Fiscal Policy:Austerity vs. Stimulus

Jeffrey FrankelHarpel Professor of Capital Formation and Growth

Senior Executive Fellows, April 22, 2014

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,– raising budget surplus (or reducing budget deficit),

• to avoid overheating the economy• & strengthen long-run debt sustainability. (Deficit = Δ debt).

Austerity vs. Stimulus

• “What is the best fiscal policy, Austerity or Stimulus?”

• The question is as foolish as the question, “Should a driver turn left or right?”

• It depends where he is in the road.– Sometimes left is the answer, sometimes right.

Austerity vs. Stimulus, continued

Cyclicality of Fiscal Policy

• Keynes favored counter-cyclical policy:– fiscal stimulus when under conditions like the 1930s

-- 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

• 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.

Cyclicality of Fiscal Policy, continued

Cyclicality of Fiscal Policy, continued

• Conspicuously, Greece & other euro members failed to reduce budget deficits during years of growth, 2002-08

– and were then forced to cut spending & raise taxes 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 !

As one should have expected,fiscal contraction is contractionary

Source: P.Krugman, 10 May 2012, via R.Portes, May 2013.

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.

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Source: IMF, 2011.I. Diwan, PED401, Oct. 2011

Greece let its deficit rise during the growth years, 2001-08,despite the 3% of GDP limit set by the Stability & Growth Pact

SGP floor

& then was forced into sharp austerity in 2010-13.

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.

Not sustainable

The US does have a long-term debt problem..

Fiscal policy

Source: Concord Coalition, spring 2013 http://www.concordcoalition.org/issues/indicators/projected-debt

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.

• 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 has come down• from 10 % of GDP in 2009 to 4 % in 2013 & 3% in 2014.

Long-term debt problem, continued

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)

Budget balancesfall in recessions

2008-09 unusual:1. magnitude 2. earliness of

fiscal contraction

New CBO estimate:2014 BD=2.8% GDP< 40-year average.

Updated budget projections CBO, Apr. 14, 2014

The evolution of projected future US Debt/GDP ratios

Phony assumption that Bush tax cuts would disappear after 2010:

Recession +extension of most Bush tax cuts

Sequester & other spending cuts:

Still out there: Coming big deficitsin Social Security & Medicare

Data: Congressional Budget Office.

Source: How Much Room for Improvement in Long-Term Budget Projections? Goldman Sachs Global Macro Research 1/30/2014

The debt problem is also “long-term” in the sense that we have known about it a long time.

"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

Long-term debt problem, continued

E.g., when Ronald Reagan, took office:

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]

Brief US fiscal history: The 1980s

• The newly elected Reagan complained of inherited debt:– “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.”)

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: GHW Bush bravely 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

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

• 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…

The Budget & Economic Outlook, 2014-2024, CBO, 2014, p.15

Spending 20 ½ % of GDP = Mandatory 12% + discretionary 7% + interest 1%.

Federal budget in 2014

Minus tax revenue 17 ½ % of GDP = budget deficit 3 % of GDP.

2/3 of federal spending is mandatory:social security, medicare, UI

2/3 is mandatory.

Only 1/3 is discretionary.

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

How to reduce the budget deficitBoth 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?

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 “tax expenditures”

• 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.

Tax expenditures are huge

The Budget & Economic Outlook, 2014-2024, CBO, 2014.

Tax expenditures are far higher than:

social security spending

or military spending

Three tax expenditures to curb

Mortgage interest deductionprojected at ½ % of GDP.

Preferential treatment of dividends & cap. gainsprojected at 0.6 % of GDP.

Exclusion of employers’ health contributionsprojected at 1.6% of GDP

The Budget & Economic Outlook, 2014-2024, CBO, 2014.

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• Social security–Raise retirement age – just a little,

• perhaps exempting low-income workers.

– 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.

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• 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.

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. Policy Vol.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 Journal vol.27, no. 2, Spring/Summer, 2007.

• “Republican and Democratic Presidents Have Switched Economic Policies,” Milken Institute Review 5, no. 1, 2003 QI.

Google “Jeffrey Frankel Harvard” for webpage or blog http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/

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

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

Appendix 1: More on the US

(a) The long-term debt problem..

