Transcript Appendix - Harvard Kennedy School

Institutions of Macroeconomic Policy
Appendices
Jeffrey Frankel
Lecture II, May 31
Fiscal Policy Institutions
Appendices
• The U.S. fiscal situation
– The standoff
– How to reduce the deficit
•
•
•
•
•
Some important macro relationships
“Fiscal conservatives”
The long-term US debt problem
US fiscal stimulus in 2013
The bias in official forecasts
• Chile’s structural budget rule
The two biggest risks to the economy in
the coming year
• Worsening of the euro’s
sovereign debt crisis,
– and contagion to other high Debt/GDP countries.
• Political breakdown in Washington
– in December 2012.
– A return to the debt ceiling standoff of August 2011,
• which led S&P to downgrade US from AAA to AA
» for the 1st time in history.
Appendix I: The US fiscal situation
The debt-ceiling standoffs are a game of “chicken”
In the 1955 movie Rebel
Without a Cause,
whoever jumps out of
his car first supposedly
“loses” the game.
James Dean does;
but the other guy
miscalculates and
goes over the cliff.
The debt-ceiling game of “chicken”
• In the summer of 2011, “fiscal conservatives”
recklessly threatened government default,
if their demands were not met.
– The resulting political dysfunction led S&P
to downgrade US bonds from AAA to AA.
• A last-minute solution postponed
the deadline to the end of 2012.
• If no action is taken then, (i) all tax cuts expire,
(ii) all discretionary spending is cut drastically, &
(iii) the debt ceiling law is violated anyway.
– => Return to recession and default !
The US fiscal situation, continued
• What changes in American fiscal policy
would be desirable if politics were not an obstacle?
• On the one hand, the economy is still weak.
• On the other hand, the U.S. can’t wait until the recovery
is complete to tackle the long run fiscal problem.
• A two-part strategy is required:
– Current steps to extend the fiscal stimulus,
• designed to maximize bang for the buck.
– Simultaneous legislated measures to lock in future progress
back toward fiscal discipline in the long run.
• Not vague speeches, but specific & firm legislative commitments.
While US fiscal stimulus should not
be withdrawn now, as is the current track,
serious steps should be taken to lock in
a return to fiscal discipline in the long run.
• All politically very difficult, needless to say.
• Any solution must begin with:
– Honest budgeting (e.g., Afghan war on-budget, etc…)
– Regime of Shared Sacrifice
– Wise up to politicians who insist the budget can be
balanced entirely through cuts in domestic spending
(while cutting taxes),
• but who raise spending when they get the chance.
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Short fiscal history: The 1980s
• In 1981, the newly elected Ronald Reagan complained
he had inherited (almost) $1 trillion of national debt:
– As $1,000 bills stacked up, the debt would reach 67 miles high.
• Reagan’s policy: sharp tax cuts (& rise in defense spending)
• The claim: budget surpluses would result.
• The reality: record deficits that added to the national debt
– a 2nd trillion in his 1st term
– a 3rd trillion in his 2nd term
– a 4th trillion when G.H.W. Bush initially continued the policies
(“Read my lips, no new taxes.”)
Fiscal history, continued: The 1990s
• The deficits were gradually cut, and then converted
to surpluses by the end of the 1990s.
• How was this accomplished?
– Regime of “Shared Sacrifice” --3 key policy steps.
• 1990: GHW Bush agreed spending caps, taxes, & PAYGO
• 1993: Clinton extended the policy.
• 1998: As surpluses emerged, “Save Social Security 1st.”
– Strong growth in late 1990s.
Fiscal history, continued: The 2000s
• The Shared Sacrifice regime ended
the day G.W. Bush took office in 2001.
• He returned to the Reagan policies:
– Large tax cuts
– together with rapid increase in spending (triple Clinton’s)
• Not just in military spending (esp. Iraq & Afghanistan),
• but also domestic spending: discretionary + Medicare drugs benefit.
• Just like Reagan, he claimed budget surpluses would result.
• Just like Reagan, the result was record deficits:
– The national debt doubled.
• I.e., GWB incurred more debt than his father + Reagan + 39 predecessors
On what basis do some fiscal conservatives
claim that tax cuts lead to budget surpluses?
• (1) Tea Party logic:
– Claim: We can do it by cutting foreign aid.
• I.e., repeal the Laws of Arithmetic.
