Senior Executive Fellows, April 23, 2013

1. Fiscal Policy:Austerity vs. StimulusJeffrey FrankelHarpel Professor of Capital Formation and Growth Senior Executive Fellows, April 23, 2013

2. Austerity vs. Stimulus Definitions • Fiscal austerity or contraction: • cut government spending or raise taxes • to raise budget surplus (or reduce budget deficit), • to avoid economic overheating • & strengthen long-run debt sustainability (deficit = Δ debt). • Fiscal stimulus or expansion: • Raise government spending or cut taxes • to provide short-term economic stimulus, • for growth & employment.

3. Austerity vs. Stimulus, continued • The question “What is the best fiscal policy, Austerity or Stimulus?” 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. 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. Central message of this talk: • During the period 2000-12, • some Emerging Market governments learned how to do counter-cyclical fiscal policy, • while many Advanced Country politicians forgot, • turning pro-cyclical instead, • exacerbating the business cycle.

7. 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 the recession, • even raising Debt/GDP. • But the United Kingdom did the same, • despite no euro-constraint forcing austerity in 2010-13. • And so did the United States !

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

9. Remainder of this talk • Consider the experiences of • Emerging Market / Developing countries • Europe • How can countries head off temptation for fiscal stimulus in the boom? • The fiscal situation in the US • Long-term • Medium-term • Short-term

10. Most 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)…

11. Emerging Market countries learned from the crises of the 1980s & 1990s. • After 2000, they reduced vulnerability to “currency mismatch” in their national balance sheets, by: • allowing more exchange rate flexibility; • shifting from dollar debt to domestic debt & FDI; • and accumulating more foreign exchange reserves. • Many took advantage of the 2002-07 expansion to strengthen their budgets.

12. Emerging Market (EM) countries strengthened their budgets after 2000 • Many EMs have, so far this century, achieved: • Lower debt levels than advanced economies; • improved credit ratings; • lower sovereign spreads; and • less pro-cyclical fiscal policies. • Historically, policy in developing-countries was pro-cyclical. • E.g., the correlation between spending & GDP was positive.

13. Correlations between Gov.t Spending & GDP 1960-1999 } procyclical Adapted from Kaminsky, Reinhart & Vegh (2004) Pro-cyclical spending countercyclical Counter-cyclical spending G always used to be pro-cyclical for most developing countries.

14. Correlations between Government spending & GDP 2000-2009 procyclical Frankel, Vegh & Vuletin(2012) In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy:Negative correlation of G & GDP. countercyclical

15. The historic role reversal Over the last decade some emerging market countries finally developed countercyclical fiscal policies: They took advantage of the boom years 2003-2007 to run primary budget surpluses and cumulate reserves. By 2007, Latin America had reduced its debt to 33% of GDP, vs. 63 % in the US. And so were able to respond to global recession of 2008-09 . E.g., Botswana, Chile, China, Korea, & Malaysia. Debt levels among rich countries (debt/GDP ratios > 90%) have reached triple those of emerging markets. Some emerging markets have earned credit ratings higher than some so-called advanced countries. 15

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

17. Public finances since 2001have become much stronger in EMs But weaker in advanced economies. World Economic Outlook, IMF, April 2012

18. Since 2008 recession, advanced countries have cut spending, relative to past recoveries; EMs have raised spending (having been relatively more conservative before 2008) World Economic Outlook (WEO) Hopes, Realities, and Risks IMF, April 2013

19. Ratio of public debt to GDP among advanced countriesis the highest since the end of WW II Source: Carlo Cotarelli “Making Goldilocks Happy,” IMF, Apr. 20, 2012

20. Greece let its deficit rise during the growth years, 2001-08,despite the 3% of GDP limit set by the Stability & Growth Pact & then was forced into sharp austerity in 2010-12. SGP floor Source: IMF, 2011.I. Diwan, PED401, Oct. 2011

21. Many leaders in advanced economies ignored the lessons of past crises. • They thought debt crises could never happen to them -- • most notably, leaders of euroland, • even after the periphery countriesviolated the deficit & debt ceilings of Maastricht and the SGP; • and even after the Greek crisis hit in late 2009 .

22. But Reinhart & Rogoff remind us: sovereign default is an old story, including among advanced countries –This Time is Different, updated in “From Financial Crash to Debt Crisis,” 2010 Sovereign External Debt: 1800-2009 Percent of Countries in Default or Restructuring 1930s 50%- 1870s 1830s 1980s Note: Sample size includes all countries, out of a total of sixty six, that were independent states in the given year. Sources: Lindert & Morton (1989), Macdonald (2003), Purcell & Kaufman (1993), Reinhart, Rogoff & Savastano (2003), Suter(1992), and Standard & Poor’s (various years).

23. Some defaulters, since the Napoleonic Wars Some governments have defaulted repeatedly, including European countries like Spain & Austria Sources: S & P; Kenneth Rogoff & Carmen Reinhart; http://jongoodwin.com/2010/04/15/die-rechnung/

24. European Debt/GDP ratios have been rising sharply, as high interest rates & negative growth overpower progress on reduction of primary budget deficits. Via: World Bank, PREM, 2012

25. Budget balance rules are in fashion. • Fiscal rules have been adopted by many countries. • Do they help? • Europe’s rules have failed (BD < 3% GDP; Debt < 60% GDP) • Maastricht Criteria & Stability & Growth Pact • Angela Merkel’s Fiscal Compact may be no better. • Such rules do not work in the US either: • Gramm-Rudman-Hollings in late 1980s • Debt ceiling legislation • Why?

