“We cannot allow ourselves to be in a situation where the debt continues to rise. That means more and more interest payments, which swell the deficit, which leads to an unsustainable situation,” he said.

“Either cuts in spending or increases in taxes will be necessary to stabilize the fiscal situation,” Bernanke said in response to a question. “The Federal Reserve will not monetize the debt.”

“Addressing the country’s fiscal problems will require a willingness to make difficult choices. In the end, the fundamental decision that the Congress, the Administration, and the American people must confront is how large a share of the nation’s economic resources to devote to federal government programs, including entitlement programs.

“Crucially, whatever size of government is chosen, tax rates must ultimately be set at a level sufficient to achieve an appropriate balance of spending and revenues in the long run. In particular, over the longer term, achieving fiscal sustainability–defined, for example, as a situation in which the ratios of government debt and interest payments to GDP are stable or declining, and tax rates are not so high as to impede economic growth–requires that spending and budget deficits be well controlled.”

At the same time he was more cautious on the ‘greenness’ of those shoots he first saw back in March, than he has been in the past.

The tenor of his comments in testimony before a US House of Representatives Committee was that the US economy isn’t as wounded as it was at the start of the year, but it’s not back to the good old days as the markets seem to be saying this week.

The Fed chief said in his remarks to the House Budget Committee that deficit concerns are already influencing the prices of long-term interest rates on US Treasury bonds. They peaked at 3.75% last week and finished overnight at 3.54%: that’s up 1% from when the Fed revealed that it would purchase government and mortgage debt on March 18.

Markets of course took their cue (and were reminded by another large unemployment forecast) and fell, with oil leading commodities lower as the US dollar turned and sent other currencies down: the Australian dollar lost 2.5 US cents in the space of a few hours overnight to end well under 79 US cents after climbing above 82.50 US cents in the wake of the surprising GDP figures for the March quarter.

Peter Fray

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Peter Fray
Editor-in-chief of Crikey