Jeffrey FrankelJeffrey FrankelHarpel Professor of Capital Formation & GrowthHarpel Professor of Capital Formation & Growth

Back to School Back to School on theon the Budget:Budget:

History & ArithmeticHistory & Arithmetic

Senior Executive FellowsSenior Executive FellowsMarch 14, 2011March 14, 2011

In September 2010, the NBER Business Cycle Committee

announced that the trough of the recession came in June

2009 which marked the end of the longest

& most severe recession since the 1930s.

As usual, we were attacked both for not having declared the obvious trough

earlier, based on the rule of 2 consecutive quarters of positive

growth,

and also for not waiting until the economy was better which showed we were “out of touch with reality.”

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BUSINESS CYCLE REFERENCE DATESBUSINESS CYCLE REFERENCE DATES   Source: NBERSource: NBER

PeakPeak TroughTrough ContractioContractionn

Quarterly dates are in parenthesesQuarterly dates are in parentheses Peak to TroughPeak to Trough

August 1929 (III)August 1929 (III)May 1937 (II)May 1937 (II)February 1945 (I)February 1945 (I)November 1948 (IV)November 1948 (IV)July 1953 (II)July 1953 (II)August 1957 (III)August 1957 (III)April 1960 (II)April 1960 (II)December 1969 (IV)December 1969 (IV)November 1973 (IV)November 1973 (IV)January 1980 (I)January 1980 (I)July 1981 (III)July 1981 (III)July 1990 (III)July 1990 (III)March 2001 (I)March 2001 (I)December 2007 (IV) December 2007 (IV)

March 1933 (I)March 1933 (I)June 1938 (II)June 1938 (II)October 1945 (IV)October 1945 (IV)October 1949 (IV)October 1949 (IV)May 1954 (II)May 1954 (II)April 1958 (II)April 1958 (II)February 1961 (I)February 1961 (I)November 1970 (IV)November 1970 (IV)March 1975 (I)March 1975 (I)July 1980 (III)July 1980 (III)November 1982 (IV)November 1982 (IV)March 1991 (I)March 1991 (I)November 2001 (IV)November 2001 (IV)

43 months43 months13138811111010881010111116166616168888

1818

Average, all cycles:Average, all cycles: 1854-2001 (32 cycles) 1854-2001 (32 cycles)

1945-2001 (10 cycles)1945-2001 (10 cycles)

  

1717

1010

June 2009 (II)

National output shows the trough

Figure 1. Monthly Output, Jan. 2006 - June 2010,Indexed to Dec. 2007 = 100

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Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

Year

Index

Val

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S-W GDP

S-W GDI

Average S-WGDP&GDI

Peak

Trough

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Danger of a double-Danger of a double-dip?dip?

There could always be new There could always be new shocks:shocks: Sovereign debt contagion, Sovereign debt contagion,

spreading from Greece, Ireland…spreading from Greece, Ireland… Hard landing for the $Hard landing for the $ Geopolitical/oil shock…Geopolitical/oil shock…

I put the I put the odds of a double dip odds of a double dip recessionrecession as small. as small.

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Time to enact return toward fiscal Time to enact return toward fiscal disciplinediscipline

The only way to do this is The only way to do this is both both reduce spending reduce spending & raise tax revenue, as we did in the 1990s.& raise tax revenue, as we did in the 1990s.

Tax revenueTax revenue Let President Bush’s tax cuts expire for the rich in 2013Let President Bush’s tax cuts expire for the rich in 2013 Introduce a VAT or phase in auctioning of tradable emission Introduce a VAT or phase in auctioning of tradable emission

permitspermits Curtail expensive and distorting tax expendituresCurtail expensive and distorting tax expenditures

E.g., Tax-deductibility of mortgage interestE.g., Tax-deductibility of mortgage interest

All politically All politically veryvery difficult, needless to say. difficult, needless to say.

