My preceding post bemoaned the tendency for many US politicians to exhibit a procyclicalist pattern: supporting tax cuts and spending increases when the economy is booming, which should be the time to save money for a rainy day, and then re-discovering the evils of budget deficits only in times of recession, thus supporting fiscal contraction at precisely the wrong time. Procyclicalists exacerbate the magnitude of the swings in the business cycle. This is not just an American problem. A similar unfortunate cycle — large fiscal deficits when the economy is already expanding anyway, followed by fiscal contraction in response to a recession — has also been visible in the United Kingdom and euroland in recent years. Greece and Portugal are the two most infamous examples. But the larger European countries, as well, failed to take advantage of the expansionary period 2003-07 to strengthen their public finances, and instead ran budget deficits in excess of the limits (3% of GDP) that they were supposed to obey under the Stability and Growth Pact. Then, over the last few years, politicians in both the UK and the continent have made their recessions worse by imposing aggressive fiscal austerity at precisely the wrong time. Historically, developing countries used to be the ones where dysfunctional political systems produced procyclical fiscal policies. Almost all of them showed a positive correlation between government spending and the business cycle during the period 1960-1999. But things have changed. Remarkably, during the decade 2000-2010, about a third of emerging market governments - in countries such as China, Chile, Malaysia, Korea, Botswana, and Indonesia - managed to reverse the historical correlation. They took advantage of the boom years 2003-2007 to strengthen their budget positions, saving up for a rainy day. They were thus in a good position to ease up when the global recession hit them in 2008-09. In fact a majority of the governments that have followed countercyclical spending policies since 2000 are in emerging market or developing countries. They figured out how to achieve countercyclicality during the last decade, precisely the decade when so many politicians in “advanced countries” forgot how to.
Archive for the ‘budget’ Category
The world is in the grip of a debate between fiscal austerity and fiscal stimulus. Opponents of austerity worry about contractionary effects on the economy. Opponents of stimulus worry about indebtedness and moral hazard.
Is austerity good or bad? It is as foolish to debate this proposition as it would be to debate whether it is better for a driver to turn left or right. It depends where the car is on the road. Sometimes left is appropriate, sometimes right. When an economy is in a boom, the government should run a surplus; other times, when in recession, it should run a deficit.
True, it is hard for politicians to get the timing of countercyclical fiscal policy exactly right. This is the reason, more than any other, why Keynesian policy lost its luster. “Fine-tuning” it was called. Sometimes the fiscal stimulus would kick in after the recession was already over.
But this is no reason to follow a pro-cyclical fiscal policy. A procyclical fiscal policy piles on the spending and tax cuts on top of booms, but reduces spending and raises taxes in response to downturns. Budgetary profligacy during expansion; austerity in recessions. Procyclical fiscal policy is destabilizing, because it worsens the dangers of overheating, inflation, and asset bubbles during the booms and exacerbates the losses in output and employment during the recessions. In other words, a procyclical fiscal policy magnifies the severity of the business cycle.
Yet many politicians in the United States, the United Kingdom, and the eurozone seem to live by procyclicality. They argue against fiscal discipline when the economy is strong, only to become deficit hawks when the economy is weak. Exactly backwards.
Consider the positions taken over the last three decades by some American politicians.
First cycle: During a recessionary period, President Ronald Reagan in his 1980 campaign and in his 1981 Inaugural Address urged immediate action to reduce the national debt “beginning today.” (Recession: austerity.) But in 1988, as the economy approached the peak of the business cycle, candidate George H.W. Bush was unconcerned about budget deficits, even though the national debt was rapidly approaching three times the level it had been when Reagan had given his speeches. “Read my lips, no new taxes,” Bush famously said. (Boom: profligacy.)
Second cycle: Predictably, the first President Bush and the Congress finally summoned the political will to raise taxes and rein in spending growth at precisely the wrong moment, that is, just as the US was entering another recession in 1990. (Recession: austerity.) Although the timing of the legislation was poor, the action was courageous. The Pay as You Go Rule and other reforms switched government finances back onto a path that eventually was to eliminate the deficits by the end of the decade.
But three years later — and even though the most robust recovery in American history had begun — every Republican congressman voted against Clinton’s 1993 legislation to continue Bush’s spending caps, PAYGO, and tax increases. Nor did they change their minds in response to the subsequent success of the policy. Even after seven years of strong growth, with unemployment at the peak of the business cycle dipping below 4% for the first time since the 1960s, George W. Bush based his 2000 campaign on a platform of large long-term tax cuts. (Boom: profligacy.)
Third cycle: Even after the Bush fiscal expansion had turned the inherited record budget surpluses into record deficits, the Administration went for a 2nd round of tax cuts in 2003, and continued a rate of growth of spending that was triple the rate under Clinton (both national security and domestic spending). Vice President Richard Cheney said “Reagan proved that deficits don’t matter.” These policies were maintained for five more years, as another $ four trillion was added to the national debt. (Boom: profligacy.)
