-GrowPac, a political organization dedicated to better government and New York’s economic advancement today announced its support for Bob Turner.

“I’m pleased to see that Congressman Bob Turner has announced he’s running for the United States Senate against Kirstin Gillibrand. GrowPac supported Bob to victory during his NY-9 special election last year, and we are very pleased to endorse Bob Turner for the United States Senate.

“Senator Gillibrand has worked for Washington’s interests even as New York has suffered from high unemployment and taxes and the sense that government is not serving the people effectively. New York deserves a Senator who brings clear principles on better government and who can represent New York’s interests, not Washington’s. I believe that’s Bob Turner.”

David Malpass

The U.S. has a law on the books called the debt limit, but the name is misleading. The debt limit started in 1917 for the purpose of facilitating more ­national debt, not reducing it. It still serves that purpose. It’s unconnected to spending, hurts our credit rating and has been an abject failure at limiting debt. It should be replaced with a new law that restrains spending when debt rises above the debt limit.

The current debt limit applies only to past obligations, not new spending, making it ineffective. It’s like stating a desired limit on your credit card bill but not limiting usage. Thus, one of America’s key structural reforms should be to replace the law with one that, when violated, forces spending reductions and asset sales but doesn’t threaten shutdown, default or nonpayment of obligations.

The 1917 law created the framework for the current national debt, ending the requirement that each bond issue pass Congress. It allowed $8 billion in national debt, the first tranche of an ultimate $30 billion debt to fund World War I, repayable in gold. Congress eventually abrogated the gold clause in a law the Supreme Court later found unconstitutional; however, the “debt limit” had served its purpose by dramatically expanding the federal government’s ability to borrow to fund deficit spending.

Efforts to fix the debt limit by attaching spending cuts or balanced budget requirements don’t work. It’s not that fiscal conservatives lack backbone or public support. It’s simply that the current debt limit doesn’t create any leverage over Washington’s ­tax-and-spend culture. Failure to increase it causes sudden nonpayment of past government obligations and contracts, which is politically and economically unacceptable to all.

In 2011 a group of fiscal conservatives committed to voting against the debt limit increase unless it included spending cuts and required a balanced budget. After a knock-down, drag-out fight that cost the U.S. its AAA debt rating, the Obama Administration warned it would shut down payments. The end result: a giant $2 trillion increase in debt and deficits, a supercommittee designed from the get-go to make the President’s case for tax increases and a weakened Republican Party.

The debt limit now stands at $16.4 trillion—2,000 times the original 1917 debt “ceiling”—and provides enough headroom to fund the ­govern-ment through the November election. Unless the law is repaired it’s likely that a process similar to that of last August will recur early in 2013. The law was written by Washington for Washington. It forces the debt limit to be increased no matter what, hurting fiscal conservatives and the U.S. credit rating.

Nor can we look to the Constitution for much protection from government debt. The Founding Fathers had no ink-ling they were creating a government that would spend nearly $4 trillion per year—25% of GDP—and borrow al-most a third of it from markets at a 0% interest rate set by the government’s own central bank. Though it clearly limits federal powers, the Constitution doesn’t limit debt or spending, and it would take time to amend.

The solution is to replace the current debt limit with an effective new law that restrains future obligations but doesn’t threaten nonpayment of past obligations. A proper debt limit should improve our credit rating, not lower it.

Fiscal conservatives should immediately start making the case to the public that the current law is harmful and needs to be replaced well before the next debt limit is hit. One approach would be to replace the debt limit with an operational ceiling on the debt-to-GDP ratio. Publicly held debt is currently at 70% of GDP—$10.6 trillion of debt versus $15.3 trillion of GDP—and is scheduled to climb to 83% by 2016. That’s way too high. It should be forced onto a downward glide path to below 50%.

The teeth in the new law matter a lot. Washington will want to put penalties on the private sector, as Europe is doing. Instead, the new debt limit should penalize Washington enough to make it do its job—work around the clock to control spending and sell assets. ­Example: If the debt ratio goes over the glide path, cut salaries each month for upper-income federal employees, including the President, Congress and senior officials. Make it very public that they are paid to control spending.

Nothing will solve the budget crisis overnight. Washington loves to appoint commissions, but they haven’t worked any better than the debt limit. We desperately need a new debt limit law, one that’s connected to the spending process, provides incentives for Washington to control itself and improves the nation’s credit rating instead of harming it.

