Senior Executive Fellows, February 25, 2014

1. Fiscal Policy:Austerity vs. StimulusJeffrey FrankelHarpel Professor of Capital Formation and Growth Senior Executive Fellows, February 25, 2014

2. Austerity vs. Stimulus Definitions • Fiscal austerity or contraction: • cut government spending or raise taxes, • raising budget surplus (or reducing budget deficit), • to avoid overheating the economy • & strengthen long-run debt sustainability. (Deficit = Δ debt). • Fiscal stimulus or expansion: • Raise government spending or cut taxes • to provide short-term economic stimulus, • for growth & employment.

3. Austerity vs. Stimulus, continued • “What is the best fiscal policy, Austerity or Stimulus?” • The question is as foolish as the question, “Should a driver turn leftorright?” • It depends where he is in the road. • Sometimes left is the answer, sometimes right.

4. Cyclicality of Fiscal Policy • Keynes favored counter-cyclical policy: • fiscal stimulus when under conditions like the1930s -- depressed income, high unemployment, low inflation, low interest rates – to moderate the downturn, • But fiscal contraction during boom periods, to prevent over-heating. • The boom, not the slump, is the right time for austerity at the Treasury.”- John Maynard Keynes (1937) Collected Writings

5. Cyclicality of Fiscal Policy,continued • Keynesian policy (“fine tuning”) fell into disfavor in part because it was hard to get the timing right: • by the time fiscal stimulus became law, the recession would be over, • e.g., the Kennedy tax cut, • passed in1964. • But that is no excuse for pro-cyclical fiscal policy. • Definition of pro-cyclical fiscal policy: Governments raise spending (or cut taxes) in booms; and are then forced to retrench in downturns, thereby exacerbating upswings & downswings.

6. Cyclicality of Fiscal Policy,continued • During the decade after 2000, • some Emerging Market governments learned how to do counter-cyclical fiscal policy, • while many Advanced Country politicians forgot, • turning pro-cyclical instead, • exacerbating the business cycle.

7. Since 2008 recession, advanced countries have cut spending,relative to past recoveries; EMs have raised spending (having been relatively more conservative before 2008) World Economic Outlook (WEO)Hopes, Realities, and Risks IMF, April 2013

8. Cyclicality of Fiscal Policy,continued • Conspicuously, Greece & other euro members failed to reduce budget deficits during yearsofgrowth, 2002-08 • and were then forced to cutspending & raisetaxes during the euro debt crisis of 2010-12, • exacerbating their recessions, • & even raising Debt/GDP. • But the United Kingdom did the same, • despite no euro-constraint forcing austerity in 2010-12. • And so did the United States !

9. Why do leaders fail to take advantage of boom times to strengthen the budget? • People don’t see the need to “fix the hole in the roof when the sun is shining.” • They do see the mistake when the storm hits, • but then it is too late. • Official forecasts are over-optimistic in boom periods, rationalizing the failure to act • according to data from 33 countries.

10. Ratio of public debt to GDP among advanced countriesis the highest since the end of WW II Source: Carlo Cotarelli “Making Goldilocks Happy,” IMF, Apr. 20, 2012

11. Greece let its deficit rise during the growth years, 2001-08,despite the 3% of GDP limit set by the Stability & Growth Pact & then was forced into sharp austerity in 2010-13. SGP floor Source: IMF, 2011.I. Diwan, PED401, Oct. 2011

12. Many leaders in advanced economies ignored the lessons of past crises. • They thought debt crises could never happen to them -- • most notably, leaders of euroland, • even after the periphery countriesviolated the deficit & debt ceilings of Maastricht and the SGP; • and even after the Greek crisis hit in late 2009 .

13. But Reinhart & Rogoff remind us: sovereign default is an old story, including among advanced countries –This Time is Different, updated in “From Financial Crash to Debt Crisis,” 2010 Sovereign External Debt: 1800-2009 Percent of Countries in Default or Restructuring 1930s 50%- 1870s 1830s 1980s Note: Sample size includes all countries, out of a total of sixty six, that were independent states in the given year. Sources: Lindert & Morton (1989), Macdonald (2003), Purcell & Kaufman (1993), Reinhart, Rogoff & Savastano (2003), Suter (1992), and Standard & Poor’s (various years).

14. European Debt/GDP ratios have risen more since 2008,as high interest rates & declining GDP overpower progress on reduction of primary budget deficits. Via: World Bank, PREM, 2012

15. As one could have predicted,fiscal contraction is contractionary: fall in GDP is worse Source: P.Krugman, 10 May 2012, via R.Portes, May 2013.