Predictably, when the worst recession since the Great Depression hit in 2007-09, politicians felt constrained from an adequate fiscal response due to the big deficits and debts the government had already been running. Republicans suddenly re-discovered the evil of budget deficits and decided that retrenchment was urgent. They opposed Obama’s initial fiscal stimulus in February 2009, even though GDP growth and employment were much worse than they had been when Reagan and Bush had launched their tax cuts and spending increases. (Recession: austerity.) Subsequently, with a new majority in the House, they succeeded in blocking further efforts by Obama when the stimulus ran out in 2011. The government spending cutbacks of the last two years are the most important reason, in my view, why the economic recovery which began in June 2009 subsequently stalled in 2011.
Three cycles. Three generations of politicians who favored expansionary fiscal policies during a boom and then decided after a recession had hit that budget deficits were bad after all. (See the graph below.)
This is not to say that the procyclicalist politicians have always succeeded in getting their policies adopted. Clinton had a strong enough congressional majority in August 1993 that he was able to pass his budget balancing legislation (Omnibus Budget Reconciliation Act) — even though every Republican in Congress voted “no” at a time when the economy was expanding. Similarly, Obama had a strong enough majority in January 2009 that he was able to pass some initial fiscal stimulus (the American Recovery and Reinvestment Act), without a single Republican vote, at a time when the economy was in freefall. But too often the countercyclicalists are overpowered by the procyclicalists.
Trying to turn left or right at precisely the wrong points in the road is a worse record than one would get by switching policies randomly. To explain this perverse pattern, let us switch metaphors in mid-stream. It is the old problem of needing to fix the hole in the roof when the sun is shining, rather than waiting for a storm to realize that it is necessary. When the economy is booming, there is no political support for painful spending cuts or tax increases. After all, everything seems fine; why make a change? Then when the deluge comes, sinners suddenly see the evils of their ways and proclaim the necessity of reforming. Of course it is very difficult to fix the roof in the middle of a thunderstorm.
Procyclical Politicians: Support for fiscal contraction (down-arrows) and fiscal expansion (up-arrows)
Any solution to the euro crisis must meet two objectives. One is short run and the other is long run. Unfortunately they tend to conflict.
The first necessary objective is to put Greece, Portugal, and other troubled countries back on a sustainable debt path, defined as a long-term trajectory where the ratio of debt to GDP is declining rather than rising. Austerity won’t restore debt sustainability. It has raised debt/GDP ratios, not lowered them. A write-down would do it. New bigger bail-outs might too, or might not. But either write-downs or bailouts would then create moral hazard and thus make even it even harder to satisfy the second necessary objective.
That second objective is to reform the system so as to make it less likely that similar debt crises will recur anew in the future. Fiscal rectitude in the long run is indeed the way to accomplish this. But it is hard to commit today to fiscal rectitude in the future. Rules to cap debt such as the Maastricht fiscal criteria, “no bailout” clause and Stability and Growth Pact (SGP) didn’t work because they were not enforceable.
Eurobonds could be part of the solution, if designed properly to take into account fiscal fundamentals, both short term and long term. These are defined as government bonds that would be the liability of euroland in the aggregate.
The creation of a standardized Eurobond market would bring a boost to help a reform plan come together, badly needed in light of the damage that years of failed European summits have done to official credibility. That boost is the latent global portfolio demand for a good eurobond.
Even when the euro was at the height of its success five years ago, its international currency status suffered from lack of a counterpart to the US Treasury bill market, a deep, liquid, standardized market in low-risk bonds. Bonds are issued by the 17 member governments. This fragmentation has hindered European financial integration and impeded any bid by the euro to rival the US dollar as international reserve currency. Central banks in China and other big developing countries are still desperate for an alternative form in which to hold their foreign exchange reserves – an alternative to holding US government securities, that is. US Treasury bills pay extremely low interest rates, and the value of the dollar has been on a negative downward trend for 40 years (ever since President Richard Nixon took the dollar off gold and devalued in 1971). Despite all of Europe’s problems, a Eurobond would be attractive to central bankers and other portfolio investors around the world, both to achieve higher expected returns than on US treasury bills and to diversify risk.
But that latent global demand for Eurobonds will not come to the table unless they are by design backed up with solid economic and political fundamentals.
Germany opposes Eurobonds on the sensible grounds that if individual national governments were allowed to issue them freely, the knowledge that somebody else was paying the bill would make the incentive for member countries to spend beyond their means worse than ever. This version of Eurobonds would be bound to fail, both economically and politically. This seems to be the version that some opponents of austerity have in mind, such as the new French president, François Hollande, though it is hard to tell.
A different version of the Eurobond proposal has recently begun to gain traction in Germany. The German Council of Economic Experts - usually called “wisemen,” although the council includes a woman — proposed last year a European Redemption Fund (hence yet another new acronym, ERF). The plan would convert into defacto Eurobonds the existing debt of (approved) member nations in excess of 60% of GDP, the supposed threshold specified in the Maastricht and SGP criteria. The ERF bonds would then be paid off over 25 years. Steps toward this proposed solution to the short-term debt problem would be paired - politically and logically - with approval of the Fiscal Compact, Angela Merkel’s proposed solution to the long-term problem.
But this seems upside down. Yes, any solution to save the euro will have to ask German taxpayers to put still more money on the line. But to use Eurobonds as the mechanism for eliminating the big debt overhang looks like the nail in the coffin of the longer term moral hazard objective. It offers absolution precisely on the margin where countries in the future will in any case have the most trouble resisting the temptation to sin again, the margin where they cross the 60% threshold.