Obfuscation on the dollar works fine for Wall Street, which reaps billions in profits from the Fed’s unstable dollar policy. It trades currencies and volatility, and makes a bundle protecting investors from the Fed by selling complex derivatives, interest-rate swaps, even triple-leveraged gold and currency funds pitched on television.

After the Fed’s statement, markets bid gold above $1,700 per ounce, the latest insult to the Founders’ clear intent for the dollar’s value to be strong and stable relative to gold and silver over the life of our republic.

Dollar weakness doesn’t work at all for economic well-being. The corollary to the Fed’s policy of manipulating interest rates downward at the expense of savers is declining median incomes. It’s no coincidence that inflation-adjusted median incomes rose in the sound-money booms of the Reagan and Clinton administrations and fell in the weak-dollar busts during the Carter, Bush and Obama years. When the currency weakens, the prices of staples rise faster than wages, hurting all but the rich who buy protection.

The economy and median incomes would do much better if the Fed said simply that it would set interest rates as best it could in order to keep the dollar’s value strong and stable in coming decades, with the goal of attracting capital, maintaining price stability and encouraging full employment.

Yet the Fed is adamant that somehow business confidence will benefit by the Fed sharing its guesses on equilibrium interest rates—which after all are far from a science—but not its vital thinking on the future value of the dollar.

The Fed’s status in Washington is unique and practically unassailable. It alone is a colossal self-funder operating outside the congressional appropriations process. Even the CIA and Navy Seals don’t enjoy the Fed’s unlimited spending power, checked only by its handpicked board and senior leadership.

Americans know this is a big problem but can’t stop it. Texas Congressman Ron Paul has created an intensely popular presidential campaign around the need for stable money and limitations on the size (the Fed employs 22,000 people) and power of the Fed.

Yet legislation is moving in the opposite direction. Dodd-Frank’s open-ended mandate has added another layer to the Fed’s power, instructing it to control bank risk (good luck), protect the financial welfare of consumers, and even advise on mortgage bailouts.

Wednesday’s meeting result could have been worse. The Fed might have announced more purchases of U.S. Treasurys and mortgage securities. It already owns nearly $2 trillion worth and has no limit on its expenditures, which fall completely outside the federal budget. Bond traders have been pleading with the Fed to announce further purchases so they can buy first and score big profits.

Stopping Fed asset purchases would help growth by allowing market distortions to subside. Its clear there’s been no benefit from the Fed’s unprecedented balance-sheet expansion, up 250% since 2008: no increase in private-sector credit (flat since 2009) and no impetus to the economy, which has been particularly weak in the quarters following Fed asset purchases.

Near-zero interest rates penalize savers and channel artificially cheap capital to government, big corporations and foreign countries. One of the most fundamental principles of economics is that holding prices artificially low causes shortages. When something of value is free, it runs out fast and only the well-connected get any. Interest rates are the price for credit and shouldn’t be controlled at zero. It causes cheap credit for those with special access but shortages for those without—primarily new and small businesses and those seeking private-sector mortgages.

The economy’s exit from Fed dominance of bond markets wouldn’t be traumatic. The Fed has been fully sterilizing its asset purchases, meaning all the cash it has used to buy bonds is still contained at the Fed, not multiplied in the private sector. The Fed accomplishes this through bank regulation and by borrowing from banks at above-market interest rates—$1.5 trillion as of Jan. 18.

The Fed can reverse this process, letting its bond portfolio mature and the private sector smoothly reabsorb the debt by drawing down the excess reserves it has on deposit at the Fed. Other bond holders may see price pressure as the Fed finally sells its portfolio, but principal losses on bonds are small compared to fluctuations in equity markets. If the Fed adopts the pro-growth stance of letting markets allocate capital and the dollar stabilize, equity market gains will heavily outweigh bond market losses, lowering the cost of capital in the private sector.

The Fed’s responsibility is to create confidence in price stability and the dollar, thus providing the best monetary policy environment for full employment. Most central banks operate on this principle. Instead, the Fed has systematically undermined economic confidence by promising to maintain zero interest rates for privileged borrowers. That policy will have to stop if the U.S. is to again achieve impressive growth.

Mr. Malpass, a deputy assistant Treasury secretary in the Reagan administration, is president of Encima Global LLC.

