At the outset of the financial crisis, the private balance, which was negative, swung sharply into surplus, and this was largely accommodated by a decrease in the public balance–in other words, an increase in the government deficit. Recently, 3 this accounting identity looked roughly like this: 6.5% of GDP private balance + (–9.5% of GDP) public balance = –3% of GDP current account balance Realistically, the public balance 4 needs to be reduced to about –3 percent of GDP over the next five years or so for the ratio of federal debt held by the public-to-GDP to stabilize around 75 percent to 80 percent of GDP. One might reasonably do more, but this just strikes me as the minimum adjustment that would be prudent and sustainable. This requires a large change from where we are today. For the accounting identity to continue to hold, which it must, there needs to be sizable shifts in the private balance and/or the current account balance. This is not a policy choice – it is basic math – but policy choices can help ensure that the adjustments take place in a way that is supportive of economic activity. The private balance can be further divided into two pieces–the household balance and the business balance. Currently, for the United States, the household balance is about 2.5 percent of GDP and the business balance is about 4 percent of GDP.
This is because the Fed’s balance sheet is unusually large, as a result of asset purchases undertaken to promote the dual mandate, and because the spread between the cost of the Federal Reserve’s liabilities (mainly the 0.25 percent rate that the Fed pays on excess reserves) and the return on its assets is unusually high. As shown in (Figure 3), the Fed’s net remittances to the Treasury have climbed sharply in recent years, rising to more than $ billion per year over the past two years, after averaging about $ billion over the 2005–07 period. 1 Subtracting net remittances from the Fed from the Treasury’s net interest cost (as a share of GDP), one can see that the increase in our enlarged federal debt has not yet generated a significant rise in the net debt service burden (Figure 4). However, the low interest rates and enlarged balance sheet, which has generated these reduced borrowing costs, will not be sustained over time. Recall that the Federal Reserve’s policy decisions are motivated solely by monetary policy considerations–how best to achieve maximum sustainable employment and price stability. This means that the ancillary effects on the federal deficit from the Fed’s monetary policy actions are incidental and will prove temporary. Eventually, as economic and financial conditions improve, the pursuit of the dual mandate will lead to a different monetary policy stance, one that requires higher short-term interest rates. And, the Federal Reserve will also eventually shrink the size of its balance sheet.