If the Fiscal Compact or proposed “debt brakes” could be relied on as a firm constraint on future behavior, then fine. But there is little reason to believe that they could, especially after confirmation of the precedent that individual spendthrifts are relieved of their excess debt burdens.
The new Fiscal Compact is unlikely to succeed where the Maastricht criteria failed, the “no bailout” clause failed, and the SGP failed. It is less credible that excessive deficits will be punished than it was three years ago - and it wasn’t credible even then. Rules don’t work without some enforcement mechanism. The problem with the SGP wasn’t that it wasn’t written strictly enough or even that it wasn’t incorporated into the constitutions of the member countries as the Fiscal Compact would have it. The problem with the SGP was that no matter how many times a member government’s deficit or debt exceeded the specified limit, the country’s officials could say (often sincerely) that the gap was the fault of unexpected circumstances such as slow growth and low tax receipts and that they expected to do better next time. Even if some court in Brussels or Frankfurt were given life-and-death power to enforce the rules, exactly which officials would it punish for violations, and how? No version of the SGP or Fiscal Compact or debt brake proposals has ever provided a satisfactory answer to that question.
Hope by some Europeans that the Fiscal Compact would finally make enforcement credible by writing the constraints into the constitutions of member states might be based on misunderstanding of the US system. One can see the logic: The US federal government has never bailed out one of the 50 states and nobody expects it to do so in the future. How has the US solved the problem of moral hazard that so plagues euroland? The states have rules to limit deficit spending. That must be the answer ! (Well, 49 of the states have rules; these laws are voluntary on the part of the states, and Vermont does not have one). State laws are not the primary explanation for the absence of US moral hazard. The primary explanation is that the right precedent was set in 1841 when the federal government declined the opportunity to bail out 8 troubled states and let them default. Euro leaders should have done the same with Greece a year or two ago. A second (related) explanation for absence of moral hazard in the US federal system is that, ever since the 1840s, when American states start to run up questionable levels of debt the private market demands an interest rate premium to compensate for the default risk. The premium acts as an automatic disincentive to further profligacy. This mechanism should have operated after the euro was created in 1999, but it never did: Greece and the other high-borrowers were able to borrow at interest rates that — disturbingly – had fallen virtually to the same levels as German bunds.
The final explanation is that when citizens started to ask more from their public sectors governments in
the 20th century (defense, entitlement spending, etc.), the expansion in the case of the United States took place at the federal level, not the state level. For this reason even the fiscally most dysfunctional of the American states, which is probably California, does not operate on a scale remotely like European national governments. US federal spending is 24% of GDP versus an EU budget of 1.2% of GDP. Europeans are not ready to transfer most spending and taxation from the national to the federal level. And even if they decide some day that they are ready, if the bailout precedent still stands then this federalization will not solve the moral hazard problem regarding the spending that remains at the national level.
The version of Eurobonds that might work is almost the reverse of the Germans’ Redemption Fund proposal. It goes under the more colorful name of “blue bonds,” originally proposed two years ago by Jacques Delpla and Jakob von Weizäcker at the think tank Bruegel. Under this plan, only debt issued by national authorities below the 60% criteria could receive eurozone backing, be declared senior, and effectively become Eurobonds. These are the “blue bonds” that would be viewed as safe by investors. When a country issued debt above the 60% threshold, the resulting junior “red bonds” would lose eurozone backing. The individual member state would be liable for them. This proposal structures the incentives “right side up.”
The blue bonds proposal has been extensively debated in Europe. As usual in such controversies, many participants in the euro debate fixate on one evil or the other –moral hazard or austerity — and fail to grapple with practical proposals to balance the two.
As I see the plan, the private markets could make the judgment as to whether a country was in the process of crossing the threshold, even before the final statistics were available, and therefore assess whether default risk on the new red bonds required an interest rate premium. If private investors judged that the new debt had genuinely been incurred in temporary circumstances beyond the government’s control (say a weather disaster), then they would not impose a large interest rate penalty. Otherwise, the sovereign risk premium mechanism would operate on the red bonds, much as it does among American states, and much as it did in Italy, Greece and the others before they joined the euro. Similarly, if the ECB after 2000 had operated under a rule prohibiting it from accepting as collateral the debt of SGP-noncompliant countries, the resulting default risk premum might possibly have headed off the entire euro sovereign debt problem early in the decade.
The point is that the red-bond mechanism would be truly automatic, as desired. Perhaps in ambiguous borderline cases the judgment whether a country had truly exceeded the limit, or whether it was still in good standing so that its debt qualified for eurobond status, would ultimately have to be made by a eurozone agency or court, with an inevitable lag. But, in the meantime, private investors could apply informed views about the merits from moment to moment. The resulting market interest rates would provide the missing discipline. Compliance would not rely on discretionary letters from Brussels bureaucrats, which have proven toothless no matter how many exclamation points are put at the end of their penalty threats. Nor would it require unenforceable debt ceilings legislated at the national level. The U.S. has one of those too. It has never had any effect, except on a very few occasions, when Congress has actively used the debt ceiling law to make everything worse.