By David Malpass

Across Europe and the United States, the fiscal crisis is setting up an epic battle among government services, pensioners, government employees, creditors and taxpayers. There is simply not enough money coming in to pay all the promises politicians have made. The shortfalls and fights are challenging our democracies and shifting wealth from the private sector to ever bigger government.

The hope has been that Europe’s debt crisis would force government downsizing in time to meet cash flow requirements. Newfound fiscal discipline would provide a silver lining to the debt crisis. But that’s not working out.

Germany’s insistence on centralized fiscal discipline for the euro zone will lead to a massive expansion of bureaucracies in Brussels, Frankfurt and Berlin. They’ll include temporary and permanent bailout funds, dangerously intrusive powers for the International Monetary Fund and the European Central Bank, endless summits, new taxes on property, and recessions.

With Europe’s government structures assured of getting even bigger, the U.K. reacted immediately by opting out. U.S. lawmakers are already objecting to the European plan to expand the IMF. As in Greece, IMF programs are antigrowth, imposing austerity on the private economy, not the government. Greece has raised value-added and property taxes, then projected revenue increases that never materialize in order to keep payments flowing to creditors and the government’s entourage.

Governments on both sides of the Atlantic are trying to use the crisis to grow rather than shrink. News of Europe’s fiscal incompetence abounds, but Washington had no budget at all in 2010 or 2011 and the federal deficit grew at record pace. President Obama sailed through 2011 without any significant spending cuts or government downsizing.

With year-end approaching, the federal budget horizon has contracted to two weeks. Common practice is for Congress and the president to spend as much as possible in December and then adjourn, hoping voters will forget about it after New Year’s Eve.

Financial markets are so sensitive to the $3.6 trillion in annual federal spending that they would likely see huge gains if Congress simply adjourned without the normal year-end blow out. Even better would be for the president to call a January cabinet meeting with the purpose of cutting spending and regulation to encourage private job growth.

In February, President Obama will be able to impose another $1.2 trillion debt-limit increase using special voting rules forced through Congress last August to avoid a government shutdown. It should be clear by now that politicians will not voluntarily reduce government or government debt. The so-called debt limit is harmful because it threatens default and broad government shutdowns, both unacceptable, but doesn’t limit spending at all.

The debt limit should be replaced with a new debt ceiling that forces Washington to cut spending. When the debt-to-GDP ratio is above target, Washington should suffer escalating penalties on its power, benefits and spending authority. There should be no threat of debt default or government shutdown. Instead, Washington should face a benefits straitjacket that is so uncomfortable for the president, his senior executives and Congress that they work around the clock to enact spending cuts and asset sales to bring debt back below target. They should get a bonus if they get the job done and embarrassing, escalating penalties if they don’t.

Here are some possible penalties: 1% pay cut per month for the 10,000 highest-paid government employees with a prohibition on it being restored; suspension of limousines for assistant secretaries and higher; market-rate monthly fee for free government parking. During periods of excess debt, the president should have impoundment authority but also be required to write a monthly letter to Congress stating preferred spending cuts equal to 20% of the fiscal deficit.

Grappling with out-of-control government spending in southern Europe, Germany is seeking automatic penalties when fiscal deficits are too large. The problem is that governments will probably write the penalties so they hit taxpayers and the private sector. It’s unlikely European governments will write penalties aimed at themselves. There’s already talk of the bloated Italian government taxing the property of the Catholic Church to avoid spending cuts and asset sales.

Across the U.S. and Europe, big government is winning the crisis game, adding taxes, regulatory power and whole new institutions. Voters want restraint, but there’s no mechanism to control government spending, so debt-to-GDP ratios go up rather than down.

Even at the state and local level, which is supposed to be closer to the people, governments find ways to grow. In an age-old government shell game, tax increases are projected to cause big revenue gains, which governments rush to spend. When actual revenues fall short, the government blames the economy, borrows the shortfall, and proposes new taxes, creating a debt cycle.

This budgeting trick is replayed year after year around the nation. New York state demonstrated this last week with Gov. Andrew Cuomo’s $2 billion increase in annual income taxes to “balance the budget.” The increase in projected tax revenues will allow a major increase in state spending in 2012. And despite balanced budget requirements, New York state and local debt has surged above $300 billion.

One of the few hopeful signs in the two-continent budget mess is that a few U.S. states and localities are experimenting with different political responses, some of which will promote growth. Wisconsin’s government stopped collecting union dues, changing the balance of political power. Heavily Democratic Rhode Island passed a law allowing a hybrid 401(k) pension system, a key structural reform that would transform the nation’s fiscal outlook if widely adopted.