• (2) The Laffer Hypothesis:
– Claim: Tax rate cuts raise income
so much that tax revenue goes up.
• (3) “Starve the Beast”
– Claim: Tax revenue decline will force spending cuts.
• “Congress can’t spend money that it doesn’t have.”
How far can we get by cutting spending?
• Total federal spending = $3 ½ trillion in round numbers.
• That spending minus tax revenue leaves
a budget deficit of $1.1 trillion in FY 2012
– down from $1.4 trillion in 2009.
• Most Republican congressmen want to exempt defense &
senior-related spending (Soc. Security & Medicare),
– to cut only non-defense discretionary spending.
– That was their official platform in 2010 election.
• How much would we have to trim non-defense
discretionary spending to balance the budget?
How far can we get by cutting spending? continued
• Start by eliminating all foreign aid.
• = 1 ½ % of total outlays, not 25% as Americans think.
• Next, veteran’s benefits.
• The same. We are now up to a total of 3 % of outlays.
• Next imagine zeroing out all federal spending on agriculture,
science & environment, education & transportation,
• which includes programs so popular that congressmen voting for them would lose
re-election. But some of the freshmen say they are willing to pay that price.
• That is a total of $364 b = 1/3 of the 2012 deficit.
• Conclusion: Domestic discretionary spending
is not where the big bucks are.
• Would also need to eliminate either all of defense,
– or all medicare payments
– or all social security payments
– while still collecting the social security taxes that are supposed to pay for it!
3 biggest spending categories:
Health, Social security, & Defense
{ Medicare
& medicaid
Concord Coalition.
Data Source: CBO, Jan. 2012
Eliminating all non-defense discretionary spending
(including also parks, weather service, food safety, SEC, FBI, border patrol,
politicians’ salaries… everything !)
would not come close to eliminating the budget deficit
$92 b
$86 b
$61 b
$59 b
$56 b
$35 b
$30 b
$17 b
$6 b
Concord Coalition.
Data Source: CBO, Jan.2012
Breakdown of federal spending
Even if one could somehow eliminate all domestic spending,
it would not come close to eliminating the deficit
in FY 2012, from $1.4 trillion in FY 2009
Deficit
$1.1 tr.
Tax
revenue
$2.5 tr.
Concord Coalition.
Data Source: CBO, Jan. 2012
• Ten years ago, if the country thought it important enough
to protect any single category against belt-tightening
in the long run -- say military or social security or taxes -it would have been arithmetically possible,
by making the cuts elsewhere.
• But we no longer have the luxury of such choices
after the legacy of the last decade —
–
–
–
–
after the effects of mammoth tax cuts (2001 & 2003),
two wars (2001, 2003),
the Medicare prescription drug benefit (2003),
and the severe financial crisis & recession (2008).
• Starting from our current position, each of the 5
components must play a role, along with taxes.
The US public discussion is framed as a battle between
conservatives who philosophically believe in strong budgets
& small government, and liberals who do not.
Democrats, Republicans, & the media all use this language.
Not the right way to characterize the debate.
[1]
• (1) The right goal should be budgets that allow
surpluses in booms and deficits in recession.
• (2) The correlation between how loudly an American
politician proclaims a belief in fiscal conservatism
and how likely he is to take genuine policy steps < 0.
[1] Never mind that small government is classically supposed to be the aim of “liberals,” in the 19th century definition, not “conservatives.”
My point is different: those who call themselves conservatives in practice tend to adopt policies that are the opposite of fiscal conservatism. I call them “illiberal.”
“Republican & Democratic Presidents Have Switched Economic Policies” Milken Inst.Rev. 2003.
U.S. fiscal policy in 2012-2013, continued
• How does one take steps today
to lock in future fiscal consolidation?
– Not by raising taxes or cutting spending today (new recession);
– nor by promising to do so in a year or two (not credible).
– There are lots of economically sensible proposals
• for spending to eliminate,
• more efficient taxes to switch to,
• and “tax expenditures” to cut.
How to reduce the budget deficit
The only way to do this is both reduce spending
& raise tax revenue, as we did in the 1990s.
• Spending.
Examples:
– Cuts in farm subsidies for agribusiness & farmers
– Cut unwanted weapons systems (a rare success: the F22 fighter)
– Cut manned space program
How to reduce the budget deficit
The only way is both reduce spending & raise tax revenue, continued.