Of course the euro countries cannot jump to a blue bond regime without first solving the problems of debt overhang and troubled banks that are front and center. Otherwise, in today’s world, the plan by itself would be destabilizing since it would put almost all countries immediately into the red. The debt paths that are currently unsustainable in many countries result from the combination of debt/GDP ratios that are already far in excess of 60%, combined with very high sovereign spreads and recessions. Relieving them of responsibility for debt up to 60% would be substantial assistance, but would not in itself restore sustainability to all members.
Thus Eurobonds are emphatically not the complete solution to these vexing problems. It is hard to say, at this late date, what the right short-term solutions are. In Greece’s case, it may be forced to default and to drop out of the euro. The banks and sovereigns in other countries will then have to be insulated from the conflagration through a combination of acronymic “bailout” money (EFSF, ESM, ECB…) and serious policy conditionality, as always. Creating this fire break between Greece and the heart of Europe would have been far easier two years ago, before debt/GDP levels and sovereign spreads climbed so high and before the credibility of the euro leaders sank so low, or even one year ago. Now the fire has spread over a much larger area and there are no natural gaps in sight for creating firebreaks.
But one thing seems clear. German taxpayers, whose longstanding fears that they would be asked to bail out profligate Mediterranean euro members have been proven correct, will not be happy when asked to put up still more money in the cause of European integration by the same elites whose assurances of the last 20 years have proven false. They will at a minimum need some credible reason to believe that future repetitions have been rendered unlikely, that the bailout is “just this once.” Official assurances do not constitute that credible reason. Nor does the Fiscal Compact, in itself. The red bonds / blue bonds scheme just might.
Why do so many countries so often wander far off the path of fiscal responsibility? Concern about budget deficits has become a burning political issue in the United States, has helped persuade the United Kingdom to enact stringent cuts despite a weak economy, and is the proximate cause of the Greek sovereign-debt crisis, which has grown to engulf the entire eurozone. Indeed, among industrialized countries, hardly a one is immune from fiscal woes.
Clearly, part of the blame lies with voters who don’t want to hear that budget discipline means cutting programs that matter to them, and with politicians who tell voters only what they want to hear. But another factor has attracted insufficient notice: systematically over-optimistic official forecasts.
Such forecasts underlie governments’ failure to take advantage of boom periods to strengthen their finances, including running budget surpluses. During the expansion of 2001-2007, for example, the US government made optimistic budget forecasts at each stage. These forecasts supported enacting big long-term tax cuts and accelerating growth in spending (both military and domestic). European countries behaved similarly, running up ever-higher debts. Predictably, when global recession hit in 2008, most countries had little or no “fiscal space” to implement countercyclical policy.
In most cases, the problems have long been plain for objective observers to see, but public officials kept their heads buried in the sand. Over the period 1986-2009, the bias in official U.S. deficit forecasts averaged 0.4 % of GDP at the one-year horizon, 1% at two years, and 3.1% at three years. Forecasting errors were particularly damaging during the past decade. The U.S. government in 2001-03, for example, was able to enact large tax cuts and accelerated spending measures by forecasting that budget surpluses would remain strong. The Office of Management and Budget long turned out optimistic budget forecasts, no matter how many times it was proven wrong. For eight years, it never stopped forecasting that the budget would return to surplus by 2011, even though virtually every independent forecast showed that deficits would continue into the new decade unabated.
How were American officials in the last decade able to make forecasts that departed so far from subsequent reality? In three sorts of ways. The first comes in the form of optimistic baseline macroeconomic assumptions such as a high and everlasting growth rate. OMB forecasts of economic growth were biased upward: by a huge 3.8% at the three-year horizon.
Second, some politicians argued that tax cuts were consistent with fiscal discipline by appealing to two fanciful theories: the Laffer Proposition, which says that cuts in tax rates will pay for themselves via higher economic activity, and the Starve the Beast Hypothesis, which says that tax cuts will increase the budget deficit but that this will put downward pressure on federal spending.
Sanguine macroeconomic assumptions will do the job in the context of OMB forecasts and fanciful theories about the effects of tax cuts can deliver the rosy scenarios of presidential speeches. But to get optimistic fiscal forecasts out of the Congressional Budget Office a third, more extreme, strategy was required. (In 2003, when some Lafferite congressmen tried to get CBO to say that “dynamic scoring” of the effects of tax rate cuts would show higher revenue, the estimates from the independent agency did not give the answer they wanted.)
To understand the third strategy, begin with the requirement that CBO’s baseline forecasts must take their tax and spending assumptions from current law. Elected officials in the last decade therefore hard-wired over-optimistic budget forecasts from CBO by excising from current law expensive policies that they had every intention of pursuing in the future. Often they were explicit about the difference between their intended future policies and the legislation that they wrote down.
Four examples: (i) the continuation of wars in Afghanistan and Iraq (which were paid for with “supplemental” budget requests when the time came, as if they were an unpredictable surprise); (ii) annual revocation of purported cuts in payments to doctors that would have driven them out of Medicare if ever allowed to go into effect; (iii) annual patches for the Alternative Minimum Tax (which otherwise threatened to expose millions of middle class families to taxes that had never been intended to apply to them); and (iv) the intended extension in 2011 of the income tax cuts and estate tax abolition that were legislated in 2001 with a sunset provision for 2010, which most lawmakers knew would be difficult to sustain. All four are examples of expensive policy measures that Congress fully intended would take place, but that it excluded from legislation so that the official forecasts would misleadingly appear to show smaller deficits and a return to surplus after 2010.