The fiscal questions facing Europe and the U.S. are central to our democracies. Can politicians be incentivized or penalized enough to lead a downsizing of government? Which unaffordable contracts and promises should be reduced? How fast will the outlays grow for lifetime pensions and retiree health care?

To win elections, politicians have promised practically endless government spending and covered up the cost, leaving generations of taxpayers obligated to pay off the debt. That’s wrong, but neither the U.S. nor Europe has a plan to stop it. A first step would be to use more effective debt and deficit limits to force governments to spend less and end the debt cycle.

Mr. Malpass, a deputy assistant Treasury secretary in the Reagan administration, is president of Encima Global LLC.

The world is waiting anxiously for Europe to use a bazooka on its debt problems—i.e., to make such a strong financial commitment to European banks and bonds that they become investable again, unfreezing markets.

But Europe probably won’t go that far in this week’s summits. This leaves in place a costly slow-motion bailout and a deepening recession.

For the U.S., it means another drag on an economy already stalled by Washington’s uncontrolled spending, taxes and regulation, as well as its weak-dollar policy.

The increasingly common view is that Europe’s crisis will worsen and Europe will eventually have to either centralize its government (imagine Brussels booming like Washington) or let the euro break apart with some countries devaluing their way to much lower living standards.

Europe wants a healthier middle ground and so should the U.S. Europe’s goal should be to control government spending, keep the euro zone together, and keep national finances separate in the interest of freedom and limited government. The problem is not the euro or national autonomy, but the euro-wide blindfold over a decade as national debts spiraled higher.

For now, Europe’s borrowing costs outside Germany will probably keep rising as confidence declines, choking off investment and spreading Greece’s crisis westward. Italy is already in a recession, and Monday’s weak orders report from German purchasing managers confirmed the risk that even Germany may be sinking into recession.

This puts Europe’s banking system at risk. It owns much of Europe’s national debt and is therefore very sensitive to falling bond prices. As Greece and Portugal move toward restructuring their bonds, with banks taking a loss, key funding sources for European banks are drying up. These include U.S. money-market funds, Europe’s floating-rate interbank market, and lately the large secured bond market.

The market’s worry is that other heavily indebted countries will also sink and restructure their bonds. For now, banks are selling assets and planning new equity issuance to fill the gap, and the European Central Bank (ECB) is temporarily providing unlimited loans to banks against weak collateral.

The bar for re-establishing confidence in Europe is probably not as high as it seems. A bold plan to cut government spending and sell government assets would work. Investors are looking for a home for trillions in idle Federal Reserve-generated dollars, and Italy’s 10-year bond has a yield of 6% compared to only 2.2% for the U.S. 10-year Treasury.

As growth deteriorates and governments refuse to downsize, Europe will be tempted to go all-in, using overwhelming financial force to restore confidence to Italian and Spanish bonds and stabilize bank funding. One technique is faster asset purchases by the ECB, enough to reduce bond yields in Italy and Spain.

This is the approach the Fed used in late 2008 when it announced that it would purchase over a trillion dollars in mortgage bonds. The severe downside was that the unbounded Fed purchases have opened a Pandora’s box of taxpayer risk and market uncertainty that will last decades.

The Fed remains fascinated with continued large-scale asset purchases even after the 2008 systemic crisis is long over and consumer-price index (CPI) inflation has hit 3.9%. Germany is more protective of stable money and price stability than the U.S. and has rejected the option of the ECB making Fed-sized asset purchases.

During the 2008 crisis, the U.S. developed another overwhelming force that might stabilize Europe’s funding problem. Four weeks after Lehman Brothers filed for bankruptcy, the Federal Deposit Insurance Corp. said it had the jaw-dropping authority to guarantee apparently unlimited amounts of new unsecured bank debt. Before this program ended, major banks were issuing five-year debt with a 100% FDIC guarantee even though the FDIC insurance fund was itself risking exhaustion.

Contrast this with Europe’s hesitation over even partial insurance for Europe’s sovereign bonds.

Still missing, however, is proof that governments like Italy’s (and America’s) can restrain spending or sell government assets fast enough to pay down debt. Italy’s debt-to-GDP ratio is already 120%, more than double a sustainable level, while the U.S., with a 70% ratio—$10.5 trillion marketable debt not counting entitlements, versus $15 trillion in GDP—is on course to grow the debt ratio to 85% by 2016 and 100% by 2021.

