The International Economy magazine (Winter 2013) asks 16 authorities, “Can Changes in Exchange Rate Valuations Affect Trade Imbalances?“   It is referring to the claim in a recent book by Stanford economist Ron McKinnon that pressure on China to let the renminbi appreciate against the dollar is fundamentally misconceived because such a movement in the exchange rate would not reduce China’s trade surplus nor American’s trade deficit.  This is part of an old debate that pre-dates the rise of the China trade problem.  Ron has long claimed that exchange rates don’t determine trade balances because they are “instead” determined by national saving versus investment.   I thought Paul Krugman demolished the argument pretty effectively 25 years ago, with a textbook graph of internal balance versus external balance.   But evidently many still fall for the argument (including some of the experts in the TIE symposium).   So I try again:

Ron McKinnon has made many important contributions to international macroeconomics over the years. But on this issue, he is simply wrong.

It goes without saying that the current account is equal to the difference between national saving and investment. But it does not follow that we should try to improve the current account in the short run by increasing national saving. Under current conditions, that would send the United States back into recession.

The national saving identity is a tautology: it does not in itself imply causation. True, many of the big movements in the U.S. current account deficit can be explained by changes in national saving: the fiscal expansion of the early 1980s, the investment boom of the late 1990s, and the new fiscal expansion of the 2000s. But the important point is that we care about a lot of things besides just external balance (the trade balance and current account). We care at least as much about internal balance (growth, employment, and inflation). To say that an increase in the budget balance and national saving would improve the trade balance does not imply that this would be good policy or that it is the only way to improve the trade balance.

Of course we need to address the budget deficit in the long run, in balanced sensible ways.  But under current circumstances — a still-weak economy, high unemployment, low inflation, rock-bottom interest rates — a reduction in public or private spending would send the economy straight back into recession. That is why the fiscal cliff of January 1, 2013, was such a danger. To observe that the trade balance would have improved if the sharp fiscal contraction had gone fully into effect would have been small consolation for the self-inflicted recession.

The U.S. trade deficit and Chinese trade surplus have diminished and so are today not quite the problems that they were five years ago. But if improving the U.S. trade balance is considered an important goal, then a devaluation or depreciation of the currency is a better tool for the job. (This proposition does not violate the national saving propositions. Nor, on the other hand, does it justify China-bashing.) Because a real devaluation would also raise demand for U.S. products — admittedly with a lag — and thus move us closer to internal balance, it would be a far more appropriate tool for improving the current account under present-day conditions than would cutting national spending or raising taxes.

     Europe’s fiscal compact went into effect January 1, as a result of its ratification December 21 by the 12^th country, Finland, a year after German Chancellor Angela Merkel prodded eurozone leaders into agreement.   The compact (technically called the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union) requires  member countries to introduce laws limiting their structural government budget deficits to less than ½ % of GDP.  A limit on the “structural deficit” means that a country can run a deficit above the limit to the extent — and only to the extent — that the gap is cyclical, i.e., that its economy is operating below potential due to temporary negative shocks.   In other words, the target is cyclically adjusted.  The budget balance rule must be adopted in each country, preferably in their national constitutions, by the end of 2013.

    Will the new approach help?   The aim is to fix Europe’s long-term fiscal problem, which since the date of the euro’s inception has been evident in the failure of the Stability and Growth Pact (SGP), the crisis in Greece and other periphery countries that surfaced in 2010, and the various ways in which these countries were subsequently bailed out.  

     There is no reason to doubt that the eurozone countries will follow through to the extent of adopting the national rules by the end of the year.  ["The granting of new financial assistance under the European Stability Mechanism is conditional on ratification of the fiscal compact and transposition of the balanced budget rule into national legislation in due time."]  But after that the fiscal compact will probably founder on precisely the same shoals as the SGP.