16. Budget balance rules are in fashion. • Fiscal rules have been adopted by many countries. • Do they help? • Europe’s rules have failed (BD < 3% GDP; Debt < 60% GDP) • Maastricht Criteria & Stability & Growth Pact • Angela Merkel’s Fiscal Compact may be no better. • Such rules do not work in the US either: • Gramm-Rudman-Hollings in late 1980s • Debt ceiling legislation • Why?

17. “Tough” rules like the SGP or BBA are too rigid. requiring fiscalcontraction whentheeconomy isweak. They also lack enforceability: Every Euro country violated the SGP. They worsen the problem of over-optimistic forecasts. E.g., when euro members go above the 3% deficit ceiling, they adjust their forecasts, not their policies. Better would be “structural” budget targets (Swiss) with forecasts from independent experts (Chile).

18. Threedistinct US fiscalproblems • The long-term debt problem • The medium-term economic problem • The short-term political problem

19. Three distinct US fiscal problems • The long-term problem -- debt unsustainability • warrants a path back to fiscal discipline. • The medium-term economic problem -- slow recovery in aftermath of the 2007-08 financial crisis, • has warranted demand stimulus, • not contraction, • which held back growth, 2011-13. • The short-term problem has been political: • Succession of artificial deadlines, threatening disaster. • Debt ceilings, fiscal cliff, sequester & shutdown.

20. Fiscal policy The US does have a long-term debt problem.. Not sustainable Source: Concord Coalition, spring 2013 http://www.concordcoalition.org/issues/indicators/projected-debt

21. The long-term US debt problem, continued • “Long-term” in the sense that debt/GDP will rise alarmingly after the 2020s • unless entitlements are put on a sound footing: • Social Security & Medicare are due to run big deficits • as the baby-boomers retire (predictably) • and the cost of health care rises rapidly (less predictably). • Definition of debt sustainability: • regardless the level of the debt, it is sustainable if the future debt/GDP ratio is forecast to fall indefinitely.

22. Long-term debt problem, continued • There is not a short-term problem: • Far from tiring of absorbing ever-greater levels of US treasury securities, global investors continue happily to lend at record-low interest rates (2008-13): • The US enjoys safe-haven status; the $ enjoys “exorbitant privilege.” • There is no fiscal crisis. The US is not Greece, • though we want to be sure not to become Greece in 20 years. • Indeed the federal budget deficit is now coming down • from 9 % of GDP in FY 2009 to 4 % in FY 2013.

23. The evolution of projected future US Debt/GDP ratios Still out there: Coming big deficits in Social Security & Medicare Sequester & other spending cuts: Recession +extension of most Bush tax cuts Phony assumption that Bush tax cuts would disappear after 2010: Data: Congressional Budget Office. Source: How Much Room for Improvement in Long-Term Budget Projections? GoldmanSachs GlobalMacroResearch 1/30/2014

24. The budget deficit is currently on a declining path. Spending cuts: Recession + extension of most Bush tax cuts: “The Rapidly Shrinking Federal Deficit” Goldman Sachs Global Economics, Commodities & Strategy Research (Hatzius), Apr.10, 2013

25. Debt /GDP is set to decline over 2014 -18. • CBPP recommends a further $1.2 tr. in spending cuts & tax rises to stabilize debt out to 2022. • But there is no need for it to hit this year. That would send us back into recession. Center on Budget and Policy Priorities, Jan.9, 2013 http://www.cbpp.org/cms/index.cfm?fa=view&id=3885

26. Long-term debt problem, continued The debt problem is also “long-term” inthesense that we have known about it a long time. E.g., when Ronald Reagan, took office: "For decades we have piled deficit upon deficit, mortgaging our future and our children's future for the temporary convenience of the present… We must act today in order to preserve tomorrow. And let there be no misunderstanding: We are going to begin to act, beginning today.” • Inaugural address, Jan. 20, 1981

27. The US public discussion is framed as a battle between conservatives who philosophically believe in strong budgets & small government, and liberals who do not.Democrats, Republicans, & the media all use this language. (1) The right goal should be budgets that allow surpluses in booms and deficits in recession. (2) The correlation between how loudly an American politician proclaims a belief in fiscal conservatism and how likely he is to take genuine policy steps < 0. [1] Never mind that small government is classically supposed to be the aim of “liberals,” in the 19th century definition, not “conservatives.” My point is different: those who call themselves conservatives in practice tend to adopt policies that are the opposite of fiscal conservatism. I call them “illiberal.” “Republican & Democratic Presidents Have Switched Economic Policies”Milken Inst.Rev.2003. It is not the right way to characterize the debate. [1]