Unrealistic macroeconomic assumptions, fanciful theories about tax cuts, and legislation that deliberately misrepresented policy plans all worked as intended, yielding over-optimistic forecasts. These in turn help to explain excessive budget deficits. In particular, they explain the failure to run surpluses during the economic expansion from 2002-2007: if growth is projected to last indefinitely, retrenchment is regarded as unnecessary.
Many have suggested that budget woes can best be held in check through fiscal-policy rules such as deficit or debt caps. Some countries have already enacted laws along these lines. The most important and well-known example is the eurozone’s fiscal rules, which supposedly limit budget deficits to 3% of GDP and public debt to 60% of GDP for countries to join. The European Union’s Stability and Growth Pact (SGP) dictated that member countries must continue to meet the criteria. We have now seen how well that worked out.
Other countries have also adopted fiscal rules, most of which fail. Switzerland’s structural budget rule (”debt brake”) is well-designed to allow higher deficits in recessions automatically, counterbalanced by surpluses in expansion periods. But the success of any budget rule depends on accurate forecasts of government spending and revenues. Getting those forecasts right has proven to be difficult for most countries.
Part of the problem is that governments that are subject to budget rules, such as Europe’s SGP, put out official forecasts that are even more biased than the US or other countries. The Greek government, for example, in 2000 projected that its fiscal deficit would shrink below 2% of GDP one year in the future and below 1% of GDP two years into the future, and that the fiscal balance would swing to surplus three years into the future. The actual balance was a deficit of 4-5% of GDP - well above the EU’s 3%-of-GDP ceiling.
In almost all industrialized countries, official forecasts have an upward bias, which is stronger at longer horizons. On average, the gap between the projected budget balance and the realized balance among a set of 33 countries is 0.2% of GDP at the one-year horizon, 0.8 % at the two-year horizon, and 1.5 % at the three-year horizon. So, how can governments’ tendency to satisfy fiscal targets by wishful thinking be overcome? In 2000, Chile created structural budget institutions that may have solved the problem. Independent expert panels, insulated from political pressures, are responsible for estimating the long-run trends that determine whether a given deficit is deemed structural or cyclical.
The result is that, unlike in most industrialized countries, Chile’s official forecasts of growth and fiscal performance have not been overly optimistic, even in booms. The ultimate demonstration of the success of the country’s fiscal institutions: unlike many countries in the North, Chile took advantage of the 2002-2007 expansion to run substantial budget surpluses, which enabled it to loosen fiscal policy in the 2008-2009 recession. Perhaps other countries should follow its lead.
[A shorter version of this op-ed was published by Project Syndicate. It draws on several recent academic publications of mine, especially "Over-optimism in Forecasts by Official Budget Agencies and Its Implications," Oxford Review of Economic Policy 27, no.4, 2011, 536-562.]
Obama’s slogan for the SOTU last night, “An Economy Built to Last,” was a way of referring to one of the accomplishments of his first years: successfully reviving the auto industry, which many had said couldn’t be done without nationalizing it. References to other accomplishments were stated more quickly, such as national security (withdrawal from Iraq, disposing of Osama bin Laden) or more obliquely, such as health care reform, financial reform, and arresting the freefall of the economy that Obama inherited in January 2009 (via fiscal stimulus and TARP - both of which are not especially popular programs).
I realize of course that some will not view these as true “accomplishments.” They will argue that we should have let the auto industry go bankrupt, or should have spent another 10 years in Iraq, or that bin Laden was deprived of his human rights, or that the Dodd-Frank bill went too far in financial regulation (or not far enough), or that a federal effort to reduce unnecessary hospital infections constitutes “socialism” or “death panels.” But most Americans wanted these policies.
Evidently the President also has in mind reducing American dependence on imported oil. And slowing the big rise in income inequality, in part by allowing to expire on schedule the tax cuts on the top earners like Mitt Romney that ten years ago brought their tax rates down to 15%.
To me, the phrase “built to last” suggests that the medium-term goal is economic growth that resembles the record expansion of the late 1990s, which was driven by expanding exports, technology, and private sector employment. This would be an improvement over the unsustainable finance-based economic expansion of the 2002-2007, or those of the 1960s, 70s or 80s; they were built on easy monetary or fiscal policy and an expanding government sector, and thus contained the seeds of their own destruction when inflation, debts and asset prices got out of control.
Indeed, as inadequate as the current economic recovery has been, the expansion of private sector jobs over the two years has exceeded the rate during the Bush Administration (when the government sector was the primary source of what limited job creation there was). This comparison holds even if one excludes the two recessions at the beginning and end of the 8-year Bush period, as the graph shows.
[TV clip, Post Mortem on the State of the Union Message," BNN," 2012.]