    Since the inception of the euro, its members have made official fiscal forecasts that are systematically biased in the optimistic direction.   Other countries do this too, but the bias among eurozone countries is, if anything, even worse than that elsewhere.  During a period of economic expansion, such as 2002-07, governments are tempted to forecast that the boom will continue indefinitely.  Forecasts for tax revenue and budget surpluses are correspondingly optimistic and so hide the need for adjustment of fiscal policies.  During a period of recession, such as 2008-2012, governments are tempted to forecast that their economies and budgets will soon rebound.  Since forecasting is subject to so much genuine uncertainty, nobody can prove that the forecasts are biased when they are made.

     Fiscal rules such as the SGP ceilings won’t constrain budget deficits, if forecasts are biased.  The reason is that governments can in any given year forecast that their growth rates, tax revenues, and budget balances will improve in the subsequent years, and then next year say that the shortfalls were unexpected.   Indeed, it turns out that the eurozone bias in official forecasts during 1999-2011 can be neatly characterized as responding to the SGP’s 3% limit on budget deficits by offering over-optimistic forecasts each time governments exceed the limit.  In other words, they adjust their forecasts rather than their policies.   (The results described here come from a new paper, coauthored with Jesse Schreger: “Over-optimistic Official Forecasts and Fiscal Rules in the Eurozone,” forthcoming 2013 in the Review of World Economy, vol.149, no.2, from Germany’s Kiel Institute.)

    Phrasing the budget rules in cyclical terms, while highly desirable in terms of macroeconomic impact, does not help solve the problem of forecast bias.  It can even make it worse.  In a year when a forecast for the actual budget deficit turns out to have been over-optimistic, the government has to admit that it made a mistake, which can carry some embarrassment.  In a year when a forecast for the structural budget deficit turns out to have been over-optimistic, the government can still claim that its own calculations show the shortfall to have been cyclical rather than structural.   After all, estimation of potential output and hence the cyclical versus structural decomposition is notoriously, even after the fact.

   Will it help that under the fiscal compact the rules are to be adopted at the national level, as opposed to the supranational level on which the SGP operated?  A look at the various rules and institutions that have already been tried by European countries shows that some work and others don’t.  Creating an independent fiscal institution that provides its own independent budget forecasts works, in that it reduces the bias in projections.  Euro area governments with an independent budget forecasting institution have a mean bias when making forecasts while in violation of the Excessive Deficit Procedure (EDP) that is smaller by 2.7% of GDP [at the one-year horizon], compared to euro area countries that are in violation of the EDP without such an independent fiscal institution.

    It would be better still if the governments were legally bound to use these independent forecasts in their budget plans (thereby borrowing an innovation from Chile).  

   Regardless how well-designed the rules are, clever and determined politicians can find ways around them.  One of the tricks is the privatization of government enterprises which reduces the budget deficit this year on a one-time non-repeatable basis, but might raise it in the long-term if the enterprise had been earning profits.  Another trick is phony legislated sunsets on tax cuts, in order to make future revenues look larger despite the political intention later to make the tax cuts permanent. 

   Still, other things equal, the right institutions can reduce the procyclicality of fiscal policy in the short run and help deliver debt sustainability in the long run.    Examples of the right institutions are cyclically adjusted budget targets combined with independent agencies that make independent fiscal forecasts.  Things can still go wrong even if such mechanisms are in place; but, as the history of the SGP illustrates, the risk is higher if they are not.

     [The original of this post appears at Project Syndicate.  Comments may be posted there.]

Politicians who advertise themselves as “fiscal conservatives” sometimes campaign on crowd-pleasing pledges to cut taxes and simultaneously reduce budget deficits.  These are difficult promises to deliver on in practice, since the budget deficit equals government spending minus tax revenue.

Aspiring fiscal conservatives may be interested in learning four innovative tricks that are commonly used by American politicians who like to promise what seems impossible.   Each of these feats has been perfected over three decades or more.  Indeed they first acquired their colorful names in the early years of the Ronald Reagan presidency:

1. The “Magic Asterisk”
2. “Rosy Scenario”
3. The Laffer hypothesis
4. The “Starve the Beast” hypothesis.

As shop-worn as these four conjuring tricks are, voters and journalists continue to fall for them. Thus they remain useful equipment in the repertoire of the fiscal conservative.

