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Fiscal Policy: Austerity vs. Stimulus Jeffrey Frankel Harpel Professor of Capital Formation and Growth

Fiscal Policy: Austerity vs. Stimulus Jeffrey Frankel Harpel Professor of Capital Formation and Growth. REAI Alumni Advisory Board Harvard Faculty Club, 9:25 – 10:25, April 25 th , 2014. . Austerity vs. Stimulus. Definitions Fiscal stimulus or expansion:

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Fiscal Policy: Austerity vs. Stimulus Jeffrey Frankel Harpel Professor of Capital Formation and Growth

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  1. Fiscal Policy:Austerity vs. StimulusJeffrey FrankelHarpel Professor of Capital Formation and Growth REAI Alumni Advisory Board Harvard Faculty Club, 9:25 – 10:25, April 25th, 2014.

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

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

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

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

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

  7. As one should have expected,fiscal contraction is contractionary Source: P.Krugman, 10 May 2012, via R.Portes, May 2013.

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

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

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

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

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

  13. Long-term debt problem, continued • There is not a short-term problem: • Far from tiring of absorbing ever-greater levels of US treasury securities, global investors continue happily to lend at record-low interest rates (2008-13): • The US enjoys safe-haven status; the $ enjoys “exorbitant privilege.” • There is no fiscal crisis. The US is not Greece, • though we want to be sure not to become Greece in 30 years. • Indeed the federal budget deficit has come down • from 10 % of GDP in 2009 to 4 % in 2013 & 3% in 2014.

  14. The US budget deficit shot up in the 2008-09 recession, but has since fallen by 2/3(from 10% of GDP to 4% of GDP in 2013) NewCBOestimate: 2014BD=2.8%GDP < 40-year average. Budget balancesfall in recessions 2008-09 unusual:1. magnitude 2. earliness of fiscal contraction Updated budget projectionsCBO, Apr. 14, 2014

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

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

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

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

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

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

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

  22. Federal budget in 2014 Spending 20 ½ % of GDP = Mandatory 12% + discretionary 7% + interest 1%. Minus tax revenue 17 ½ % of GDP = budget deficit 3 % of GDP. The Budget & Economic Outlook, 2014-2024, CBO, 2014, p.15

  23. 2/3 of federal spending is mandatory:social security, medicare, UI Only 1/3 is discretionary. 2/3 is mandatory.

  24. Eliminating all domestic discretionary spending would not be enough to eliminate the deficit.

  25. How to reduce the budget deficit Both reduce spending & raise tax revenue, as we did in the 1990s. • Discretionary spending. Examples: • Eliminate agricultural subsidies. • Cut manned space program. • Trim National Guard • Close unwanted military bases • Cut unwanted weapons systems • F-22 Raptor fighter production discontinued (after $67b for 200). • F-35 Joint Strike Fighter? ($600b/10 yrs.) • The C-27J Spartan cargo aircraft? ($567m for 21, direct into storage) • The M1 Abrams tank? (more? Or upgrades?) • Virginia-class submarine? ($2.6 b) • Global Hawk Block 30 drone program?

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

  27. Tax expenditures are huge are far higher than: Tax expenditures social security spending or military spending The Budget & Economic Outlook, 2014-2024, CBO, 2014.

  28. Three tax expenditures to curb Exclusion of employers’ health contributions projected at 1.6% of GDP Mortgageinterestdeduction projected at ½ % of GDP. Preferential treatment of dividends & cap. gains projected at 0.6 % of GDP. The Budget & Economic Outlook, 2014-2024, CBO, 2014.

  29. Social security Raise retirement age – just a little, perhaps exempting low-income workers. Lock it in today. Index benefit growth to chain measure of inflation. Further options: To please Democrats: Raise the cap on social security taxes. To please Republicans: encourage private accounts though they contribute nothing to closing the gap. 29

  30. Health care Encourage hospitals to standardize around best-practice medicine. Pay health providers for “value,” not per medical procedure. Standardize around best-practice treatment: evidence-based (to be facilitated by electronic health records). E.g., pursue the checklist that minimizes patient infections, and avoid unnecessary medical tests & procedures. That is not “death panels.” Levers to get providers to follow best practices: make Medicare payments conditional or offer protection from malpractice litigation. Curtail corporate tax-deductibility of health insurance. 30

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

  32. Appendices 1: More on the US - a) The long-term debt problem - b) Did the 2009 fiscal stimulus work? - c) Procyclical politicians - d) Partisan stand-offs, 2011-2013 2: Budgets in EM / Developing Countries 3: Balanced Budget Rules

  33. Appendix 1: More on the US (a) The long-term debt problem.. National debt/GDP is the highest since WWII spike.Source: CBO, March 2012

  34. Appendix 1: More on the US (a) The long-term debt problem.. National debt/GDP is the highest since WWII spike.

  35. Long-term debt problem, continued Federal Not sustainable

  36. Federal debt ratiounder health cost growth assumptions Source: How Much Room For Improvement in Long-Term Budget Projections?Goldman Sachs Global Macro Research 1/30/2014 Data: Congressional Budget Office.

  37. 1(b) Did the 2009 fiscal stimulus work? • Obama was sworn in on January 20, 2009. • The economy had been in freefall since the Lehman Bros. failure Sept. 15: GDP fell 8.3 % p.a. in Q4. • He signed the American Recovery & Reinvestment Act into law Feb. 17. • The economic statistics: • The stock market turned around March 9, 2009. • The rate of job loss bottomed out in March 2009. • GDP stopped falling. Recession ended in June.

  38. The stock market turned around immediately Jan.20,2009 March 9,2009

  39. GDP stopped falling immediately. Jan.202009 Jan.20,2009 June,2009 Level of GDP, monthly (Dec.2006-Dec.2013), estimated by Macroeconomic Advisers

  40. The rate of job loss turned around quickly Jan.202009 Jan.20,2009 June,2009

  41. Appendix 1(c) SomeUSpoliticianshavepursuedpro-cyclical (i.e., destabilizing) fiscal policy1st cycle: Recession: austerity. Boom: profligacy. • 1988: As the economy neared the peak of the business cycle, candidate George H.W. Bush was unconcerned about budget deficits: • “Read my lips, no new taxes.” • 1980-81:Reagan’sspeeches pledging action to reduce the national debt “beginning today” came during a period of severe recession.

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

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

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

  45. The US has its own version of biased forecasts Official US forecasts in the 2000s • White House forecasts were over-optimistic all along. • OMB in Jan. 2001 forecast rapid rise in tax revenue, • in effect assuming there would never be a recession. • Four tricksto justify tax cuts, dating from the 1980s: • The Magic Asterisk • Rosy Scenario • Laffer Hypothesis • Starve the Beast Hypothesis

  46. The US version of biased forecasts, continued Official US forecasts in the 2000s • Congressional Budget Office forecasts are honest. • But the Bush Administration adopted new tricks, • so that “current-law budget” would show future surpluses: • continuation of Iraq & Afghan wars treated as a surprise each year; • phony sun-setting of tax cuts…

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

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

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

  50. Appendix 2: EM / Developing CountriesMost experience with sovereign debt problems during our lifetimes arose in developing countries • Recycling of petrodollars after 1974 - • ended in the international debt crisis of 1982 • and the Lost Decade of growth in Latin America. • Emerging market inflows in the 1990s • ended in currency crashes: • Mexico (1994), • East Asia, Russia (1997-98) • Turkey, Argentina (2001)…

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