Jeffrey FrankelHarpel Professor of Capital Formation & Growth

Economic & Fiscal Outlook

Senior Executive FellowsApril 30, 2012

World Economic Outlook, IMF, April 2012

Euro-recession is pulling down growth.

The US is doing better.

GDP growth forecasts for 2012–13 (percent)

Emerging Market growth is slowing too, but solidly >0.

After 3 years, the U.S. in 2011 finally achieved its pre-recession level of GDP

Jan. 2007 – Feb. 2012, monthly, estimated by Macroeconomic Advisers

Obama Inauguration

End of recession

Data Source: U.S. Bureau of Labor Statistics

Obama Inauguration

End of recession Private

sector job creation (by quarter)

Average rate of private job creation between the two recessions (Nov. 2001-Dec.2007)

Average rate of private job creation throughout 8 Bush years(Jan. 2001-Jan.2009)

Possible risks to the recovery in 2012

• Euroland: Worsening of sovereign debt crisis?– and contagion to other high Debt/GDP countries.

• Political breakdown in Washington?• like the debt ceiling standoff of August 2011• which led S&P to downgrade US from AAA to AA

» for the 1st time in history.

• Emerging markets: hard landing?– particularly in China.

• Major oil crisis?– from military confrontation with Iran.

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 probably violated anyway.

– I.e., a return of the stand-off:• => Danger of recession and default !

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Sovereign debt worries ...

• Who is vulnerable to contagion?

• The emerging market countries are in much better shape than past decades,• in an amazing & historic role reversal.

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A remarkable role-reversal:

• Debt/GDP of the top 20 rich countries (> 80%) is already more than twice that of the top 20 emerging markets;

• and rising rapidly.

Country creditworthiness is now inter-shuffled“Advanced” countries (Formerly) “Developing” countriesAAA Germany, UK SingaporeAA+ US, FranceAA Belgium ChileAA- Japan ChinaA+ KoreaA Spain Malaysia, South AfricaA- Brazil, Thailand, BotswanaBBB+ Italy ColombiaBBB- Iceland, Ireland IndiaBB+ Indonesia, PhilippinesBB Portugal Costa Rica, JordanB Burkina FasoCC Greece S&P ratings, Feb.2012 domestic currency

What Determines Country Vulnerability?

• Fundamentally: Quality of institutions.– This does not mean “tough” rules that lack enforceability

• like Stability & Growth Pact, debt ceiling or Balanced Budget Amendment.

– Better would be structural budget targets (Swiss) with forecasts from independent experts (Chile).• The smartest commodity producers in boom years

save export earnings in a Sovereign Wealth Fund (Botswana)

– One third of developing countries have graduated from pro-cyclical spending to countercyclical since 2000.

– The US, UK & euro countries could learn from them.

Correlations between Govt. Spending & GDP1960-1999

procyclical

G always used to be pro-cyclical for most developing countries.

countercyclical

Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours”

Pro-cyclical spending

Counter-cyclical spending

}

In the last decade, about 1/3 developing countries

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

Frankel, Vegh & Vuletin (2011)

procyclicalcountercyclical

Correlations between Govt. Spending & GDP2000-2009

The US budget

• 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.

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While fiscal stimulus should not be withdrawn now, 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.

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

Concord Coalition. Data Source: CBO, Jan.2012

$6 b

$30 b

$17 b

$56 b

$35 b

$61 b $59 b

$86 b

$92 b

Breakdown of federal spending

Concord Coalition. Data Source: CBO, Jan. 2012

Taxrevenue$2.5 tr.

Deficit$1.1 tr.

in FY 2012, from $1.4 trillion in FY 2009

Even if one could somehow eliminate all domestic spending, it would not come close to eliminating the deficit

• 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 deficitThe 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

Joint Committee of Taxation, Jan. 2012

$128 b

$93 b

$84 b

$305 billion

Doing nothing is an option

CBPP, May 2011

The long-term problem is entitlements

Concord Coalition. Data Source: CBO, Jan. 2012

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• 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.

Including“Did Obama Turn Around the Economy?” Project Syndicate, Feb. 17, 2012.

"Small Countries, Big Ideas," forthcoming, Business Economics (National Association of Business Economists), April 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.

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For background writings, you can Google “Jeffrey Frankel Harvard”

Or go to my webpage: http://www.hks.harvard.edu/fs/jfrankel/index.htm

Or my blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/

Appendix I: 3 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

R. R

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G.H

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ush

W.J

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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 receivedper tax dollar paid in 2005

versus party vote ratio in preceding election

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

“red”states

“blue”states low inflow of US

$

big inflow of US $

Appendix II: The Long-term 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

Over-optimistic economic assumptions in 2001, e.g., growth rate

Bush tax cuts (which were supposed to expire in 2011)

Wars in Iraq &Afghanistan (so far)}

}

}

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 III

• If we opt for short-term fiscal stimulus– or at least on counteracting the current fiscal contraction,

• what form should it take?

U.S. fiscal policy in 2012-2013

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 would 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.

• .

• 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. – Some business tax cuts can also give bang

for the buck. • such as temporary credits for investment or hiring.

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.

U.S. fiscal policy in 2012-2013, cont.