THE BIGGEST THREAT TO THE GLOBAL ECONOMY IS …
Anti-market bias. -Bryan Caplan • Procrastination. -Peter Diamond • Short-term thinking. -Esther Dyson • A euro meltdown. -Dean Baker • Tax-cut fanatics. -Jeffrey Frankel • The bond market. -Andy Sumner •
MY OUT-OF-THE-BOX SUGGESTION TO REVIVE THE GLOBAL ECONOMY IS
Wipe out debts. -Daron Acemoglu • Require candidates for national office to pass ninth-grade tests on arithmetic, history, and geography. -Jeffrey Frankel • Double down on science. -Tyler Cowen • A government lottery where winners have mortgages, student loans, or other debt paid off. -Mark Thoma • We don’t need “out-of-the-box” solutions; we need “head-out-of-the-sand” ones. -Adam Hersh • Pray. -David Smick
BARACK OBAMA’S BIGGEST ECONOMIC MISTAKE HAS BEEN …
Letting Larry Summers go. -Gary Hufbauer • Not reorganizing the big banks. —David Smick • Trying too hard to find common ground with an opposition that won’t compromise on any terms. -Vincent Crawford • Assuming office in January 2009. -Jeffrey Frankel
OCCUPY WALL STREET IS …
A misdirected tantrum. -Philip Levy • A harmless pastime for unemployed youth. -Gary Hufbauer • Reasonable complaints about crony capitalism plus self-righteous economic illiteracy. -Bryan Caplan
BY ELECTION DAY 2012, THE U.S. ECONOMY WILL BE …
Improving, but leaving many people behind. -Arnold Kling . Limping along, with unemployment declining but still around 8 percent. -Daron Acemoglu . Blamed for the outcome. -Jeffrey Frankel
ECONOMISTS SHOULD BE PAYING MORE ATTENTION TO …
How people actually behave rather than how they are idealized to behave. -Abhijit Banerjee • Corporate governance. -Peter Diamond • The fact that macroeconomic theory went up a blind alley some 20 years ago. -Jeffrey Frankel • Creeping protectionism across the global economy. -Gary Hufbauer • The impediments to job creation for young people. -Valerie Ramey • Reality. -James D. Hamilton
US News and World Report asks, “Who is handling its debt crisis better: Europe or the United States?” My answer follows.
In both Europe and the United States, the current public debt woes are attributable to mistakes made by political leaders going back more than a decade. In both cases the tremendous magnitude of the long-term debt problems has only become evident for all to see recently, by which time it was too late for the straightforward policy solutions that were viable options previously.
It is hard to judge whether it is Europe or the United States that has screwed up worse. On the one hand, Europe is now much closer to full-fledged crisis: the debt problems in Mediterranean members are virtually insoluble at current interest rates, are probably pushing Europe back into recession, and could well result in one or more countries forced to leave the euro. By contrast, there is no true fiscal crisis here yet; the world’s investors are still buying large quantities of US bonds at low interest rates.
On the other hand, the mistakes by US politicians are more gratuitously self-inflicted than on the other side of the Atlantic. In 2001, all we had to do was continue the fiscal progress that had been made during the 1990s: preserve the budget surplus and move on to address the longer term problems of social security and Medicare in a deliberate and balanced manner. Instead we recklessly enacted massive tax cuts and tripled the rate of growth of federal spending, in ways guaranteed to generate serious fiscal troubles in the decade of the 2010s and beyond. The debt-ceiling standoff last summer was but the latest self-inflicted wound, new evidence that the US political system is not functioning.
To be sure, euroland too has made serious policy mistakes. But one can sympathize with the difficulty of agreeing policy across 17 sovereign governments. The political fissures have been inevitable ever since 1999, when the euro members (then 11) adopted a single currency without a single fiscal authority, in what was nevertheless a historic and laudable enterprise. As they say, “why should anyone be surprised at the difficulty of getting 17 national legislatures to agree, when the United States cannot even do it with one?”
It is not too late for American politicians to enact the economically sensible policy: current short-term fiscal stimulus simultaneous with steps to lock in a long-run return to fiscal responsibility (which cannot possibly be accomplished solely by discretionary spending cuts, entitlement reform, or tax revenues, but rather should include all three). For euroland, unfortunately, even if the politicians could come together, there no longer exists an option for preserving the monetary union in quite the form originally envisioned.
After a month of high drama the Senate at high noon today voted to pass a bill to raise the debt ceiling. How to evaluate this outcome? If I must give a one-word verdict, it would be “good.” If I can expand to two words, it would be “not good.” If I can elaborate to 20 words: “The legislation confirms the sorry state of our public deliberations, but it is probably the best that could be hoped for,” given where the negotiations were as the big hand on the clock approached twelve.
In what sense was the outcome to the debt ceiling standoff good? It was much better than a number of alternatives that could have easily happened. After the pin had been pulled out of the hand grenade, Washington managed to put it back in. Specifically, it is good that:
- 1. Those who favored a US default — in some cases deliberately, not just as a bargaining tactic — did not prevail.
- 2. Those who sought to force the Congress and White House to go through the madness of voting on the debt ceiling every few months between now and the next presidential election did not prevail.
- 3. The bill’s 10 years of spending cuts are not front-loaded. Frontloading would have substantially raised the chances of going back into a new recession. (So would have default or an uncertainty-maximizing short-term fix.)
- 4. The bill has a mechanism that just might in November demonstrate to the arithmetically innumerate that it is literally impossible to eliminate the budget deficit if the cuts are to come primarily in discretionary non-security spending. Instead, military spending, entitlements, and tax revenues will have to be part of the eventual solution — as also favored by the American people in polls, even a majority of Republicans. This epiphany on the part of the people who are described as die-hard fiscal conservatives is needed before we can break the political log-jam. A solution is not possible so long as the extremists are under the mistaken belief that the deficit can be eliminated with cuts concentrated in domestic discretionary spending and so long as they have veto power in the eyes of the Republican leaders.