When economies and the work force were growing, politicians and government unions promised workers they would pay their pensions and health-care costs without limit. They counted on a pyramid of new workers and, at many U.S. pension funds, rosy assumptions about strong investment earnings and short life spans for retirees. They borrowed trillions, helped by low interest rates, faulty bond ratings, fake accounting and, in Europe, a political conspiracy to ignore the 3% European treaty limit on deficits.

Thus an epic battle is underway in Europe and the U.S. over the size of government amid shrinking resources. The euro zone’s path forward is clear but politically difficult. As nations, they need to cut government spending, sell assets and allow private-sector competitiveness. As a part of a union, the euro zone has to divide up the losses from past deficits, restore confidence in sovereign bonds, and create a system that won’t let politicians borrow as much as they did.

The alternatives—the current dilatory bailout or a faster path to default and the breakup of the euro—would be devastating for all.

Mr. Malpass, a deputy assistant Treasury secretary in the Reagan administration, is president of Encima Global LLC.

With unemployment high and President Obama locked into antigrowth tax increases, the Federal Reserve is again being called on to intervene in financial markets. The latest bad idea is for the Fed to try to lower long-term interest rates (or “flatten the yield curve”) by lengthening the maturity of its $2.6 trillion bond portfolio.

The Fed should instead be using its considerable energy and expertise to provide sound money, and using its bully pulpit to encourage federal spending restraint and regulatory reform in line with its full-employment mandate.

To try to flatten the yield curve, the Fed would buy more long-maturity bonds and finance them by selling some of its shorter-term bonds (dubbed Operation Twist) or by further increasing the $1.6 trillion in short-term deposits it holds for commercial banks (in other words, more quantitative easing).

Either way, borrowing short and lending long is risky financial behavior. It exposes the taxpayer to interest rate risk—since the Fed’s bond holdings will lose value if interest rates go up.

Just as worrisome, Fed bond purchases shorten the maturity of the national debt. When it buys bonds, the Fed negates the Treasury Department’s bond issuance, the goal of which should be to put longer-maturity debt into the global private sector while bond yields are low.

Long-maturity Treasury bonds protect taxpayers from higher interest costs in the event that interest rates have to rise in the future. But this won’t happen if the Fed just buys the bonds back and holds them on its own balance sheet. By my estimates, the Fed’s Treasury bond purchases in 2008-2011 shortened the average maturity of the national debt to four years from five, not counting the further shortening from the Fed’s purchases of mortgage bonds. 

The Fed will get attaboys from markets if it buys more bonds. The bond market loves a whale, a big buyer who doesn’t care about price. It’s even better when the purchases are announced in advance, giving markets an opportunity to buy first. When the Fed signaled it would buy mortgage bonds in 2008, markets bought them heavily before the Fed, locking in huge profits.

Similarly, markets bought Treasury bonds in September 2010 after the Fed signaled it would be a buyer. This drove yields down and prices up before the Fed began its purchases.

Most of Washington wants the Fed to buy more bonds too. With the deficit running over $1 trillion per year, Treasury has to move a lot of them. The Fed can’t buy them all, though—the White House budget calls for the national debt to increase by another $10 trillion, pushing the debt limit to $24 trillion in 2021 according to the Office of Management and Budget’s mid-session review.

Applause doesn’t mean it’s right for the Fed to keep buying. After all, Wall Street and Washington gave the Fed hurrahs for its low interest rate bubble policy in 2004-2006. The motto was “dance till the music stops.” More Fed purchases would hurt savers by lowering, for example, CD yields, add to market uncertainty, further distort short-term credit markets, and worsen the Fed’s conflict of interest in setting interest rates, because its bond portfolio will lose value if it raises rates.

More fundamentally, the Fed should not be in the business of dangling bond purchases in front of world markets. Since the financial crisis, the Fed has been transforming itself from a monetary policy agency into a market-intervention shop, helping explain the thirst for gold, which has shot up to more than $1,800 per ounce.

Operation Twist (named in honor of the 1960s dance craze) was first tried in the Kennedy administration. It consisted of Treasury issuing extra 18-month debt while the Fed bought back longer-term debt. In a study published in April, the San Francisco Fed said the operation, which caught markets by surprise, may have reduced bond yields by 0.15%—but only for a short period.

