07/13/2011 06:12 pm ET Updated Sep 12, 2011

Bernanke Warns Against Short-Term Spending Cuts As Budget Deal Deadline Looms

Federal Reserve Chairman Ben Bernanke urged American leaders not to cut spending too aggressively in the short term, warning that a sharp and quick response to the federal budget deficit could imperil the already weakening economic expansion.

"We really don't want to just cut, cut, cut," Bernanke said Wednesday before the House Committee on Financial Services. "You need to be a little bit cautious about sharp cuts in the very near term because of the potential impact on the recovery. That doesn't at all preclude -- in fact, I believe it's entirely consistent with -- a longer-term program that will bring our budget into a sustainable position."

The chairman's words, unusually strong for a man whose smallest utterances tend to move markets, appeared to undercut the arguments of some Republican lawmakers, who insist strenuous cutting is required to shrink the federal budget deficit. Overly swift reductions in federal spending could actually worsen the nation's budget imbalance by weakening economic growth and dampening tax revenues, Bernanke suggested.

Lawmakers in Washington are consumed by a struggle to reach a quick budget deal. Republicans have tied the debate over raising the debt ceiling to the debate over how to reduce the federal deficit, refusing to increase borrowing authority unless their demands for spending cuts are met. Economists, financiers and taxpayers the world over are watching the deliberations, with the U.S. government's credit rating potentially at stake.

The government will hit the debt ceiling by Aug. 2 if no deal is reached, the Treasury has said. But Treasury Secretary Timothy Geithner said he wants a deal even sooner, in the next several days.

If no deal is struck and the borrowing limit isn't raised, the government will be forced to abruptly reduce spending. That could mean halting Social Security payments, or pay to the military. And it could mean defaulting on the nation's debt, an event without precedent in modern history that economists say would likely send interest rates soaring, induce job cuts and plunge the economy back into recession.

But Bernanke warned against acting too hastily to reduce the federal deficit, appearing to echo earlier comments in which he said the debt ceiling was the "wrong tool" for repairing the nation's budget. Spending cuts, if imposed in the short term, can have the unintended effect of hurting revenue by reducing the nation's taxable income, he suggested.

"I just want to be clear that cutting programs or raising taxes in ways that will reduce aggregate demand, spending and the ability of consumers to meet their bills and purchase goods and services is going to slow the economy," the chairman said.

"That's in turn going to offset some of the benefits of the cuts," he continued, "because it will reduce revenues and make the deficit worse on the short term."

Federal spending tends to increase demand in the economy by putting more dollars in people's wallets, economists say. That spending might include tax incentives for businesses to hire workers, or aid for local governments to help fund projects that repair infrastructure and boost employment.

Ideally, government spending yields results in excess of the value of the money spent. Higher employment fosters a general sense of confidence and optimism, which encourages more hiring and investment in a virtuous cycle.

With the budget deficit widening and the debt running above $14.3 trillion, most lawmakers agree that spending must be reduced. But the timeline for these cuts, and the specific programs that will be affected, are a subject for contentious debate.

The economy is hurting, with the unemployment rate at 9.2 percent, gas prices high and home prices continuing a punishing decline. Bernanke underscored these weaknesses in his testimony, arguing that any budget cutting must be handled with care, so as not to shatter the fragile economic recovery.

Still, some lawmakers insist on immediate action. That view was summed up by Rep. Sean Duffy (R-Wis.), who questioned Bernanke during the hearing.

"Maybe this is a rhetorical question, but if we're not going to cut now, I mean, when?" Duffy asked. "At what point is there going to be political courage to get the debt under control if we can't do it today?"

Bernanke resisted wading into a political debate. But on the debt ceiling issue, a case in which a political fight risks inflicting real economic damage, he was firm: The limit must be raised on time.

"The right analogy for not raising the debt limit is going out and having a spending spree on your credit card, and then refusing to pay the bill," he said. "We saw what happened in 2008, 2009, where we had two consecutive quarters of 6 percent negative growth in the economy. I think something on that order of magnitude would be certainly conceivable."