The first term was coined by Reagan’s Budget Director, David Stockman.  Originally it was an act of desperation, because the numbers in the 1981 budget plan didn’t add up.  “We invented the ‘magic asterisk’:  If we couldn’t find the savings in time - and we couldn’t-we would issue an IOU. We would call it ‘Future savings to be identified.’” [p.124]   Since that time the Magic Asterisk has become a familiar device in the American policy arena.   Recent examples include the recommendation of the Simpson-Bowles commission to cut real spending growth by precise amounts, without saying where.   US Presidential candidate Mitt Romney has done the same in his spending plan.    Another current application of the Magic Asterisk is Romney’s plan to eliminate enough tax expenditures to make up the revenue lost by cutting marginal tax rates by 20% (which is $5 trillion in revenue), while steadfastly refusing to say what tax expenditures he would eliminate.

As Election Day nears, the pressure on a candidate to get more specific grows.  The conjurer is thus forced to go to Trick Two:  since he can’t find enough tax loopholes to eliminate, he must claim that what he meant by closing the revenue gap was that stronger economic growth will bring in the added revenue.   The most popular magician’s assistant of all time makes her encore on the stage.  Murray Weidenbaum, Reagan’s first Council of Economic Advisers Chairman, deserves the credit for originally dreaming up Ms. Rosy Scenario, “perhaps my most lasting legacy” [p.57].  The Reagan Administration in its early years forecast 5% income growth (twice the long-run average), in order to imply in its projections a boost to revenues big enough to make up for its many tax cut measures [p.93-97].   Since then candidates of every party have made use of Rosy’s talents.

Indeed official growth forecasts are systematically overly optimistic in almost all of a sample of 33 countries, contributing to overly optimistic budget forecasts.   European governments are particularly biased.

In the Republican primaries last year, candidate Tim Pawlenty assumed a 5 per cent growth rate to make his own plan work.   He was all but laughed out of the race.  Mitt Romney probably can’t get away with this sleight-of-hand either.   The press asks, “Why should we believe that the growth rate will magically accelerate just because you become president?   Where will this GDP come from?   It sounds like pulling a rabbit out of a hat.”  Right on cue, it is time for Trick 3.

Trick 3 is the famous Laffer Hypothesis.   This is the proposition, identified with “supply side economics,” that reductions in tax rates are like magic beans:  they stimulate economic growth a lot — so much so that total tax revenue (the tax rate times income) goes up rather than down.   One might think that the Romney campaign would never resurrect such a hoary and discredited trick.  After all, two of his main economic advisers, Glenn Hubbard and Greg Mankiw, both have textbooks in which they say that the Laffer Hypothesis is incorrect as a description of US tax rates.  Mankiw’s book, in its first edition, even called its proponents “charlatans.”  But the historical record is that each Republican presidential candidate since Reagan has had good economic advisers who disavow the Laffer Hypothesis.  Yet time and again the president (or candidate), and his vice president (or running mate) and his political aides read from a script that relies on the Laffer logic (Appendix I). They are the ones who make the policy if the candidate wins, not the academic economist.   George W. Bush had these same two top economic advisers in his first term, Hubbard and Mankiw, when he cut taxes and transmogrified a record surplus into a record deficit.