The modern version would probably be even less effective since markets are expecting it. The Fed’s idea is that the private sector will go looking for riskier and longer duration assets to make up for the bonds the Fed bought. But the evidence is clear that this isn’t working: The Fed’s near-zero interest rate policy and its huge overhang of bonds create uncertainty. This hurts small-business confidence and discourages job growth.

The twist from the second round of quantitative easing (QE2) contributed to the sharp economic slowdown in the first half of 2011 when the Fed was buying $70 billion in bonds per month. The more it bought, the slower the economy grew as the twist sucked capital from savers and small businesses to the government.

The Fed has conducted a controversial experiment with near-zero interest rates and massive bond purchases. These policies have hurt growth and added to unemployment by distorting financial markets. The Fed should be directing calls for action to the administration for tax reform, spending restraint and bank regulatory reform—each a proven job creator. The central bank has already bought nearly $2 trillion in longer-term bonds, a massive intervention in markets, with no constructive results. It’s time to move on.

Wall Street will threaten a tantrum if the Fed doesn’t buy more long bonds. But most of the private sector would welcome a respite from constant government intervention. And the dollar might stop its slide, slowing the hemorrhage of growth capital from the United States.

Mr. Malpass, a deputy assistant Treasury secretary in the Reagan administration, is president of Encima Global LLC.

“There’s a pro-growth wave of change underway in America and New York. Adele and I know Bob will help reverse Washington’s takeover of the economy, strengthen the relationship with Israel and represent NY-9 proudly.”

Beyond the Gold and Bond Bubbles

By DAVID MALPASS

Treasury bond yields have been at near-record lows and gold prices at record highs, attracting millions of investors into idle assets through coins, exchange-traded funds and even warehousing facilities. This reflects fear about inflation and the stability of the financial system and, for some, the coming breakdown of society under the weight of $3.6 trillion in annual Washington spending and transfer payments.

Last week’s letup in the gold and bond-buying bubbles was good news. It meant less fear that the financial system will collapse. The Federal Reserve and the Obama administration should pile on by championing sound money and fiscal restraint as a way to rechannel capital into growth.

Fed Chairman Ben Bernanke’s Jackson Hole speech last Friday, in which he did not announce still more quantitative easing, was a welcome step back from the frenetic central-bank activism that has been adding uncertainty to an already weak economy. The Fed has bought over $2 trillion of bonds since 2008 and forced interest rates to near-zero, which hasn’t helped small businesses or created jobs.

Mr. Bernanke should directly confront the fear index imbedded in high gold prices and low bond yields. Gold at more than $1,800 per ounce is a loud public statement of no confidence in our central bank. It means people would rather buy gold than hire workers or start businesses—that they don’t trust the central bank to maintain the value of their money.

Former Fed Chairman Paul Volcker thought of high gold prices as his enemy and repeatedly said so as a way to build confidence in the central bank. In the 1970s, high gold prices reflected Fed incompetence that had produced inflation, stagnation and malaise. Jimmy Carter named Mr. Volcker to replace G. William Miller as Fed chairman in 1979, a rare moment of Washington accountability. Gold then fell in the 1980s and ’90s in what was called affectionately “The Great Moderation.” Inflation and oil prices followed gold prices down, tax rates were cut, and jobs became plentiful. Foreign capital beat a path to America’s door, the mirror image of the exodus of growth capital the Fed’s weak dollar is fueling.

Equally harmful in our current environment, low bond yields (negative yields in some cases) signal fear of deflation and a collapse in the financial system. Investing on these fears hurts growth—investors buy billions in gold to protect from inflation and billions in government bonds to protect from deflation. It’s like a farmer plagued by both floods and droughts and having to buy insurance against both extremes.

It’s not an abstract fear. The Fed caused high inflation in the 1970s and participated in a weak-dollar policy in the 2000s that made gold a vital investment for capital preservation. And the Fed has repeatedly warned of a Japan-style deflation over the last decade, itself buying bonds in huge quantities and now forcing more capital into dead-end government bonds by assuring near-zero interest rates into 2013.

Reinforcing investor fears, the Fed has caused extraordinarily wide and harmful swings in interest rates, the value of the dollar, gasoline prices and inflation in recent decades. This makes precautionary investments like gold, bonds and foreign diversification more profitable than investing the old fashioned way in small, growing businesses.