• Tax revenue options
– Let President Bush’s tax cuts for the rich expire in 2013
– Curtail expensive and distorting tax expenditures
• E.g., Tax-deductibility of mortgage interest,
•
& health insurance
• Subsidies to oil industry…
– Or more ambitious tax reform
• Introduce a VAT or consumption tax
• Or phase in auctioning of tradable emission permits
Distortionary subsidies hiding as tax expenditures
$128 b
$305 billion
$93 b
$84 b
Joint Committee of Taxation, Jan. 2012
Is doing nothing an option?
CBPP, May 2011
The long-term problem is entitlements
Concord Coalition.
Data Source: CBO, Jan. 2012
• Social security
– Raise retirement age – just a little
– Progressively index future benefit growth to inflation
– Optional options:
• To please Democrats: Raise the cap on social security taxes.
• To please Republicans: encourage private accounts
– though that contributes nothing to closing the gap.
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• Health care
– Encourage hospitals to standardize
around best-practice medicine.
• Standardize around best-practice treatment
– e.g., to pursue the checklist that minimizes patient infections,
– and avoid unnecessary medical tests & procedures.
– That is not “death panels.”
• Lever: make Medicare payments
conditional on these best practices
– To please Republicans: rein in malpractice litigation.
– Curtail corporate tax-deductibility of health insurance,
• especially gold-plated.
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For writings on US budget underlying this lecture,
Google “Jeffrey Frankel Harvard”
.
Or go to my webpage: http://www.hks.harvard.edu/fs/jfrankel/
Or my blog:
http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/
Including
“Did Obama Turn Around the Economy?” Project Syndicate, Feb. 17, 2012.
“A Lesson From the South for Fiscal Policy in the US and Other Advanced
Countries,” Comparative Economic Studies, 2011.
“Snake-Oil Tax Cuts,” Economic Policy Institute, Briefing Paper 221, 2008.
Appendix II: Macroeconomic relationships
Definitions
•
•
•
•
•
•
•
•
•
GDP = Gross Domestic Product = Output
C = Consumption by households
Net Taxes= Taxes - transfers
I = Investment by firms (e.g., plant & equipment)
G = Government spending on goods & services
X-M = exports-imports = Trade Balance
NS = National Saving = S + BS
BS = Budget Surplus;
BD = Budget Deficit
CA = current account balance, also equal to change
in net international investment position
• ORT = official reserve transactions by central bank,
i.e., fx intervention. = change in fx reserves
Important macroeconomic
accounting identities
• National income identity
Income = GDP
C + S + Net Taxes = C + I + G + X-M
(excl. int.transfers)
• National Saving identity
S + (Net Taxes -G) = I + X-M
NS = S + BS = I + CA Balance
• Balance of payments identity
CA Balance = Private capital outflows + ORT
Two competing applications
of the National Saving Identity
NS = I + CA
• Twin deficits view
– A change in BS is reflected largely in (NS &) CA.
• Versus Feldstein-Horioka view
– A change in BS (& NS) is reflected largely in I.
Key concepts in public spending
• within total outlays, distinction between:
– government spending on goods & services (enters GDP directly)
– government transfer payments
• some countries observe distinction between:
– capital budget
– current budget
• off-budget:
– government pension plans
– state-owned enterprises (SOEs)
– implicit or explicit liabilities: bailout guarantees for banks,
private pensions, province debts, etc.
Budget balance concepts (surplus/deficit):
Budget Deficit = G Spending + Govt.Transfers - Tax Rev.
• Federal
– vs. consolidated (including municipal & state/province)
• Borrowing requirement
– includes rollover of maturing debt
• Operational balance
– excludes inflation component of interest payments
• Primary balance
– excludes all of nominal interest payments
• Structural balance
– excludes cyclical component
Some macro models
Effects of fiscal expansion
• Keynesian model
G => GDP  With multiplier effect.
=> Imports  => TB 
• IS-LM:
G => i  => Investment 
Crowding out.
• Mundell-Fleming: G => i  => $ appreciates => TB 
More crowding out.
• Portfolio crowding out: BD => Debt rising over time => i 
More crowding out.
• Debt Dynamics: A path of ever-rising Debt/GDP is explosive.
Some important macro models,
continued
• Incentive effects of taxes:
– Elementary economics: tax distort incentives
• e.g., high marginal tax rates on income.
