LONDON - New York Federal Reserve Bank President William Dudley late Thursday said fiscal policy consolidation coordinated with global rebalancing of consumption and savings is needed to sustain world recovery and it needs to be done soon.
There must be, he said, credible exits from both fiscal policy and monetary policy which can be hard to execute. Waiting -- at least for the fiscal adjustments -- can be "a risky strategy."
Speaking to the Society of Business Economists, Dudley scanned the challenges being faced by economies that must scale back fiscal stimulus while addressing deficits that are partly structural, saying the way that is done "will determine whether the path forward will be relatively smooth or instead will be more tortuous."
While addressing his recommended remedies to the world at large, Dudley's warnings seemed particularly appropriate for countries, like the United States, with huge fiscal deficits.
The difficulties in moving from a cyclical recovery to "more balanced and sustainable" growth globally, he said, demand a credible fiscal exit plan which is much preferable to holding back on adjustment planning.
"The bigger the economy grows over time, the more fiscal resources can be made available," he said. "Taking steps that do not hurt long-term productivity growth would seem preferable to steps that reduce the amount of invested capital -- both physical and human -- and/or its quality."
Now that the financial system is on "a bit of firmer ground" is the time to confront the challenges, Dudley said. Fiscal consolidation, fiscal exit strategies, a rebalancing of global consumption and investment plus regulatory reform are "interlinked" and so require a coordinated approach, he suggested.
"Without regulatory reform, we will not have the robust and resilient financial system that we need to match savers and borrowers around the world," Dudley said. "Without fiscal consolidation, financial market participants will balk at providing the funds needed to close the gap between government revenue and spending."
He continued, "Without rebalancing the composition of global demand, long-run economic growth will likely be weaker." Weaker long-run growth "will lead to excessive unemployment and less government revenue, which, in turn, will make it more difficult to put fiscal policies on a sustainable course."
"In many countries, including the United States," he said, "budget deficits have widened sharply and the level of debt is growing faster than gross domestic product. This trend is unsustainable."
The problem, Dudley said, "is not so much that the economic downturn has caused large budget deficits to open up -- this always happens which a decline in economic activity leads to a sharp drop in revenue and increased spending on the safety net -- but instead is more due to the fact that these deficits have a very large structural component."
Structural deficits are persistent and require changes in tax and spending policies "even after the individual economies have recovered and the unemployment rates in these countries have fallen as low as is possible consistent with price stability," he said.
In the United States he said the Congressional Budget Office estimates that the structural federal budget deficit "rose by nearly $1 trillion between fiscal 2007 and fiscal 2009" to 7.3% of potential GDP.
While an accommodative fiscal stance during the crisis was appropriate, and, in the U.S., was particularly so given the fact the federal funds rate "could not be pushed any lower." Yet fiscal accommodation leads to market participants becoming become worried "that many countries are now on unsustainable fiscal paths."
Investors worried about the potential for default could limit investment, leading to "sharply higher interest rates and a fiscal crisis."
Although Dudley frequently referred to the United States, he did not also specifically refer to Greece, Spain or Portugal.
"Just as there needs to be a credible exit strategy for monetary policy stimulus to anchor inflation expectations," Dudley said, "there also needs to be a credible exit strategy from fiscal policy stimulus to anchor expectations about the risks of sovereign debt default."
Exits are "not going to be easy," he said, even without considering the importance of political will to legislate unpopular higher taxes or lower spending. "There is also the important issue of timing," he said.
"The economic recovery is still very fragile," he continued. "This means that premature fiscal retrenchment could jeopardize the recovery and push a convalescent economy into a double-dip recession."
That raises the question, he said, "Why not just wait and see how things go?" In the United States, he said, "market participants appear to be quite tolerant of the current large fiscal imbalance."
Long-dated U.S. Treasury yields "have stayed low despite signs that the economy is recovering," he said.
Waiting, however, is "a risky strategy," he said, "because it fully exposes the economy to the vagaries of market sentiment and because shifts in such sentiment can have important consequences for both the deficit path and the economy."
A shift in sentiment "can be self-reinforcing," he went on. "Risk premia rise, driving up interest rates and debt service costs."
Higher rates "constrain economic activity -- making it even more difficult to sustain an economic recovery."
Then, "Once confidence begins to erode, it can do so very quickly," he said. And even if a country were willing to pay higher rates, "this path is not viewed as credible given the implications such rates have for future debt service costs and deficits." Waiting can make the ultimate adjustments worse, he said.
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