Trick 4, “Starve the Beast,” typically comes later, if and when the president is elected, has enacted his tax cuts, and discovers that smoke and mirrors don’t work against hard fiscal reality. He can’t find enough spending to cut (Magic Asterisk has disappeared up the conjurer’s sleeve); the acceleration in GDP is nowhere to be seen (Rosy Scenario has vanished in thin air); and tax revenues have not grown (no rabbit in the Laffer hat).   The audience is now told that losing tax revenue and widening the budget deficit was the plan all along.  The performer explains that the deficit is all the fault of Congress for not cutting spending and that the only way to tame the beast is raise the budget deficit because “Congress can’t spend money it doesn’t have.”  This trick never works either, of course.  Congress can in fact spend money it doesn’t have, especially if the “conservative” president has been quietly sending it budgets every year that call for that.   “Starve the Beast” as a budget strategy, like the other three, dates back to the first Reagan Administration. (Bartlett, 2007, p.6-7.)

By the time the crowd realizes it has been had, the confidence man has pulled off the greatest trick of all:  yet another audience who came to see the deficit shrunk instead leaves the theater with the deficit bigger than when it came in.

References
Bruce Bartlett, 2007, “‘Starve the Beast’ Origins and Development of a Budgetary Metaphor,”The Independent Review, XII, 1, summer, 5-26.
Jeffrey Frankel, 2008, “Snake-Oil Tax Cuts,” Economic Policy Institute, Briefing Paper 221, September.
–2011, “Over-optimism in Forecasts by Official Budget Agencies and Its Implications,” Oxford Review of Economic Policy vol.27, no. 4, 536-562. NBER WP 17239; Summary in NBER Digest.
David Stockman, 1986, The Triumph of Politics: Why the Reagan Revolution Failed (Harper & Row).
Murray Weidenbaum, 2005, Advising Reagan: Making Economic Policy, 1981-82 (Washington Univ., St.Louis).

[A version of this column appeared earlier at Project Syndicate, which has the copyright.  Comments can be posted there.]

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.]  

         My preceding blog-post discussed the process whereby the undervalued renminbi and large Chinese trade surplus have begun to adjust in earnest, over the last three years.

        The adjustment in the Chinese trade balance is reminiscent of Japan with a 30-year lag, like other aspects of the US-China relationshkp (though not all).  Japan’s balance of trade in goods and services went into deficit in 2011, for the first time since 1980.  Special factors have played a role in the last year, including high oil prices and the effects of the tsunami in March 2011.  But the downward trend in the trade balance is clear.   Even the current account temporarily showed a deficit in January.  (Because Japan has long been the world’s largest creditor, a large surplus in investment income is usually enough to change any trade deficit into a surplus on the overall current account.)

           This development has received relatively little attention in the United States.  This is curious in the respect that two decades ago the Japanese trade balance, which then was in substantial surplus, was the subject of intense focus and worry.  At the time, some influential foreign commentators warned that Japan had discovered a superior model of “the capitalist developmental state,” featuring strategic trade policy among other attractions, and that the rest of us had better emulate them.  Either that or the Japanese were cheating and we had better stop them.  

          Most economists did not share the views of these “revisionists,” but argued rather that the trade balances were determined by macroeconomics: Japan’s current account was so high because its national saving rate was so high.  The best explanation for the high Japanese saving rate, in turn, was not cultural differences or government policies, but rather demographics.  The Japanese population was relatively young then compared to other advanced economies, but it was rapidly aging, as the result of a decline in the birth rate since the 1940s and an increase in longevity.  In 1980, 9% of the population was age 65 or older; now this ratio is more than 23%, one of the very highest in the world.   As a consequence, Japanese citizens who 30 years ago were saving for their retirement are now dissaving, precisely as economic theory predicted. (E.g., Horioka, 1986, 1992.)    Household saving has declined from 14% of disposable income twenty years ago to 2%.   The trade and current account balances have now come down as well.    

       The downward trend in Japan’s saving rate and trade balance illustrate again that the laws of international economics eventually work, even in Asia.

[This post, and the one preceding it, were together published as an op-ed by Project Syndicate.]

 References

Jeffrey Frankel, 1993, “The Japanese financial system and the cost of capital,” in Japanese Capital Markets, edited by Shinji Takagi (Basil Blackwell Inc.): 21-77.

