Bernanke's right hand: exit interview with Federal Reserve Governor Kevin Warsh. In April, TIE founder and editor David Smick sat down with the departing U.S. central banker.

• Author: Smick, David
• Position: Interview

TIE: The facts of the U.S. debt situation are terrifying. By the year 2025, according to the Congressional Budget Office, federal spending on entitlements and interest payments will consume 100 percent of government revenues. That means there's no money for anything else. In fact, unfunded entitlements may be larger than the size of today's public debt by a 9-to-1 margin. Shouldn't the Federal Reserve as an institution be sounding more of an alarm about this situation? At what point will the debt complicate the job of conducting monetary policy? Have Fed officials, through their bond purchases, unwittingly contributed to the lack of fiscal discipline in Washington?

Warsh: The fiscal shortfall, even by the conventions used by the Congressional Budget Office and the Office of Management and Budget, is significant across all time horizons. And the unfunded, unaccounted for liabilities assumed by the federal government are even more consequential. We are on an unsustainable fiscal path. The sooner policymakers deal with this stark fiscal situation, the better. At this moment, markets appear reasonably tolerant of the fiscal trajectory, and they will remain so precisely until they are no longer tolerant. Policymakers must get ahead of the day of reckoning.

Washington just finished dealing with the 2011 budget, and while near-term spending issues are often described as being relatively small in contrast to these longer-term structural problems, it's best to put points on the board whenever feasible. I'm encouraged by the actions over the last couple of months.

While monetary policymakers must pay attention to the judgments of the fiscal authorities, the Fed should not try to compensate for their failings. Debt monetization ought not to be the business of the Federal Reserve. But highlighting the size, scope, and stakes of the fiscal challenge is a very constructive role for the Fed to play. And a clarion call for reform is needed.

TIE: Do you buy the argument that sometimes the global bond market moves in a sequential series of vicious attacks? In other words, Stage One in the 1990s came with the market attacks during the Asian financial crisis. Stage Two is today's European sovereign debt and banking crisis. Stage Three will be market reaction at some point to America's deficits and debt.

Despite the dollar being the reserve currency and the United States being the world's largest economy, will there relatively soon be a day of reckoning? Standard & Poor's has issued its warning. Some European central bank regulators are quietly warning their banks about the perceived risks of the U.S. Treasury market.

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Warsh: Like it or not, the United States is part of one imperfectly integrated global economy and financial market. Markets periodically test weakness. And they don't stop testing until they are confronted with overwhelming facts or overwhelming force, the former being my preferred policy response. Market participants tend to start with the weakest in the herd, but they rarely stop there. We saw it in the U.S. banking crisis, beginning with Bear Stearns and Lehman Brothers. The Europeans have witnessed it more recently with respect to countries in the so-called periphery.

The United States remains the largest, most resilient economy in the world, with great demographics, great productivity, and a great ability to innovate. But this is no time for complacency. The dollar's role as the world's reserve currency is no birthright. It must be earned every day. We should not take our low current financing costs in the Treasury markets as license to kick the can down the road. We should not fool ourselves into thinking that Treasury financing is immune to the laws of arithmetic. Fundamental reform is needed. If reforms happen sooner, they will be under the control of policymakers. If deferred, reforms will be forced upon the body politic at a time of the market's choosing.

TIE: Imagine it's one month before the outbreak of the Great Financial Crisis. The yield on a ten-year U.S. Treasury bond is roughly 4 percent. I have a crystal ball which says that by the spring of 2011, the economy will be growing at between 2 percent and 3 percent with unprecedented levels of deficits and debt and a huge expansion in the central bank's balance sheet. In addition, in part because developing world economies have been growing at an astounding pace, commodity prices including oil are skyrocketing. Wouldn't you have assumed back then, given these factors, that the yield on the ten-year U.S. Treasury would be significantly higher than 4 percent? Yet it has remained below that level for some time. What is the market saying about future inflation? Is the world so economically and financially perilous that the traditional U.S. safe haven status is affecting the yield curve? Or is the long end of the bond market simply influenced by the Fed's efforts to keep short-term rates near zero percent and to purchase bonds at the longer end of the yield curve? Or is a rise in long-term interest rates just around the corner? Or are we at the end of some strange historic cycle mired in global overcapacity?

Warsh: The financial crisis may have first manifested itself on U.S. shores, but it was, properly understood, a global crisis. And even to this day, funding costs for stronger...