Bernanke: Fix fiscal woes or risk 'sudden and severe' contraction of economy

Federal Reserve Chairman Ben Bernanke implored Washington policymakers Tuesday to get the nation's fiscal house in order for the good of the economy.

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The head of the nation's central bank used a high-profile speech to outline a "must-do" list for Congress and the White House in the comings months: avoid the "fiscal cliff," raise the debt ceiling and come up with a long-term plan to bring down the deficit. Finally, Bernanke said it's important do so with as little drama as possible.

"Coming together to find fiscal solutions will not be easy, but the stakes are high," he told the New York Economic Club. 

"Finding long-term solutions that can win sufficient political support to be enacted may take some time, but meaningful progress toward this end can be achieved now if policymakers are willing to think creatively and work together constructively."

Bernanke's comments come as congressional leaders of both parties and the White House have begun meeting in earnest to discuss ways to avoid automatic spending cuts and expiring tax rates set for the new year, while crafting the framework for a broader deficit-reduction package. 

"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," he said.

The Fed chairman has warned Congress for months about the importance of avoiding the "severe fiscal tightening" that makes up the fiscal cliff, and underlined it yet again in his new remarks.

But the upside of the situation is that if policymakers can strike a deal to dodge the cliff and bring down the deficit, they would be sowing the seeds for a stronger economy in 2013.

"Cooperation and creativity to deliver fiscal clarity — in particular, a plan for resolving the nation's longer-term budgetary issues without harming the recovery — could help make the new year a very good one for the American economy," he said.

Bernanke noted that the economic comeback from the financial crisis has taken longer than expected, but that there are reasons for hope. For one, the housing market is finally showing "clear signs of improvement," and financial markets have regained strength since the meltdown as well. He attributed much of the prolonged slowdown to a number of "headwinds" facing the economy, including the fiscal cliff and the European debt crisis.

While issuing a fresh warning on the fiscal cliff, Bernanke also began to press Washington on another major pending threat to the economy — the debt ceiling. 

The Treasury anticipates that the current limit — the subject of a major standoff in the summer of 2011 that led to a credit downgrade — will be exhausted by early 2013. 

While that battle over the ceiling rattled markets and stifled confidence, Bernanke warned that another conflict on the issue could wreak even more havoc.

"As you will recall, the threat of default in the summer of 2011 fueled economic uncertainty and badly damaged confidence, even though an agreement ultimately was reached," he said. "A failure to reach a timely agreement this time around could impose even heavier economic and financial costs."

Bernanke steered clear of weighing in on the stickiest issues surrounding fiscal cliff talks, such as what should be done with entitlement programs or the tax rates for the nation's wealthiest earners. 

But he did warn that the world's financial markets will not tolerate the nation's current fiscal trajectory indefinitely. He called on Washington to come up with a "credible" plan to bring down the nation's deficit, saying it is "urgently needed" to protect the U.S. economy.

But at the same time, he warned that policymakers also need to make sure they do not add to the headwinds weighing on the economic recovery with their policy moves. However, the good news from the Fed head is that those two goals are "fully compatible and mutually reinforcing."

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