Understanding US Fiscal Problems: A Comprehensive Analysis

1. US Fiscal ProblemsJeffrey FrankelHarpel Professor of Capital Formation and GrowthHarvard Kennedy School CEO/WPO Presidents’ Seminar Harvard Business School January 29, 2013

2. 3 different US fiscal problems • The long-term debt problem, • dominated by rapid growth in entitlements,without tax revenues to pay for them. • The short/medium term problem: severe recessionin the aftermath of the 2007-08 financial crisis • called for demand stimulus; • which fiscal policy would have been suited to deliver, • far more so than monetary policy. • The short-term political problem: • A succession of artificial “cliffs” and shutdown deadlines.The US has mismanaged its finances as badly as Europe. • without excuse of 17 legislatures, just 2 deadlocked political parties.

3. National debt/GDP is the highest since WWII spike.Source: CBO,March 2012 The US has a long-term debt problem.

4. The US has a long-term 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 (unpredictably). • Definition of debt sustainability: • regardless the level of the debt, it is sustainable if the future debt/GDP ratio is forecast to fall indefinitely.

5. US long-term debt problem, continued Not sustainable

6. US long-term debt problem, continued • The problem is not short-term: • Far from tiring of absorbing ever-greater levels of US treasury securities, global investors continue happily to lend at record-low interest rates (2008-): • The US enjoys safe-haven status; the $ enjoys “exorbitant privilege.” • There is no fiscal crisis. The US is not Greece. • We just want to be sure not to become Greece in 20 years. • Indeed the federal budget deficit is coming down • from 10 % of GDP in 2009 to 7 % in 2012. • despite the continued weakness in the economy. • Recent steps will bring debt/GDP down over 2014-18. • 2011-13 $1.5 trillion in spending cuts • + $0.6 tr. 1/1/2013 tax “increase” (relative to having let all Bush tax cuts expire).

7. Debt/GDP will probably 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, as the January 2013 fiscal cliff would have. Center on Budget and Policy Priorities, Jan.9, 2013 http://www.cbpp.org/cms/index.cfm?fa=view&id=3885

8. US long-term debt problem, continued The debt problem is also “long-term” inthesense that we have known about it a long time. E.g., Ronald Reagan, on taking 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

9. Other advanced countries have the same long-term problem: Rich countries’ Debt/GDP is the highest since the WWII spike.

10. Historic Role Reversal:Public finances in Emerging Marketshave become much stronger since 2000 Historic Role Reversal:Public finances in Emerging Marketshave become much stronger since 2000 even while weakening in advanced economies. World Economic Outlook, IMF, April 2012

11. Country creditworthiness is now inter-shuffled “Advanced” countries (Formerly) “Developing” countries AAA Germany, UK Singapore, Hong Kong AA+ US, France AA Belgium Chile AA- Japan China A+ Korea A Malaysia, South Africa A- Brazil, Thailand, Botswana BBB+ Ireland, Italy, Spain BBB- Iceland Colombia, India BB+ Indonesia, Philippines BB Portugal Costa Rica, Jordan B Burkina Faso SD Greece S&P ratings, Feb.2012 updated 8/2012

12. 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]

13. 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.”)

14. 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.

15. 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

16. Cyclicality &Fiscal Policy: • The question “What is the right fiscal policy, Austerity or Stimulus?” is as foolish as the question “Should a driver turn west or east?” • It depends where he is in the road. • Sometimes west is the right answer, sometimes east. • “The boom, not the slump, is the right time for austerity at the Treasury.”- John Maynard Keynes (1937) Collected Writings

17. Another respect in which many EMs have improved their policies since the crises of the late-1990s:A shift from pro-cyclical fiscal policy to counter-cyclical • They took advantage of the 2002-07 boom to strengthen their budget positions, • allowing them to run deficits when the global recession hit in 2008-09. • Some examples: • China was able to respond with big stimulus. • Chile, Korea, Malaysia, Botswana, Indonesia.

18. Cyclicality of Fiscal Policy • During the same period when some EM governments finally learned counter-cyclical fiscal policy (2000-12) , many Advanced-Country politicians forgot how to do it. • Most conspicuously, Greece & other euro members failed to reduce budget deficits during years of growth, 2001-08 • and were then forced to cut spending & raise taxes during the euro debt crisis of 2010-12, • exacerbating recessions, even raising Debt/GDP. • But the United Kingdom did the same, • despite no euro-constraint forcing austerity in 2010-12.

19. 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 2010-12. SGP floor Source: IMF, 2011.I. Diwan, PED401, Oct. 2011

20. Some US politicians have pursued pro-cyclical (i.e., destabilizing) fiscal policy1st cycle: Recession: austerity. Boom: profligacy. • 1988: As the economy neared the peak of the business cycle, candidate George H.W. Bush was unconcerned about budget deficits: • “Read my lips, no new taxes.” • 1980-81:Reagan’sspeeches pledging action to reduce the national debt “beginning today” came during a period of severe recession.

