US budget deficit is not sustainable, Bernanke warns

Ben Bernanke took his "something must be done" message about the US deficit to Capitol Hill once again yesterday, telling lawmakers that they risked riling financial markets if they fail to tackle the exploding costs of government health and social security programmes.

The Federal Reserve chairman took a soothing tone about the short-term prospects for the US economy, saying that problems in the eurozone will have only a "modest" effect on the recovery, but said that the country's longer-term financial trajectory was "unsustainable".

In testimony to the House of Representatives' budget committee, he took a swipe at deficit hawks who want swingeing cuts to government spending immediately, saying the economy was too fragile to withstand the withdrawal of the economic stimulus.

But he urged Congress to reassure markets that it could be serious about tackling the deficit in the longer term. While the deficit is projected to fall from a peak of 10.6 per cent of GDP next year, it bottoms out late in the current decade at more than 3 per cent, the figure commonly regarded as sustainable by economists, he said.

"A variety of projections that extrapolate current policies and make plausible assumptions about the future evolution of the economy," Mr Bernanke said, "show a structural budget gap that is both large relative to the size of the economy and increasing over time."

While the US government is currently funding its $12 trillion debt at historically low interest rates, since its bonds are seen as a safe haven from turmoil in sovereign debt markets elsewhere, financial markets could turn against the country, with serious consequences, he said.

"Right now is not the time to radically reduce our spending, or raise our taxes, because the economy is still in recovery mode and needs that support. However, the risk, of course, of ongoing deficits is the potential loss of confidence in markets and the way to reassure the markets is by creating a plausible plan for a medium-term stability in the fiscal situation. Obviously you can't run deficits of 10 per cent of GDP forever."

The Fed chairman – made more politically astute by the furore surrounding his appointment to a second term in the post earlier this year – steered clear of offering any views on which government spending programmes ought to be cut. But he pointed out that social security spending and government health insurance schemes contributed the most to the projected deficits.

Equity markets rallied on Mr Bernanke's testimony, after he said the US recovery had made "an important transition from being supported primarily by inventory dynamics and by fiscal policy toward recovery being led now more by private final demand, including consumer spending". He said that any slowdown in Europe as a result of austerity measures would not significantly upset the US recovery.