Any solution requires:Any solution requires: Honest budgeting Honest budgeting (e.g., Iraq war on-budget, etc…)(e.g., Iraq war on-budget, etc…) Regime of Shared SacrificeRegime of Shared Sacrifice Wise up to politicians who insist on doing it entirely on Wise up to politicians who insist on doing it entirely on

the spending side & but who raise overall spending the spending side & but who raise overall spending when they get the chance.when they get the chance.

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 first.”

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 (e.g., 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 left more debt than his father + Reagan + 39 predecessors

On what basis do “fiscal conservatives” claim that tax cuts lead to budget surpluses?

(1) Tea Party logic: Claim: We can do it by cutting Head Start & 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.”

Goal of eliminating budget deficits

Threats of a government shut-down, either when a continuing resolution is needed to keep the

government operating, or when an increase in the national debt ceiling is required. 

Description of showdown as a high-stakes game of chicken is right.  

But at least some of the Tea Partiers say that their goal is literally to avoid an increase in the debt ceiling – not just as a bargaining ploy or abstract goal, but they want to cut spending so sharply that there is no more need

to borrow.  

Similarly, Senators Mike Lee (Utah) & John Kyl (Ariz.) have revived proposals for a balanced budget amendment.

How far can we get by cutting spending?

Total federal spending = $3 ½ trillion in round numbers.    

That spending minus tax revenue left a budget deficit of $1.3 trillion in FY 2010.  

Most Republican congressmen want to exempt defense & senior-related spending (Soc.Security & Medicare),

to make all the cuts in non-defense discretionary spending.  That was their official platform in November’s election. Aside from Ron Paul, a genuinely sincere

libertarian.

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.  Foreign aid is only about 1% of total outlays, not 25% as people think. 

Next imagine zeroing out all of veterans’ benefits and all federal spending on education & transportation.  

That includes programs so popular that the congressmen voting for them would lose re-election. 

But some of the freshmen say they are willing to pay that price.   We are only up to 6% of total outlays.  

Now eliminate all non-defense discretionary spending:  parks, weather service, food safety, SEC, FBI, border patrol,

politicians’ salaries… everything !  Does that close the gap?    It only gets you half way there!  

Conclusion: Domestic discretionary spending is not where the big bucks are.

These 4 categories = 6% of outlays

The arithmetic works out quite simply.

 Of the $3 ½ trillion in federal outlays, 1/5 is non-defense discretionary spending.   Another 1/5th is defense.   Social security is the third 1/5th.    Medicare is the fourth 1/5th

slightly less now, but far far more in the future.    The last 1/5th is interest on the debt

(which will also grow enormously in the future) plus other entitlements.   

1/5 + 1/5 + 1/5 + 1/5 + 1/5

The arithmetic works out quite simply, continued.

Numerically speaking, we would have to eliminate

not just all non-defense discretionary spending, but also all defense. 

Or else all social security spending but still collect the payroll taxes that are supposed to fund it! 

Or else all Medicare spending.  

The unmistakable implication: a solution to our long-term fiscal problems must involve some sharing of sacrifice among each of these 5 categories, and increased tax revenue as well.    

Admittedly, the Republican leadership’s goal for the current fiscal year was to reduce domestic spending by “only” $100 billion.  

But the freshmen’s position: this goal is not enough.  At the same time, they can’t come up with that

much in specific cuts that they are willing to put their names to,

let alone enough to offset the Dec. extension of Bush tax cuts, let alone anything like budget balance.

Why? The familiar reasons: domestic discretionary spending is not where the money is.

Reasonable medium term goals:

raise taxes as a share of GDP at least to 18%, = what it was during the Reagan administration,

& lower spending to 23% = what it was then as well. 

 

Of course these two numbers still leave us with a deficit of 5% of GDP, = Reagan’s record. 

It will take us much longer to get back to the fiscal rectitude of Clinton.   It is not possible to eliminate the need to borrow, in the short run.   

Ten years ago, if the country thought it was important enough to protect any single category against belt-tightening in the long run - say 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.“Conservatives,” “liberals,” & 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.