National debt/GDP is the highest since WWII spike.

Debt / GDP is set to decline over 2014 -18.

Center on Budget and Policy Priorities, Jan.9, 2013 http://www.cbpp.org/cms/index.cfm?fa=view&id=3885

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.

Long-term debt problem, continued

Federal

Not sustainable

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.

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.

The stock market turned around immediately

March 9,2009

Jan.20,2009

GDP stopped falling immediately.

Jan.20,2009

Level of GDP, monthly (Dec.2006-Dec.2013), estimated by Macroeconomic Advisers

June,2009

Jan.202009

The rate of job loss turned around quickly

Jan.20,2009

June,2009

Jan.202009

Appendix 1(c) Some US politicians have

pursued pro-cyclical (i.e., destabilizing) fiscal policy

1st cycle:

• 1980-81: Reagan’s

speeches pledging action to reduce the national debt “beginning today” came during a period of severe recession.

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.”

Recession: austerity.

Some US politicians have sought pro-cyclical fiscal policy, continued

2nd cycle

• 1990: The first President Bush summoned the political will to raise taxes & rein in spending (PAYGO) at precisely the wrong moment -- just as the US entered another recession.

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: After his fiscal expansion had 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.”

Recession: austerity.

Some US politicians have sought pro-cyclical fiscal policy, continued

3rd cycle

• 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.

Recession: austerity.

Thus, through 3 cycles, the efforts at austerity came during recessions,

followed by fiscal expansionwhen the economy was already expanding.

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 tricks to justify tax cuts, dating from the 1980s:• The Magic Asterisk• Rosy Scenario• Laffer Hypothesis• Starve the Beast Hypothesis

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…

• 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.

Appendix 1(d): 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, Jan. 1, 2013.• Sequestration into effect March 1, 2013• Government shutdown, Oct. 1-16, 2013• Debt ceiling, Oct.17, 2013.

The 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 Republicans may have miscalculated.

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)…

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

50%-

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).

1980s1930s1870s1830s

Emerging Market (EM) countries learned from the crises of the 1980s & 1990s.

• Some EMs took advantage of the 2002-07 expansion to strengthen their budgets.

• They 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.

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Correlations between Gov.t Spending & GDP1960-1999

procyclical }G always used to be pro-cyclical

for most developing countries.

countercyclical

Adapted from Kaminsky, Reinhart & Vegh (2004)

Pro-cyclical spending

Counter-cyclical spending

55

Correlations between Government spending & GDP 2000-2009

In the last decade, about 1/3 developing countries

switched to countercyclical fiscal policy:Negative correlation of G & GDP.

Frankel, Vegh & Vuletin (2012)

procyclicalcountercyclical

56

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.

– 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.

During the decade after 2000,

• 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.

Cyclicality of Fiscal Policy, continued

Country creditworthiness is now inter-shuffled“Advanced” countries (Formerly) “Developing” countriesAAA Germany, UK Singapore, Hong KongAA+ US, FranceAA Belgium ChileAA- Japan ChinaA+ KoreaA MalaysiaA-Thailand, BotswanaBBB+ Ireland, Italy, Spain BBB- Iceland ColombiaBB+ PhilippinesBB Portugal Costa Rica, JordanB Burkina FasoSD Greece

S&P ratings, Feb.2012 updated 8/2012

But weaker in advanced economies.

World Economic Outlook, IMF, April 2012

Public finances after 2001became stronger in EMs

Since 2008 recession, advanced countries have cut spending, relative to past recoveries;

World Economic Outlook (WEO) Hopes, Realities, and Risks

IMF, April 2013

EMs have raised spending (having been relatively more conservative before 2008)

• Fiscal rules have been adopted by many countries.

• But the rules are usually violated.• 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?

How can countries address chronic deficits?

Appendix 3: Budget Balance Rules

Countries with Balanced Budget Rules frequently violate them.

International Monetary Fund, 2014

BBR: Balanced Budget Rules

DR: Debt Rules

ER: Expenditure Rules

%

%

<50%

• “Tough” rules like the SGP or BBA are too rigid. • requiring fiscal contraction when the economy is weak.• They also lack enforceability:• Every Euro country 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).