by Calculated Risk on 11/20/2012 12:15:00 PM

From Fed Chairman Ben Bernanke: The Economic Recovery and Economic Policy. A few excerpts:

A third headwind to the recovery--and one that may intensify in force in coming quarters--is U.S. fiscal policy. Although fiscal policy at the federal level was quite expansionary during the recession and early in the recovery, as the recovery proceeded, the support provided for the economy by federal fiscal actions was increasingly offset by the adverse effects of tight budget conditions for state and local governments. In response to a large and sustained decline in their tax revenues, state and local governments have cut about 600,000 jobs on net since the third quarter of 2008 while reducing real expenditures for infrastructure projects by 20 percent.

More recently, the situation has to some extent reversed: The drag on economic growth from state and local fiscal policy has diminished as revenues have improved, easing the pressures for further spending cuts or tax increases. In contrast, the phasing-out of earlier stimulus programs and policy actions to reduce the federal budget deficit have led federal fiscal policy to begin restraining GDP growth. Indeed, under almost any plausible scenario, next year the drag from federal fiscal policy on GDP growth will outweigh the positive effects on growth from fiscal expansion at the state and local level. However, the overall effect of federal fiscal policy on the economy, both in the near term and in the longer run, remains quite uncertain and depends on how policymakers meet two daunting fiscal challenges--one by the start of the new year and the other no later than the spring.

What are these looming challenges? First, the Congress and the Administration will need to protect the economy from the full brunt of the severe fiscal tightening at the beginning of next year that is built into current law--the so-called fiscal cliff. ...

As fiscal policymakers face these critical decisions, they should keep two objectives in mind. First, as I think is widely appreciated by now, the federal budget is on an unsustainable path. The budget deficit, which peaked at about 10 percent of GDP in 2009 and now stands at about 7 percent of GDP, is expected to narrow further in the coming years as the economy continues to recover. ...

Even as fiscal policymakers address the urgent issue of longer-run fiscal sustainability, they should not ignore a second key objective: to avoid unnecessarily adding to the headwinds that are already holding back the economic recovery. Fortunately, the two objectives are fully compatible and mutually reinforcing. Preventing a sudden and severe contraction in fiscal policy early next year will support the transition of the economy back to full employment; a stronger economy will in turn reduce the deficit and contribute to achieving long-term fiscal sustainability. At the same time, a credible plan to put the federal budget on a path that will be sustainable in the long run could help keep longer-term interest rates low and boost household and business confidence, thereby supporting economic growth today.

Bernanke is mostly repeating what he has said before: address the budget deficit, but not too quickly: "the federal budget is on an unsustainable path" and "avoid unnecessarily adding to the headwinds that are already holding back the economic recovery". Hopefully policymakers will resolve the "fiscal slope" and not play politics again with the debt ceiling.