Three pieces of evidence to support the claim that “fiscal conservatives” are not:

(i) The voting pattern among the 258 Congressmen who signed an unconditional pledge not to raise taxes: As of 2004, 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.

Vs. the 1990s: The Shared Sacrifice approach succeeded in eliminating budget deficits, importantly by slowing spending.

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Spending and Budget Balance(inverse) as % of GDP (Current US$)

Spending/GDP Budget Balance/GDP

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W.J

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G.W

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Source: OMB

ρ = 0.86

(ii) Spending & deficts both rose sharply when Presidents Reagan, Bush I, & Bush II took office.

(iii) States ranked by federal spending received

per tax dollar paid in 2005versus party vote ratio in preceding election

Republican states take home Republican states take home significantly more federal $ significantly more federal $ (relative to taxes paid)(relative to taxes paid) than Democratic statesthan Democratic states

“red”states

“blue”states low inflow of US $

big inflow of US $

U.S. fiscal policy in 2010-2011, continued

How does one take steps today to lock in future fiscal consolidation?

Not by raising taxes or cutting spending today (see above);

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.

U.S. fiscal policy in 2010-2011, continued

One big reform might work best: pass legislation today to put Social Security on a sound financial footing in the long term.

It would consist of a combination of raising the retirement age

just a little (in proportion to lengthening life spans)

and slowing the growth of benefits for future retirees just a little (perhaps by “progressive indexation).

If Washington could fix Social Security, it would address the long-term fiscal outlook, yet would create no drag for the current fragile recovery.

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SpendingSpending Cuts in farm subsidies for agribusiness & farmers, incl. Cuts in farm subsidies for agribusiness & farmers, incl.

ethanol ethanol Cut unwanted weapons systems Cut unwanted weapons systems (a rare success: the F22 fighter)(a rare success: the F22 fighter) Cut manned space program…Cut manned space program…

Social securitySocial security Raise retirement age – just a littleRaise retirement age – just a little Progressively index future benefit growth to inflationProgressively index future benefit growth to inflation Raise the cap on social security taxes.Raise the cap on social security taxes.

Health careHealth care Encourage hospitals to standardize around best-practice Encourage hospitals to standardize around best-practice

medicine medicine to pursue the checklist that minimizes patient infections, to pursue the checklist that minimizes patient infections, avoid unnecessary medical tests & procedures,avoid unnecessary medical tests & procedures, & standardize around best-practice treatment.& standardize around best-practice treatment. Lever: making Medicare payments conditional on these best practices .Lever: making Medicare payments conditional on these best practices .

Curtail corporate tax-deductibility of health insurance, Curtail corporate tax-deductibility of health insurance, especially gold-plated.especially gold-plated.

When will US adopt the tough measures to get back to fiscal

sustainability?

Ideally, we would begin soon adopt measures that would begin to go into effect in 2012 and over the coming decades – repeating the 1990s success.

Otherwise, in response to future crises, when it will be much more painful !

Appendix: More on the budgetThe two-part strategy that would have made sense at the end of 2010

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: Steps to extend the fiscal stimulus,

designed to maximize bang for the buck. Simultaneous steps to lock in future progress

back toward fiscal discipline in the long run.

U.S. fiscal policy in 2010-2011, continued

Maximizing bang for the buck ≡ fiscal stimulus that gives the most demand per $ added to long-term debt.

Example that would minimize bang for the buck: proposal to make permanent the 2010 estate tax abolition . Almost as poorly targeted: proposal to prevent the Bush tax

cuts from expiring in 2011 for those households > $250,000.

If the stimulus has to take the form of tax cuts, then the best options are: extending President Obama’s “Make Work Pay” tax cuts, fixing the Alternative Minimum Tax, and extending the Bush tax cuts for those households < $250,000. Some business tax cuts could also give high bang for the buck.

such as temporary credits for investment or hiring.

U.S. fiscal policy in 2010-2011, continued

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.

The national debt as a share of GDP

Source: CBO, March 2011

Projected shares of budget in 2021

Source: CBO, March 2011