21. Some US politicians have sought pro-cyclical fiscal policy, continued2nd cycle Recession: austerity. Boom: profligacy. • 1993-2000: Despite the most robust recovery in US history, • 1993: all Republican congressmen voted against Clinton’s legislation to continue PAYGO etc. • 2000: Even after 7 years of strong growth, with unemployment < 4%, George W. Bush campaigned on a platform of tax cuts. • 2003: Afterhisfiscal expansionhad turned the inherited surpluses into deficits, GWB went for a 2nd round of tax cuts & continued a spending growth rate 3 x Clinton’s. • VP Cheney: “Reagan proved that deficits don’t matter.” 1990: Predictably, the first President Bush summoned the politicalwill to raise taxes & rein in spending (PAYGO) at precisely the wrong moment -- just as the US entered another recession.

22. Some US politicians have sought pro-cyclical fiscal policy, continued3rd cycle Recession: austerity. • 2007-09: Predictably, when the new worst recession since the Great Depression hit, Republican congressmen suddenly re-discovered the evil of deficits, deciding that retrenchment was urgent. • They opposed Obama’s initial fiscal stimulus in February 2009. • 2011: Subsequently, with a majority in the House, they blocked further efforts by Obama when the stimulus ran out, despite still-high unemployment.

23. Thus, through 3 cycles, the efforts at tightening came during recessions, followed by fiscal expansionwhen the economy was already expanding.

24. Why do leaders fail to take advantage of booms 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 periods of expansion, rationalizing the failure to act.

25. Failure to take advantage of booms to strengthen the budget, continued • Budget balance rules are in fashion. • EU: SGP, Debt brake, Fiscal compact. • US: State budget limits; Debt ceiling, Proposed Balanced Budget Amendment. • But 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. • The US has its own version of biased forecasts.

26. Failure to strengthen the budget in booms,continued Official US forecasts in the 2000s • White House forecasts were over-optimistic all along. • OMB in Jan. 2001 forecast rapid rise in tax revenue, • in effect assuming there would never be a recession. • Four tricksto justify tax cuts, dating from the 1980s: • The Magic Asterisk • Rosy Scenario • Laffer Hypothesis • Starve the Beast Hypothesis • Congressional Budget Office forecasts are honest. • But the Bush Administration adopted new tricks, • so that “current-law budget” would show future surpluses: • continuation of Iraq & Afghan wars treated as a surprise each year • phony sun-setting of tax cuts…

27. Where are we now, in January 2013? • 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 ?

28. Repeated partisan stand-offs in Congresshave each ended by “kicking the can down the road.” In the summer of 2011, “fiscal conservatives” at 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 at the end of 2012 risked fiscal contraction sharp enough to cause a new recession.

29. Repeated partisan stand-offs, continued More self-inflicted deadlines coming up: Mar. 1: Postponed sequestration of discretionary spending hits $1.2 tr. over decade, ½ defense, ½ domestic. Mar.27: Government shutdown, unless Congress passes Continuing Resolution (like 1995). Apr.15: Both houses supposed to pass budget resolutions, to allow: May 18(+): New debt ceiling, postponed from January 23, 2013. Grounds for hope: each time, the hostage-takers lose a little more credibility.

30. The game of “Chicken” In the 1955 movie Rebel Without a Cause, whoever jumps out of his car first supposedly “loses” the game. James Dean does; but the other guy miscalculates and goes over the cliff. . I think the Republicans miscalculated,in part because they asked for something impossible.

31. How far can we get by cutting spending? Totalfederalspending = $3½ trillionin round numbers. That spending minus tax revenue leaves a budget deficit of $1.1 trillion in FY 2012, down from $1.4 trillion in 2009. Most Republican congressmen want to cut only non-defense discretionary spending, to exempt defense & senior-related spending(Soc. Security & Medicare).  That was their official platform in the 2010 election. How much would we have to trim non-defense discretionary spending to balance the budget?

32. 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 farming, 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!

33. 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

34. 3 biggest spending categories:Health, Social security, & Defense { Medicare & medicaid Concord Coalition. Data Source: CBO, Jan. 2012

35. 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

36. 12 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 legacy of the last decade — 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.

37. 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 switch to, and “tax expenditures” to cut. If there were no political constraints…

38. 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 • Cut National Guard, Reserves, & unwanted bases • Cut unwanted weapons systems • A rare success: the F22 Raptor fighter. Now 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 billion)

39. 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… • 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

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

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

42. Social security Raise retirement age – just a little, perhaps exempting low-income workers. Progressively index future benefit growth to inflation. Optional 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. 42

43. 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 protection from malpractice litigation. Curtail corporate tax-deductibility of health insurance, especially gold-plated. 43

44. http://ksghome.harvard.edu/~jfrankel/Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/ Background writings by Jeffrey Frankel on fiscal policy: • On Graduation from Fiscal Procyclicality,” 2013, with C.Végh & G.Vuletin, J. Developmt. Econ. Summarized in "Fiscal Policy in Developing Countries: Escape from Procyclicality," Vox.eu, 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. • "Small Countries, Big Ideas," Business Economics(National Association of Business Economists), April 2012. • “A Lesson From the South for Fiscal Policy in the US and Other Advanced Countries,” Comparative Economic Studies. 53, no.3, Sept. 2011. • “Snake-Oil Tax Cuts,” 2008, EPI, Briefing Paper 221. HKS RWP 08-056 Google “Jeffrey Frankel Harvard” for webpage or blog http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/