Since late last year, market concerns have mounted over the ability of
Greece and a number of other euro-area countries to manage their sizable budget
deficits and high levels of public debt. By early May, financial strains had
increased significantly as investors focused on several interrelated issues,
including whether the fiscally stronger euro-area governments would provide
financial support to the weakest members, the extent to which euro-area growth
would be slowed by efforts at fiscal consolidation, and the extent of exposure
of major European financial institutions to vulnerable countries.
U.S. financial markets have been roiled in recent weeks by these
developments, which have triggered a reduction in demand for risky assets:
Broad equity market indexes have declined, and implied volatility has risen
considerably. Treasury yields have fallen as much as 50 basis points since late
April, primarily as a result of safe-haven flows that boosted the demand for
Treasury securities. Corporate spreads have widened over the same period, and
some issuance of corporate bonds has been postponed, especially by
In response to these concerns, European leaders have put in place a number
of strong measures. Countries under stress have committed to address their
fiscal problems. A major assistance package has been established jointly by the
European Union (EU) and the International Monetary Fund (IMF) for Greece. To
backstop near-term financing needs of its members more generally, the EU has
established a European Financial Stabilization Mechanism with up to 500 billion
euros in funding, which could be used in tandem with significant bilateral
support from the IMF. EU leaders are also discussing proposals to tighten
surveillance of members' fiscal performance and improve the design of the EU's
fiscal support mechanisms.
In addition, to address strains in European financial markets, the European
Central Bank (ECB) has begun purchasing debt securities in markets that it sees
as malfunctioning, and has resumed auctions of three- and six-month loans of
euros in unlimited quantities to borrowers with appropriate collateral. To help
ease strains in U.S. dollar funding markets, the Federal Reserve has
reestablished temporary U.S. dollar liquidity swap lines with the ECB and other
major central banks. To date, drawings under these swap lines remain quite
limited and far below their peaks reached at the height of the financial crisis
in late 2008, but they are nevertheless providing an important backstop for the
functioning of dollar funding markets.
More generally, our ongoing international cooperation sends an important
signal to global financial markets that we will take the actions necessary to
ensure stability and continued economic recovery.
The actions taken by European leaders represent a firm commitment to
resolve the prevailing stresses and restore market confidence and stability. If
markets continue to stabilize, then the effects of the crisis on economic
growth in the United States seem likely to be modest.
Although the recent fall in equity prices and weaker economic prospects in
Europe will leave some imprint on the U.S. economy, offsetting factors include
declines in interest rates on Treasury bonds and home mortgages as well as
lower prices for oil and some other globally traded commodities. The Federal
Reserve will remain highly attentive to developments abroad and to their
potential effects on the U.S. economy.
Ongoing developments in Europe point to the importance of maintaining sound
government finances. In many ways, the United States enjoys a uniquely favored
position. Our economy is large, diversified, and flexible; our financial
markets are deep and liquid; and, as I have mentioned, in the midst of
financial turmoil, global investors have viewed Treasury securities as a safe
haven. Nevertheless, history makes clear that failure to achieve fiscal
sustainability will, over time, sap the nation's economic vitality, reduce our
living standards, and greatly increase the risk of economic and financial
Our nation's fiscal position has deteriorated appreciably since the onset
of the financial crisis and the recession. The exceptional increase in the
deficit has in large part reflected the effects of the weak economy on tax
revenues and spending, along with the necessary policy actions taken to ease
the recession and steady financial markets. As the economy and financial
markets continue to recover, and as the actions taken to provide economic
stimulus and promote financial stability are phased out, the budget deficit
should narrow over the next few years.
Even after economic and financial conditions have returned to normal,
however, in the absence of further policy actions, the federal budget appears
to be on an unsustainable path. A variety of projections that extrapolate
current policies and make plausible assumptions about the future evolution of
the economy show a structural budget gap that is both large relative to the
size of the economy and increasing over time.
Among the primary forces putting upward pressure on the deficit is the
aging of the U.S. population, as the number of persons expected to be working
and paying taxes into various programs is rising more slowly than the number of
persons projected to receive benefits.
Notably, this year about 5 individuals are between the ages of 20 and 64
for each person aged 65 or older. By the time most of the baby boomers have
retired in 2030, this ratio is projected to have declined to around 3. In
addition, government expenditures on health care for both retirees and
non-retirees have continued to rise rapidly as increases in the costs of care
have exceeded increases in incomes. To avoid sharp, disruptive shifts in
spending programs and tax policies in the future, and to retain the confidence
of the public and the markets, we should be planning now how we will meet these
looming budgetary challenges.
Achieving long-term fiscal sustainability will be difficult. But unless we
as a nation make a strong commitment to fiscal responsibility, in the longer
run, we will have neither financial stability nor healthy economic growth.