Charles Yuji Horioka, 1992, “Future trends in Japan’s saving rate and the implications thereof for Japan’s external imbalance,”  Japan and the World Economy, Vol. 3, Issue 4, April: 307-330.

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.

** This column (along with others’ answers to the question) first appeared in the Debate Club of U.S. News & World Report , Nov. 7, 2011, which has the copyright. **

[My reactions to developments in the euro crisis can be seen in four clips from CNBC's Kudlow Report in October and one on BNN in November.] 

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.

I never cease to be frustrated that the current public policy debate is described as a contest of ideas: fiscal conservatives versus liberals.   It is not just Republicans or Tea Partiers who believe that they are fiscal conservatives, no doubt sincerely.   Democrats and liberals seem to accept this characterization at face value, as does most of the media.  

The problem is that a heavy majority of the supposed fiscally conservative congressmen, although passionate about cutting government spending in the abstract, are in truth no better able to find specific dollars of budget cuts that they can support or defend to their constituents than are the Democrats.   Factoring in their immutable desire to cut taxes, I believe that if the Republicans were in full control, we would have larger budget deficits in the coming years than if the Obama crowd retained power.  This is what happened in a big way when Presidents Reagan and GW Bush took office promising to cut the debt while also cutting taxes.   Spending, deficits, and debt soared during their terms, relative to their respective Democratic predecessors.  There is no reason to think anything has changed. 

The first thing the Republicans did after their congressional victories in the November election was achieve their precious extension of the Bush tax cuts for the wealthy.  This extension will raise the budget deficit by more than all the domestic spending cuts that all of the Congressional freshmen have identified put together. 

Next they turned to their campaign to kill Obamacare.  It was a surprising achievement one year ago when President Obama managed to pass a health reform bill that simultaneously would improve medical treatment while bending down the cost curve in the long run (through such policies as persuading hospitals to cut down on unnecessary surgery and to reduce infections).   But it is even more surprising that the conservatives can continue to get away with simultaneously tarring the reform as “death panels” while refusing to acknowledge that it will cut costs.   Their plans for going back to our previous health care system include suspending their own rule that bills that would increase spending (as determined by the non-partisan Congressional Budget Office) must be paid for.

The zeal to cut funding for such tiny programs as the National Endowment for the Humanities and Planned Parenthood is accepted as evidence of the sincerity of the fiscal conservatives.  I wish the Democrats would not fall for that bait.  Their anguish over such cuts, while understandable, plays into the old narrative of big versus small government.  The same with the bigger, but still small, categories of domestic spending such as food stamps.  The Right reacts to such liberal anguish with glee, while the Center infers - less vindictively, but no more accurately - that such cuts are part of a painful but necessary fiscal adjustment.    Losing the center is no way to put together a political majority. 

Yes, fiscal adjustment is necessary.   I might even think that such cuts would be a price worth paying, if they were a proportionate component of a comprehensive plan to address the long-run fiscal situation.   But they are nothing remotely like that.   Rep. Paul Ryan’s supposedly tough long-term plan to cut spending doesn’t balance the budget until 50 years from now and runs up another $62 trillion in national debt in the meantime, as Matt Miller and others point out.  Moreover, as everyone knows, the cuts that the House passed last week are not going to take effect anyway:  the Senate and the presidential veto render them all but irrelevant.   As usual, it is all about perceptions.  I don’t think the perception should be that Democrats stand in the way of fiscal responsibility. So I would prefer to divert the narrative from the unenlightening and sterile debate of small versus big government, to the realities of arithmetic and history.

Evidently the four-word slogan “No Taxation Without Representation” is too complicated to fit on some people’s bumper stickers.  They have chopped off the last two words.  They don’t want taxation period.

The “Tea Partiers” revere the Constitution. But some might lack the knowledge of early American history that they claim.  In honor of George Washington’s birthday, February 22, I would like to recall a bit of that history.