28. BriefUSfiscalhistory: The1980s The newlyelected Reagan complainedof the inheriteddebt: “Our national debt is approaching $1 trillion. …A trillion dollars would be a stack of 1,000-$ bills 67 miles high.” address to Congress, Feb. 18, 1981. Reagan’s actions: sharp tax cuts& rise in defense spending. The claim: budget surpluses would result. The reality: record deficits that added to the national debt a 2nd trillion in his 1st term a 3rd trillion in his 2nd term a 4th trillion when G.H.W. Bush initially continued the policies. (“Read my lips, no new taxes.”)

29. US fiscal history,continued: The 1990s The deficits were gradually cut, and then converted to surpluses by the end of the 1990s. How was this accomplished? Regime of “Shared Sacrifice” -- 3 key policy events. 1990: GHWBushbravelyagreed spendingcaps, taxes&PAYGO 1993: Clinton extended the policy. 1998: As surpluses emerged, “SaveSocialSecurity 1st.” Strong growth in late 1990s.

30. Fiscal history,continued: The 2000s The Shared Sacrifice regime ended on the day G.W. Bush took office in Jan. 2001. He returned to the Reagan policies: Large tax cuts together with rapid increase in spending(triple Clinton’s) not just in military spending (esp. Iraq & Afghanistan), but also domestic spending: discretionary + Medicare drugs benefit. Just like Reagan, he claimed budget surpluses would result. Just like Reagan, the result was record deficits: The national debt doubled. I.e., GWB incurred more debt than his father + Reagan + 39 predecessors

31. Where are we now? • The political crisis: • repeated partisan standoffs in Congress. • To reduce the budget deficit: • how far can we get by discretionary spending cuts? • Where are the right places to squeeze, • politics aside ?

32. Repeated partisan stand-offs in Congress In the summer of 2011, Congressat first refused the usual debt ceiling increase, recklessly threatening government default. Political dysfunction led S&P to downgrade US bonds from AAA. “Fiscal cliff” deadline, Jan. 1, 2013. Sequestration into effect March 1, 2013 Government shutdown, Oct. 1-16, 2013 Debt ceiling, Oct.17, 2013.

33. The game of “Chicken” In the 1955 movie Rebel WithoutaCause, whoever jumps out of his car first supposedly “loses” the game. James Dean does; but the other guy miscalculates and goes over the cliff. . The Republicans may have miscalculated.

34. How far can we get by cutting spending? Totalfederalspending = $3½ trillionin round numbers. That spending minus tax revenue left a budget deficit of $1.1 trillion in FY 2012, down from $1.4 trillion in 2009. Many Republican congressmen have campaigned to cut only non-defense discretionary spending, to exempt defense & senior-related spending(Soc. Security & Medicare). And adamantly no tax increase.  How much would we have to trim non-defense discretionary spending to balance the budget?

35. How far can we get by cutting spending?continued Start by eliminating PBS funding =1/10,000 of spending Then all foreign aid.  = 1 ½ % of total outlays, not 25% as Americans think.  Next, veterans’ benefits. The same. We are now up to a total of 3 % of outlays. Next imagine zeroing out all federal spending on agriculture, science & environment, education & transportation,   which includes programs too popular for congressmen to vote for.    That is a total of $364 b = 1/3 of the 2012 deficit.  Conclusion: Domestic discretionary spending is not where the big bucks are. Would would also need to eliminate either all of defense, or all medicare payments or all social security payments while still collecting the social security taxes that are supposed to pay for it!

36. Eliminating all non-defense discretionary spending(including also parks, weather service, food safety, SEC, FBI, border patrol, politicians’ salaries… everything !)would not come close to eliminating the budget deficit $92 b Total ≈½ deficit $86 b $61 b $59 b $56 b $35 b $30 b $17 b $6 b Concord Coalition. Data Source: CBO, Jan.2012

37. 3 biggest spending categories:Health, Social security, & Defense { Medicare & medicaid Concord Coalition. Data Source: CBO, Jan. 2012

38. Breakdown of federal spending Even if one could somehow eliminate all domestic spending, it would not come close to eliminating the deficit Budget deficit was $1.1 trillion in FY 2012 Outlays: $3.5 trillion Deficit $1.1 tr. Tax revenue $2.5 tr. Concord Coalition. Data Source: CBO, Jan. 2012 Updated: http://cbo.gov/sites/default/files/cbofiles/attachments/2012_09_MBR.pdf

39. 13 years ago, if the country thought it important enough to protect any single category against belt-tightening in the long run -- say military or social security or tax cuts for the rich -- it would have been arithmetically possible, by making the cuts elsewhere. But we no longer have the luxury of such choices — after the effects of mammoth tax cuts (2001 & 2003), two wars (2001, 2003), the Medicare prescription drug benefit (2003), and the severe financial crisis & recession (2008). Starting from our current position, each of the 5 components must play a role, along with taxes.