The result: Growth has stagnated. With gold prices flying through the roof, interest rates at near-zero and 10-year bond yields at only 2%, too much capital has been diverted into protecting investors from monetary-policy extremes.

The Fed takes the view that gold prices have limited meaning and that low bond yields are desirable as stimulus, not a market-based indicator of slow growth and high risks to the financial system. This leaves the financial world in suspense over whether the Fed will buy back more of the national debt or even new types of assets as some are urging. The uncertainty is great for the Fed-watching community and Wall Street, which profits by buying bonds in advance of Fed purchases. But the suspense hurts growth and jobs.

To break this cycle, the Fed needs to rebuild a monetary system in which the dollar is a strong and stable store of value and capital is allocated based on interest rates and market forces rather than the rationing of regulatory capital. Gold prices would be lower and bond yields higher in anticipation of a growing economy and a safer financial system.

Unless the Fed breaks the cycle, many of the arguments for buying gold and bonds still pertain. The Fed owes $2.8 trillion in liabilities, undercutting confidence in the dollar and the financial system. It is willing to promise zero interest rates for years but not willing to criticize the declining value of the dollar, one of the most important metrics of central banking.

These missteps aren’t fatal. The Fed’s plump balance sheet can be pared back when growth starts. Last week’s improvement in the gold/bond fear index provides an opportunity for the Fed and the administration to talk up the economy and put a bullish top on the price of gold.

Instead of locking in 2013 interest rates, as it has done, the Fed should reassure markets that sound monetary policy will produce lower gold prices and higher bond yields over time, an important step in restarting growth. The status quo—piling trillions into foreign countries, gold and idle Treasury bonds—sucks capital away from growth. The Fed should put an end to it.

Mr. Malpass, a deputy assistant Treasury secretary in the Reagan administration, is president of Encima Global LLC.

Since there were three dissents at the Fed’s August meeting, the high costs of using the nation’s central bank to subsidize the national debt — the dollar’s collapse, the price spikes in gold and oil, the 3.6% CPI inflation rate, and the uncertainty over what the Fed might buy next — must be part of the policy debate.  Add to those problems the comfort the Fed’s 2010-2011 QE2 bond purchases gave the White House to propose wild spending in its February budget knowing the Fed was bailing them out.  Of course the Fed hasn’t yet said it won’t do it all again in time for the 2012 election.

A bit more good news.  Chairman Bernanke called for a new budgeting process to avoid a repeat of the August debt limit fiasco.  As I’ve written on this page, fiscal conservatives should be using the forced debt limit increase to create a budget process that restrains spending.  The current debt limit doesn’t work that way — it threatens default but doesn’t cause spending cuts.  No wonder — it was written by Congress as a way to make deficit spending easier, not harder.
 
In his speech, Bernanke said: “The negotiations that took place over the summer disrupted financial markets and probably the economy as well.”  No kidding.  He went on: “Similar events in the future could, over time, seriously jeopardize the willingness of investors around the world to hold U.S. financial assets or to make direct investments in job-creating U.S. businesses.”   That’s a reference to the rapidly approaching 2013 debt limit increase, which threatens to be a replay of 2011 where little was accomplished in the way of spending restraint.   

As a goal for fiscal policy, Bernanke proposed ensuring that the debt-to-GDP ratio declines over time. Good idea.  I think the debt limit should be rewritten so that it causes spending cuts, not default, whenever the debt-to-GDP ratio is above a ceiling that goes down year by year.  We’re in nose-bleed territory in terms of debt and should climb down.  Unfortunately, the latest CBO deficit forecasts show no meaningful fiscal restraint underway, with debt going up every year and the debt-to-GDP ratio rising above 80% even with rosy economic assumptions.   

As is regularly the case, the Chairman’s speech didn’t mention the weak dollar, probably the most important problem facing the U.S. economy.  The elephant in the lodge at Jackson Hole? The giant sucking sound of capital fleeing the U.S. for safer havens — gold, Swiss francs, Chinese yuan.   By omitting any complaint about dollar weakness and skyrocketing gold prices,  the Fed Chairman tacitly left in place the weak-dollar policy the U.S. launched in 2004.  The consequence is lower living standards, lower real per capita incomes.  A sinking middle class trounced George’s Bush’s economic performance and is doing the same to President Obama, undercutting business investment and shifting jobs and capital abroad.
 