The mechanism is to force Congress to confront an unpleasant but clear choice between (i) on the one hand, deep automatic cuts that hit defense, which are anathema to most Republicans, and Medicare, which are anathema to Democrats, and (ii) on the other hand, the more thoughtful recommendations of a bi-partisan Joint Select Committee on Deficit Reduction, which would certainly spread out the pain more to include increased tax revenues, anathema to Republicans, and other entitlement cuts, anathema to Democrats. The 12-member panel is to report its recommendations in late November, and the Congress is to vote on them in December. This mechanism is of course crude, but may be just the sort of thing we need to force individual congressmen to confront arithmetic.
Some have asked how this panel will differ from the ill-fated Simpson-Bowles commission. A critical difference is the requirement that the Congress must vote up-or-down on the recommendations. (This was also a feature of the original version of what became the National Commission on Fiscal Responsibility and Reform; but the provision was voted down by Senate Republicans, including some who had sponsored the proposal until President Obama came out in favor of it in January 2010.)
In what sense was today’s outcome to the debt ceiling stand-off “not good?” It would have been better if:
- 1. The Republicans had agreed to some of President Obama’s various compromise proposals over the last year and a half; or
- 2. The showdown had at the last minute forced a “$4 trillion” Grand Bargain in which all sides had ceded ground in order to adopt a workable and credible plan to get back to fiscal responsibility gradually over the coming decade, rather than subsisting on political rhetoric.
- 3. The outcome had included something to help the current faltering recovery.
- 4. President Obama had come off looking like Gary Cooper.
[Comments can be posted at SeekingAlpha.]
Everywhere one looks, problems of fiscal policy are now center stage. Among advanced countries, the news is bad: Europe’s periphery teeters, the U.K. slashes, the U.S. deadlocks, Japan muddles. But in the rest of the world there is better news: In an historic reversal, many emerging market and developing countries have over the last decade achieved a countercyclical fiscal policy.
In the past, developing countries tended to follow procyclical fiscal policy: they increased spending (or cut taxes) during periods of expansion and cut spending (or raised taxes) during periods of recession. Many authors have documented that fiscal policy has tended to be procyclical in developing countries, in comparison with a pattern among industrialized countries that has been by and large countercyclical. (References for this proposition and others are available.) Most studies look at the procyclicality of government spending, because tax receipts are particularly endogenous with respect to the business cycle. Indeed, an important reason for procyclical spending is precisely that government receipts from taxes or mineral royalties rise in booms, and the government cannot resist the temptation or political pressure to increase spending proportionately, or even more than proportionately. One can find a similar pattern on the tax side by focusing on tax rates rather than revenues, though cross-country evidence is harder to come by.
Figure I (which is a version of evidence presented in Kaminsky, Reinhart and Vegh, 2004) depicts the correlation between government spending and GDP for 94 countries over the period 1960-1999. More precisely, it shows the correlation between the cyclical components of spending and GDP; the longer term trends are taken out. The set includes 21 developed countries, which are represented by black bars, and 73 developing countries, represented by yellow bars. A positive correlation indicates government spending that is procyclical, that is, destabilizing. A negative correlation indicates countercyclical spending, that is, stabilizing.
There is no missing the message. Yellow bars lie overwhelmingly on the right hand side: more than 90 percent of developing countries show positive correlations (procyclical spending). Black bars dominate the left hand side: around 80 per cent of industrial countries show negative correlations (countercyclical spending).
Over the last decade there has been a historic shift in the cyclical behavior of fiscal policy in the developing world. Figure II updates the statistics, showing the period 2000-2009. The number of yellow bars on the left side of the graph (negative correlations) has greatly increased. Around 35 percent of developing countries [26 out of 73] now show a countercyclical fiscal policy, more than quadruple the share during the earlier period.
Figure III presents a scatter plot with the 1960-1999 correlation on the horizontal axis and the 2000-2009 correlation on the vertical axis. The lower right quadrant shows the graduates from procyclical to countercyclical fiscal policy. The star performers include Chile and Botswana; but 24 developing countries altogether (out of 73) have made this historic shift.
The evidence of countercyclicality among many emerging market and developing countries matches up with other criteria for judging maturity in the conduct of fiscal policy: debt/GDP ratios, rankings by rating agencies, and sovereign spreads. Low income and emerging market countries in the aggregate have achieved debt/GDP levels around 40 percent of GDP over the last four years. [The IMF estimates the 2011 ratio at 43 per cent among emerging market countries and 35 per cent among low-income countries]. This is the same period during which debt in advanced countries has risen from about 70 per cent of GDP to 102 percent. The financial markets have ratified the historic turnaround. Spreads are now lower for many emerging markets than for some “advanced countries.” Rating agencies rank Singapore as more creditworthy than Belgium, Korea ahead of Portugal, Mexico ahead of Iceland, and just about everybody ahead of Greece. Euromoney ranks Chile as less risky than Japan, Korea less risky than Italy, Malaysia less risky than Spain, and Brazil less risky than Portugal.