– “Laffer curve” (which usually fails):
t  => GDP  so much that total tax revenue
(= t x GDP) goes up rather than down.
• Barro’s “Ricardian debt neutrality”:
BD => S => NS unchanged .
(Another economic theory that fails.)
Appendix III: 3 pieces of evidence to support
the claim that US “fiscal conservatives” are not:
• (i) The voting pattern among the 258 Congressmen
who signed an unconditional pledge not to raise taxes:
– They had voted for more spending
than those who did not sign the pledge. [2]
• (ii) The pattern of spending
under different presidents.[3]
• (iii) The pattern of states whose Senators
win pork & other federal spending. [4]
•
•
•
[2] William Gale & Brennan Kelly, 2004, “The ‘No New Taxes’ Pledge,” Tax Notes, July.
[3] JF “Snake-Oil Tax Cuts,” EPI, Briefing Paper 221. 2008.
[4] JF Red States, Blue States and the Distribution of Federal Spending, 3/31/2010.
(ii) Spending & deficts both rose sharply when
Presidents Reagan, Bush I, & Bush II took office.
Vs. the 1990s: The Shared Sacrifice approach succeeded in eliminating
budget deficits, importantly by slowing spending.
(iii) States ranked by federal spending received
per tax dollar paid in 2005
versus party vote ratio in preceding election
“red”
states
“blue”
states
big inflow of US $
Republican states take home
significantly more federal $
(relative to taxes paid)
than Democratic states
low inflow of US $
Appendix IV:
The long-term US debt problem
• (1) From where did the debt come?
• (2) What will drive debt in the future?
– The problem is not budget deficits in the next few
years, which are coming down.
– The problem is the far larger increases in
entitlement programs based on current promises
• Social security
• Medicare and other health programs
(1) How did we
get here?
$13 trillion in 2011 debt,
relative to 2001 official projection
}
Wars in Iraq &Afghanistan (so far)
}
Bush tax cuts (which were
supposed to expire in 2011)
}
Over-optimistic economic
assumptions in 2001, e.g., growth rate
Source: The Great Debt Shift:
Drivers of Federal Debt Since 2001,
Pew Charitable Trust,
2009-11 fiscal
stimulus in response
to the recession
accounts for less
than 1/3 of recent
deficits
and is rapidly
disappearing.
CBPP, May 2011
(2) The long-term problem
Appendix V
U.S. fiscal stimulus in 2013
• If we opt for short-term fiscal stimulus
– or at least on counteracting the fiscal contraction
• that has been in effect for the last year
• and is scheduled for a quantum leap at the end of 2012;
• what form should it take?
U.S. fiscal policy in 2012-2013, cont.
• Maximizing bang for the buck ≡ fiscal stimulus
that gives the most demand per $ added to
long-term debt.
• Examples that minimize bang for the buck:
– proposal to make estate tax abolition permanent.
– Almost as poorly targeted: proposal to prevent the
Bush tax cuts from expiring in 2013 for those
households > $250,000.
• .
U.S. fiscal policy in 2012-2013, cont.
• If the stimulus has to take the form of
tax cuts, then the best options are:
– extending President Obama’s payroll tax cuts,
– fixing the Alternative Minimum Tax, and
– extending the Bush tax cuts for those
households < $250,000.
U.S. fiscal policy in 2012-2013, cont.
• But spending boosts demand
more than tax cuts do,
– because the latter are partly saved.
• Extend elements of the Obama stimulus
– such as infrastructure investment and
– giving money to the states
• so that they don’t have to lay off teachers, policemen,
firemen, subway drivers & construction workers.
Appendix VI
The procylicality of fiscal policy:
More on optimism bias & the case of Chile
Ten econometric findings regarding bias
toward optimism in official budget forecasts.
Frankel, 2011, “Over-Optimism in Forecasts by Official Budget Agencies and Its Implications.” Oxford Review of Economic Policy.
•
•
Official forecasts of budgets & GDP in a sample
of 33 countries are overly optimistic on average.
The bias toward optimism is:
–
–
–
•
stronger the longer the forecast horizon.
greater in booms
Greater among governments
that are under budget rules (SGP).
Chile’s official forecasts are not overly optimistic.
–
Chile has apparently avoided the problem of official
forecasts that unrealistically extrapolate51
in boom times.
10 econometric findings regarding bias toward
optimism in official budget forecasts, continued.