26. “Tough” rules like the SGP or BBA are too rigid. requiring fiscalcontraction whentheeconomy isweak. They also lack enforceability: Every Euro country has violated the SGP. They worsen the problem of over-optimistic forecasts. E.g., when euro members go above the 3% deficit ceiling, they adjust their forecasts, not their policies. Better would be “structural” budget targets (Swiss) with forecasts from independent experts (Chile).

27. Threedistinct US fiscalproblems • The long-term debt problem • The medium-term economic problem • The short-term political problem

28. Three distinct US fiscal problems • The long-term problem -- debt unsustainability • warrants a path back to fiscal discipline. • The medium-term economic problem -- slow recovery in aftermath of the 2007-08 financial crisis, • warrants demand stimulus today, not contraction, • which is now holding back growth. • The short-term problem is political: • A succession of artificial “cliffs” & shutdown deadlines, each threatening disaster. • Since March 1: the “sequester” is in effect • $1.2 tr. over decade = ½ defense + ½ domestic.. • Soon we will hit the debt ceiling again.

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

30. 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.

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

32. 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 20 years. • Indeed the federal budget deficit is now coming down • from 10 % of GDP in FY 2009 to 7 % in FY 2012. • despite the continued weakness in the economy. • Recent steps will bring debt/GDP down over 2014-18. • 2011-13 $1.5 trillion in spending cuts • + $0.6 tr. 1/1/2013 tax “increase” (relative to having renewed all Bush tax cuts).

33. The budget deficit is currently on a declining path. “The Rapidly Shrinking Federal Deficit” Goldman Sachs Global Economics, Commodities & Strategy Research (Hatzius), Apr.10, 2013

34. Debt /GDP is set to decline over 2014 -18. • CBPP recommends a further $1.2 tr. in spending cuts & tax rises to stabilize debt out to 2022. • But there is no need for it to hit this year. That would send us back into recession. Center on Budget and Policy Priorities, Jan.9, 2013 http://www.cbpp.org/cms/index.cfm?fa=view&id=3885

35. 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

36. 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]

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

38. 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.

39. 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

40. Where are we now, in April 2013? • The political crisis: • repeated partisan standoffs in Congress. • To reduce the budget deficit: • how far can we get by discretionary spending cuts? • Where are the right places to squeeze, • politics aside ?

41. Repeated partisan stand-offs in 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 at the end of 2012 risked fiscal contraction sharp enough to cause a new recession. New debt ceiling, May 18(+): postponed from January 23, 2013.

42. 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.

43. How far can we get by cutting spending? Totalfederalspending = $3½ trillionin round numbers. That spending minus tax revenue left a budget deficit of $1.1 trillion in FY 2012, down from $1.4 trillion in 2009. Many Republican congressmen have campaigned to cut only non-defense discretionary spending, to exempt defense & senior-related spending(Soc. Security & Medicare). And adamantly no tax increase.  That was their official platform in the 2010 election. How much would we have to trim non-defense discretionary spending to balance the budget?

44. How far can we get by cutting spending?continued Start by eliminating PBS funding =1/10,000 of spending Then all foreign aid.  = 1 ½ % of total outlays, not 25% as Americans think.  Next, veterans’ benefits. The same. We are now up to a total of 3 % of outlays. Next imagine zeroing out all federal spending on agriculture, science & environment, education & transportation,   which includes programs too popular for congressmen to vote for.    That is a total of $364 b = 1/3 of the 2012 deficit.  Conclusion: Domestic discretionary spending is not where the big bucks are. Would would also need to eliminate either all of defense, or all medicare payments or all social security payments while still collecting the social security taxes that are supposed to pay for it!

45. Eliminating all non-defense discretionary spending(including also parks, weather service, food safety, SEC, FBI, border patrol, politicians’ salaries… everything !)would not come close to eliminating the budget deficit $92 b Total ≈½ deficit $86 b $61 b $59 b $56 b $35 b $30 b $17 b $6 b Concord Coalition. Data Source: CBO, Jan.2012

46. 3 biggest spending categories:Health, Social security, & Defense { Medicare & medicaid Concord Coalition. Data Source: CBO, Jan. 2012

47. Breakdown of federal spending Even if one could somehow eliminate all domestic spending, it would not come close to eliminating the deficit Budget deficit was $1.1 trillion in FY 2012 Outlays: $3.5 trillion Deficit $1.1 tr. Tax revenue $2.5 tr. Concord Coalition. Data Source: CBO, Jan. 2012 Updated: http://cbo.gov/sites/default/files/cbofiles/attachments/2012_09_MBR.pdf

48. 12 years ago, if the country thought it important enough to protect any single category against belt-tightening in the long run -- say military or social security or tax cuts for the rich -- it would have been arithmetically possible, by making the cuts elsewhere. But we no longer have the luxury of such choices after the legacy of the last decade — after the effects of mammoth tax cuts (2001 & 2003), two wars (2001, 2003), the Medicare prescription drug benefit (2003), and the severe financial crisis & recession (2008). Starting from our current position, each of the 5 components must play a role, along with taxes.

49. 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…

50. How to reduce the budget deficit The only way to do this is both reduce spending & raise tax revenue, as we did in the 1990s. • Spending. Examples: • Eliminate agricultural subsidies. • Cut manned space program. • Trim National Guard & Reserves, • Close unwanted military bases • Cut unwanted weapons systems • A rare success: the F22 Raptor fighter. Now F-35 Joint Strike Fighter? ($600b/10 yrs.) • Global Hawk Block 30 drone program? • The C-27J Spartan cargo aircraft? • Upgrades to the M1 Abrams tank • Virginia-class submarine? ($2.6 b)