Largely as a result of their improved fiscal situations during the period 2000-2007, many emerging markets were able to bounce back from the 2008-2009 global financial crisis more quickly than advanced countries.
What explains the ability of some countries, particularly emerging market and developing countries, to escape the trap of procyclical fiscal policy? Many researchers have pointed to the importance of institutions. In new research we find that the cyclicality of a country’s fiscal policy is inversely correlated with the country’s institutional quality (which includes measures of law and order, bureaucracy quality, corruption, and other risks to investment). The relationship holds also when instrumental variables are used.
Although one thinks of institutions as slow-moving, they can change over time. Chile’s institutional quality has risen strongly since the early 1980s, during which time its fiscal policy has turned from procyclical to countercyclical. A country with good institutional quality in the general sense of rule of law can help lock in countercyclical fiscal policy through specific budget institutions. Chile did it with the structural budget reforms of 2000 and 2006. Chile’s approach could be emulated by others.
Fiscal rules, such as euroland’s Stability and Growth Pact, may accomplish little in themselves. Rules can actually worsen the tendency of governments to make overly optimistic forecasts for economic growth and budget balance. Chile’s key innovation was to give responsibility for forecasting to independent expert commissions, insulated from politicians’ wishful thinking.
Even advanced countries have something to learn about countercyclical fiscal policy from Chile and others to the South. Saving during expansions such as 2001-06 is critical for weathering the storm in recessions such as 2008-09. Otherwise there may be no way out but to adjust at the worst possible time.
In the 1955 movie Rebel Without a Cause, James Dean and a teenage rival race two cars to the edge of a cliff in a game of chicken. Both intend to jump out at the last moment. But the other guy miscalculates, and goes over the cliff with the car.
This is the game that is being played out in Washington this month over the debt ceiling. The chance is at least 1/4 that the result will be similarly disastrous.
It is amazing that the financial markets continue to view the standoff with equanimity. Interest rates on US treasury bonds remain very low, 3% at the ten-year maturity. Evidently it is still considered a sign of sophistication to say “This is just politics as usual. They will come to an agreement in the end.” Probably they will. But maybe not. (I’d put a ½ probability on an agreement that raises the debt limit, but just muddles through in terms of the genuine long term fiscal problem. That leaves at most a ¼ probability of a genuine long-term solution of the sort that President Obama apparently proposed last week - described as worth $4 trillion over ten years.)
My advice to investors is to shift immediately out of US treasuries and into high-rated corporate bonds. If the worst happens, you will probably save yourself from a big capital loss within the next month. If not, there is no harm done.
The game is not symmetric. The Republicans are the ones who are miscalculating. Evidently they are confident of prevailing: they rejected the President’s offer, even though he was willing to cut entitlement programs.
The situation is complicated because there are a number of different people crammed into the Republican car. There is one guy who is obsessed with the theory that, come August 3, the federal government could retain its top credit rating if it continued to service its debt by ceasing payment on its other bills. But this would mean failing to honor legal obligations that have already been incurred (paying suppliers for paper clips that have already been bought, paying soldiers their wages for last month’s service, sending social security recipients their checks, etc.). This is like observing that the cliff is not a 90 degree drop-off, but only 110 degrees. It doesn’t matter: the car would still go crashing into the ocean far below. The government’s credit would still be downgraded and global investors would still demand higher interest rates to hold US treasuries, probably on a long-term basis.
There are other guys (and gals) in the car who are even more delusional. They are dead set on a policy of immediately eliminating the budget deficit (e.g., those opposed to raising the debt ceiling no matter what, or those campaigning for a balanced budget amendment), and doing it primarily by cutting nondefense discretionary spending. This is literally impossible, arithmetically. But they honestly don’t know this. It is as if they were insisting that the car can fly. Sometimes it can be a good bargaining position to adopt a very extreme position. But if you are demanding that the car flies, you are not going to get your way no matter how determined you are.
It seems likely that the man in the driver’s seat - House Speaker John Boehner - does realize that his fellow passengers don’t have the facts quite right. But there is also a game of chicken going on within the Republican car. The crazies have said they will oppose in the next Republican primary election any congressman who votes to raise the debt ceiling or to raise tax revenues. (Yes, they think they would support someone who would eliminate the budget deficit primarily by cutting non-defense discretionary spending; but remember, this is arithmetically impossible.) The guy who is riding shot-gun in the car - the one who believes the car can fly — is trying to put his foot on top of Boehner’s on the accelerator pedal.
It seems to me that Boehner, too, is miscalculating. Given that the car can’t fly, the crazy guy is probably going to oppose him in the primaries no matter what he does. So I don’t see what his plan is. But whatever it is, he has made it clear that he doesn’t plan to agree to any increase in tax revenues.
As a result the Republican leadership is in the remarkable situation of refusing to agree to Obama’s offer to solve the problem so long as the solution includes raising tax revenue, even if it is via such measures as ending distortionary subsidies for ethanol, oil companies, and corporate jets.
If I had to guess: The financial markets will wake up just before August 3. US bond prices will finally fall. The market reaction will shock the Republican leadership into action. (Precedents include the delayed congressional passage of the unpopular TARP legislation in the fall of 2008 and the delayed passage of an unpopular IMF quota increase 10 years earlier.) They will finally make the small but necessary concessions on tax revenues. But by then it might be too late.