Chairman Bernanke did tackle Europe’s debt crisis, though briefly.  It is one of the diceyist problems facing the world’s central bankers.  With Europe’s fabled August vacations in full swing, policymakers there have sunk into paralysis.  Dangerous fights have broken out over whether Greece should be forced to provide collateral for new loans and whether the European Central Bank has the authority to buy large quantities of government debt the way the Fed has been doing.  Bernanke was circumspect: “I have confidence that our European colleagues fully appreciate what is at stake in the difficult issues they are now confronting and that, over time, they will take all necessary and appropriate steps to address those issues effectively and comprehensively.”  That’s an optimist for you.

Contrasting the U.S. with AAA countries such as the UK and Germany, S&P said it expects debt-to-GDP ratios there to peak around 2015 but continue to worsen here. S&P kept France in the AAA category, leaving the U.S. in the ditch. Double ouch.

Citing a $2 trillion “error” in S&P’s debt projections, the White House reaction was to shoot the messenger in a desperate effort to avoid this being labeled the ‘Obama downgrade’. On Friday, Treasury convinced S&P to use CBO’s “baseline scenario” which assumes discretionary spending grows slower than nominal GDP. Good luck with that. It’s a big stretch given Washington’s ability to inflate the baseline, double count spending cuts and go back on previously agreed cuts. S&P had been assuming faster spending growth, a baseline that I think is closer to reality because it incorporates Congress’s bias toward more spending and the possibility of occasional recession-related bursts in spending.

The Administration’s misdirection strategy may have worked. The August 6 New York Times and Time Magazine stories emphasized the change in S&P’s ten-year debt projections instead of highlighting the U.S. fiscal mess. Many news stories profiled the S&P employees involved in the rating rather than S&P’s multi-year track record warning the U.S. about its fiscal deterioration.

The reality is grim. Even after lowering its assumptions about federal spending growth, S&P projects marketable government debt in 2015 at $14.5 trillion, 79% of GDP. Debt would grow to over $20 trillion in 2021, 85% of GDP including state-and-local debt.

In the real world, the U.S. fiscal deficit and the debt-to-GDP ratio depend heavily on GDP growth rates. They are weak now and hard to predict, leaving a good chance that the debt-to-GDP ratio is heading toward 100% of GDP, much higher than either version of the S&P projections.

The problem is that our current federal spending system has few effective controls. The Constitution was amazingly farsighted but didn’t envision a government so successful and jaded that it could ever borrow $100 billion much less $20 trillion as now envisioned.

Washington benefits from more spending and doesn’t want it to stop. Making matters worse, an offshoot of the flawed 1974 Budget and Impoundment Act makes it a felony for executive branch officials to spend less than Congress appropriates no matter how wasteful or misguided a program.

By negotiating with Vice President Biden and then each other, fiscal conservatives missed an opportunity this summer to restrain spending. The administration opposed spending restraint almost to the end. That is the heart of the S&P complaint.

My previous pieces on this page have advocated replacing the current dysfunctional debt limit with true spending restraint. To grow fast and create private sector jobs, we need a glide path to a permanent debt-to-GDP ceiling much lower than current levels. Rather than a debt default, it should use escalating penalties on government to force discrete decisions on spending cuts including entitlements. The compromise to use commissions and unworkable across-the-board sequester is typical Washington responsibility ducking. S&P saw through the dodge in its downgrade, expressing skepticism that the super-committee would cut spending and that the sequester would be implemented.

In the near-term, markets should take the downgrade in stride. It wasn’t a surprise, and other ratings agencies such as Moody’s and Fitch have maintained their U.S. ratings at the highest grade. S&P chose to release the rating on Friday after the market close, reducing its impact. The U.S. fiscal deterioration spelled out in the S&P downgrade has been underway for years, and it’s unlikely that the S&P opinion will cause new revelations. Many funds categorize U.S. Treasuries as riskless without reference to the bond rating, limiting the impact on yield.

In the longer-term, the downgrade will be expensive unless it helps force an improvement in Washington’s spending patterns. Instead, the U.S. is likely to continue ultra-loose spending and monetary policies, with a harmful impact on the dollar, investment in the U.S., GDP growth and employment. There’s the risk that this downgrade is just the first in a series (as is often the case). Perhaps most costly, it’s another clear marker for investors that the U.S. is in economic decline.

David Malpass, president of Encima Global and chairman of GrowPAC, was deputy assistant Treasury secretary in the Reagan administration.