•
The key macroeconomic input for budget
forecasting in most countries: GDP.
In Chile: the copper price.
•
Real copper prices mean-revert
– in the long run,
– but this is not always readily perceived.
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Official forecasts of budgets & GDP
are overly optimistic on average
in a sample of 33 countries
• (1) Government forecasts of the budget balance
(App. Table 1)
– The average across all countries is an upward bias of:
• 0.2% of GDP at the 1-year horizon,
• 0.8% of GDP 2 years ahead,
• and a hefty 1.5% at 3 years ahead.
• (2) Government forecasts of the GDP growth rate
– The average across all countries is an upward bias of:
• 0.4 % when looking 1 year ahead,
• 1.1 % at the 2-year horizon,
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• and 1.8% at 3 years.
(App.Table 2)
Official forecasts are overly optimistic, continued
• The bias appears in US & other advanced countries.
– Chile on average under-forecast its growth rate.
• The sample of 33 countries:
–
–
–
–
26 from Europe (of which, 16 € members)
1 other major advanced country (US), and
3 advanced commodity-exporters (Australia, Canada, & NZ),
3 middle-sized emerging market commodity-exporters
(Chile, Mexico & South Africa)
.
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Official budget forecasts are biased
more if GDP is currently high & especially at longer horizons
Budget balance forecast error
as % of GDP, Full dataset
(1)
(2)
(3)
33 countries
One year
ahead
Two years
ahead
Three years
ahead
GDP
relative to
trend
0.093***
0.258***
0.289***
(0.019)
(0.040)
(0.063)
Constant
0.201
0.649***
1.364***
(0.197)
(0.231)
(0.348)
Variable is lagged so that it lines
in which the forecast179
was made.
Observations
398up with the year 300
*** p<0.01
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Robust standard errors in parentheses, clustered by country.
(6) Official budget forecasts are more optimistically biased
in countries subject to a budget deficit rule (SGP)
Budget balance forecast error
33 countries
SGPdummy
(1)
(2)
(3)
(4)
One year
ahead
Two years
ahead
One year
ahead
Two years
ahead
0.658
0.905**
0.407
0.276
(0.398)
(0.406)
(0.355)
(0.438)
0.189**
0.497***
(0.0828)
(0.107)
SGP dummy *
(GDP - trend)
Constant
as a % of GDP, Full Dataset
0.033
0.466*
0.033
0.466*
(0.228)
(0.248)
(0.229)
(0.249)
300
398
300
Observations
399
*** p<0.01, ** p<0.05, * p<0.1
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Robust standard errors in parentheses, clustered by country.
Poll ratings of Chile’s
President over time
In 2009, the popularity of the Socialist President of Chile Michelle Bachelet
rose sharply (both with respect to handling of the economy and overall),
to the highest levels since the restoration of democracy 20 years earlier.
More remarkable: the rise in the polls, from very low to very high, came just as the
economy moved from rapid growth to slow growth -- not the usual pattern. Why?
Chart source: Eduardo Engel, Christopher Neilson & Rodrigo Valdés, “Fiscal Rules as Social Policy,” Commodities Workshop, World Bank, Sept. 17, 2009
Poll ratings
of Chile’s
Presidents
and Finance
Ministers
And the
Finance
Minister?:
August 2009
In August 2009, the
popularity of the
Finance Minister,
Andres Velasco,
ranked behind only
President Bachelet,
higher than any
other minister since
democracy. Why?
Chart source: Eduardo Engel, Christopher Neilson & Rodrigo Valdés, “Fiscal Rules as Social Policy,” Commodities Workshop, World Bank, Sept. 17, 2009
Chile’s structural budget rule
• Government must set a fiscal target:
– In booms, can only spend structural revenue,
• must save the cyclical component.
– Structural ≡ economy at full employment
& price of copper at its long-run level
– Under Bachelet, structural deficit target was 0.
• Estimates of structural vs. cyclical
are made by commissions of experts,
not politicians, which avoids wishful thinking.
– In other countries, official fiscal forecasts have optimism bias.
JF, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” 2011.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
In 2008, a copper price spike had looked permanent to many.
In 2009, the price reverted toward its long run trend.
Application to other countries
• Any country could adopt the Chilean mechanism,
– not just commodity-exporters.
• Suggestion:
give the panels more institutional independence
– as is familiar from central banking:
• laws protecting them from being fired.
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