40. What steps should be taken today to lock in future fiscal consolidation? Not by raising taxes or cutting spending today(new recession); nor by promising to do so in a year or two(not credible). There are lots of economically sensible proposals for spending to eliminate over time, more efficient taxes to phase in, and “tax expenditures” to phase out. If there were no political constraints…

41. How to reduce the budget deficit The only way to do this is both reduce spending & raise tax revenue, as we did in the 1990s. • Spending. Examples: • Eliminate agricultural subsidies. • Cut manned space program. • Trim National Guard & Reserves, • Close unwanted military bases • Cut unwanted weapons systems • A rare success: the F22 Raptor fighter. F-35 Joint Strike Fighter? ($600b/10 yrs.) • Global Hawk Block 30 drone program? • The C-27J Spartan cargo aircraft? • Upgrades to the M1 Abrams tank • Virginia-class submarine? ($2.6 b)

42. How to reduce the budget deficit The only way is both reduce spending & raise tax revenue, continued. • Tax revenue options • We could have let G.W. Bush’s tax cuts expire in 2013. • Can still curtail expensive&distorting“taxexpenditures” • E.g., Tax-deductibility of mortgage interest, • & of health insurance • Subsidies to oil industry, low tax rate on carried interest, … • Or launch more ambitious tax reform: • Introduce a VAT, sales, or consumption tax • or phase in an energy or carbon tax • or auctioning of tradable emission permits

43. Distortionary subsidies hiding as tax expenditures $128 b $305 billion $93 b $84 b Joint Committee of Taxation, Jan. 2012

44. The long-term problem is entitlements Concord Coalition. Data Source: CBO, Jan. 2012

45. Social security Raise retirement age – just a little, perhaps exempting low-income workers. Index benefit growth to chain measure of inflation. Further options: To please Democrats: Raise the cap on social security taxes. To please Republicans: encourage private accounts though they contribute nothing to closing the gap. 45

46. Health care Encourage hospitals to standardize around best-practice medicine. Pay health providers for “value,” not per medical procedure. Standardize around best-practice treatment: evidence-based (to be facilitated by electronic health records). E.g., pursue the checklist that minimizes patient infections, and avoid unnecessary medical tests & procedures. That is not “death panels.” Levers to get providers to follow best practices: make Medicare payments conditional or offer protection from malpractice litigation. Curtail corporate tax-deductibility of health insurance. 46

47. http://ksghome.harvard.edu/~jfrankel/Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/ Writings by Jeffrey Frankel on fiscal policy: • On Graduation from Fiscal Procyclicality,” 2013, with C.Végh & G.Vuletin, J. Developmt. Econ. Summary: "Fiscal Policy in Developing Countries: Escape from Procyclicality," VoxEU, 2011. NBER WP 17619. • "Over-optimism in Forecasts by Official Budget Agencies and Its Implications," Oxford Review of Econ. PolicyVol.27,Issue 4, 2011, 536-62. NBER WP 17239; Summary in NBER Digest, Nov.2011. • “Snake-Oil Tax Cuts,” 2008, EPI, Briefing Paper 221. HKS RWP 08-056. • "Responding to Crises,"Cato Journalvol.27, no. 2, Spring/Summer, 2007. • “Republican and Democratic Presidents Have Switched Economic Policies,”Milken Institute Review 5, no. 1, 2003 QI. Google “Jeffrey Frankel Harvard” for webpage or blog http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/

48. Appendices 1: More on the US - a) The long-term fiscal outlook - b) Did the 2009 fiscal stimulus work? - c) Procyclical politicians 2: More on EMs / Developing Countries

49. Appendix 1(a): The long-run US fiscal outlookThe budget deficit, though falling now, may resume rising after 2015 if interest rates revert to normal. US Economics Analyst: 14/07 - Fiscal Policy: Back to “Normal” (Phillips), Global Sachs Global Macro Research 2/14/14

50. The trajectory of health care costshas unexpectedly declined over the last 5 years. US Economics Analyst: 14/07 - Fiscal Policy: Back to “Normal” (Phillips), Global Sachs Global Macro Research 2/14/14