The Boston Tea Party is not in fact the most appropriate historical precedent for the grass roots protests that have received so much attention over the last year.  The famous slogan motivating the patriots in Boston Harbor in 1773 was “No Taxation Without Representation.”  But democratic representation was achieved with the American Revolution. The Whisky Rebellion of 1794 is a much closer parallel for today’s protestors.   Or the earlier Shays’ Rebellion of 1787, the episode of anarchy to which many Americans reacted by seeking a federal constitution.    The pitchfork-carriers in these rebellions were protesting against taxation with representation.   They did not want to pay the taxes necessary to fund the government services they enjoyed — which at that time meant servicing the debt from the Revolutionary War. (Sound familiar?)  President George Washington, not the rebels, was defending the Constitution against its first severe test, when he personally put down the Whiskey Rebellion with force.   

Incidently, the rebels had no appreciation of good public finance theory either, needless to say.  Theory urges taxing a beverage the excessive consumption of which imposes high costs on others.  Whiskey, rather than tea. President Washington, and his Treasury Secretary, Alexander Hamilton, probably understood that principle.  Today, it means taxing fossil fuels more (and payrolls less).

The National Journal asks for views on a recent proposal from Len Burman .  I couldn’t agree more with the idea:  we need to limit tax expenditures.  
 
With regard to the politics, one would have to see whether the phrase “cut tax expenditures” polls more like the phrase “cut expenditures,” which I assume polls well, or like the phrase “raise taxes,” which of course polls horribly.  I have no idea.  But at least there is a hope of breaking through the mindless artificial “Taxes versus Spending” rhetoric that dominates Washington.

With regard to the merits of the idea as economic policy — in a context where strong measures to reduce the budget deficit will be necessary in coming years — Burman is completely right.   Most tax expenditures tend by nature to be distortionary.   Many of them are convoluted ways of making what would otherwise be a subsidy look like a tax deduction.

Agreeing to the general principle of limiting tax expenditures is easier than agreeing to all the detailed implications.   Looking at the list of the actual 12 largest tax expenditures would give most people pause.   But much less so for economists.    The only one on the list that gives me serious pause, personally, is #7:  the “charitable deduction (other than education and health).”   But the top two deserve to be cut, as part of a larger fiscal package, not just because they would save a lot of money, but also to get economic incentives right.  Those top two are the exclusion for employer-sponsored health insurance and the mortgage interest deduction.
 
A proposal to eliminate the mortgage interest deduction would of course get zero support in Congress, because it is political suicide with middle class voters.   A more moderate proposal to freeze the amount of the deduction would also be unpopular.  The same with three other pro-housing tax expenditures out of Len’s list of 12:    exclusion of net imputed rental income, capital gains exclusion on home sales, and property tax deduction.   All politicians and voters (excluding economists) continue to believe that public policy should tilt in favor of home ownership.   Notwithstanding the recession that began with the sub-prime mortgage crisis of 2007, economists have not made even a dent in popular perceptions, with our arguments against artificially tilting the field away from rental housing and the rest of the capital stock, which is what you do when you tilt toward owner-occupied housing.   That the bias is toward high leverage in home ownership makes it worse.  To take another example, whatever happens ultimately to Fannie Mae and Freddie Mac, they certainly won’t be abolished.    Americans believe too strongly in the dream of home ownership to absorb fully the point that you are not doing a family a favor if getting them into their own house means burdening them with debt that they will probably not be able to repay.

“Political impossibility” is not a reason not to try.  After all, our country will not get through the next few decades, fiscally, unless we make some “politically impossible” changes.   But I emphasized the housing issue in the preceding paragraph to make a different point.   Almost all commentators on the financial crisis, whether from the left or right, talk as if the causes of the crisis are obvious and our leaders are idiots for not having acted to fix the problem ahead of time.  Needless to say, those on the left blame the right, for deregulation, and those on the right blame the left, for moral hazard.   And yet there is still zero support for fixing the housing policy parts of the problem, on which economists have almost unanimous agreement (and did ahead of the crisis).

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