Institutions of Macroeconomic Policy

Appendices

Jeffrey Frankel

Lecture II, May 31Fiscal Policy Institutions

Appendices

• The U.S. fiscal situation– The standoff

– How to reduce the deficit

• Some important macro relationships

• “Fiscal conservatives”

• The long-term US debt problem

• US fiscal stimulus in 2013

• The bias in official forecasts• Chile’s structural budget rule

The two biggest risks to the economy in The two biggest risks to the economy in the coming yearthe coming year

• Worsening of the euro’s Worsening of the euro’s sovereign debt crisis,sovereign debt crisis,– and contagion to other high Debt/GDP countries.and contagion to other high Debt/GDP countries.

• Political breakdown in Washington Political breakdown in Washington – in December 2012.in December 2012.– A return to the debt ceiling standoff of August 2011,A return to the debt ceiling standoff of August 2011,

• which led S&P to downgrade USwhich led S&P to downgrade US from from AAA to AAAAA to AA» for the 1for the 1stst time in history. time in history.

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.

Appendix I: The US fiscal situation

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 violated anyway.– => Return to recession and default !

The US fiscal situation, continued

• 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 US fiscal stimulus should not While US fiscal stimulus should not be withdrawn now, as is the current track, be withdrawn now, as is the current track,

serious steps serious steps shouldshould be taken to lock in be taken to lock in a return to fiscal discipline in the long run.a return to fiscal discipline in the long run.

• All politically very difficult, needless to say.All politically very difficult, needless to say.

• Any solution must begin with:Any solution must begin with:– Honest budgeting Honest budgeting (e.g., Afghan war on-budget, etc…)(e.g., Afghan war on-budget, etc…)

– Regime of Shared SacrificeRegime of Shared Sacrifice– Wise up to politicians who insist the budget can be Wise up to politicians who insist the budget can be

balanced entirely through cuts in domestic spending balanced entirely through cuts in domestic spending (while cutting taxes), (while cutting taxes),

• but who raise spending when they get the chance.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 deficit

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.

• Spending. Spending.

Examples:Examples:– Cuts in farm subsidies for agribusiness & farmersCuts in farm subsidies for agribusiness & farmers

– Cut unwanted weapons systems (Cut unwanted weapons systems (a rare success: the F22 fighter)a rare success: the F22 fighter)

– Cut manned space programCut manned space program

How to reduce the budget deficit

The only way is The only way is both both reduce spending & raise tax revenuereduce spending & raise tax revenue, continued, continued..

• Tax revenue optionsTax revenue options– Let President Bush’s tax cuts for the rich expire in 2013Let President Bush’s tax cuts for the rich expire in 2013

– Curtail expensive and distorting tax expendituresCurtail expensive and distorting tax expenditures• E.g., Tax-deductibility of mortgage interest, E.g., Tax-deductibility of mortgage interest, • & health insurance& health insurance• Subsidies to oil industry…Subsidies to oil industry…

– Or more ambitious tax reform Or more ambitious tax reform • Introduce a VAT or consumption taxIntroduce a VAT or consumption tax• Or phase in auctioning of tradable emission permitsOr 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

Is doing nothing an option?

CBPP, May 2011

The long-term problem is entitlements

Concord Coalition. Data Source: CBO, Jan. 2012

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

– Progressively Progressively indexindex future benefit growth to inflation future benefit growth to inflation

– Optional options:Optional options:• To please Democrats: Raise the cap on social security taxes.To please Democrats: Raise the cap on social security taxes.• To please Republicans: encourage private accountsTo please Republicans: encourage private accounts

– though that contributes nothing to closing the gap.though that contributes nothing to closing the gap.

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• Health careHealth care– Encourage hospitals to standardize Encourage hospitals to standardize

around best-practice medicine. around best-practice medicine. • Standardize around best-practice treatmentStandardize around best-practice treatment

– e.g., to pursue the checklist that minimizes patient infections, e.g., to pursue the checklist that minimizes patient infections, – and avoid unnecessary medical tests & procedures.and avoid unnecessary medical tests & procedures.– That is not “death panels.”That is not “death panels.”

• Lever: make Medicare paymentsLever: make Medicare payments conditional on these best practices conditional on these best practices

– To please Republicans: rein in malpractice litigation.To please Republicans: rein in malpractice litigation.

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

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

.

For writings on US budget underlying this lecture, Google “Jeffrey Frankel Harvard”

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

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

Appendix II: Macroeconomic relationships

Definitions• GDP = Gross Domestic Product = Output

• C = Consumption by households• Net Taxes= Taxes - transfers• I = Investment by firms (e.g., plant & equipment)

• G = Government spending on goods & services• X-M = exports-imports = Trade Balance• NS = National Saving = S + BS• BS = Budget Surplus; BD = Budget Deficit• CA = current account balance, also equal to change

in net international investment position• ORT = official reserve transactions by central bank,

i.e., fx intervention. = change in fx reserves

Important macroeconomic accounting identities

• National income identity Income = GDP (excl. int.transfers)

C + S + Net Taxes = C + I + G + X-M

• National Saving identity S + (Net Taxes -G) = I + X-M NS = S + BS = I + CA Balance

• Balance of payments identity CA Balance = Private capital outflows + ORT

Two competing applicationsof the National Saving Identity

NS = I + CA

• Twin deficits view – A change in BS is reflected largely in (NS &) CA.

• Versus Feldstein-Horioka view– A change in BS (& NS) is reflected largely in I.

Key concepts in public spending

• within total outlays, distinction between:– government spending on goods & services (enters GDP directly)

– government transfer payments

• some countries observe distinction between:

– capital budget

– current budget

• off-budget:

– government pension plans

– state-owned enterprises (SOEs)

– implicit or explicit liabilities: bailout guarantees for banks, private pensions, province debts, etc.

Budget balance concepts (surplus/deficit):

Budget Deficit = G Spending + Govt.Transfers - Tax Rev.

• Federal – vs. consolidated (including municipal & state/province)

• Borrowing requirement – includes rollover of maturing debt

• Operational balance – excludes inflation component of interest payments

• Primary balance – excludes all of nominal interest payments

• Structural balance – excludes cyclical component

Some macro models

Effects of fiscal expansion

• Keynesian model G => GDP With multiplier effect. => Imports => TB

• IS-LM: G => i => Investment Crowding out.

• Mundell-Fleming: G => i => $ appreciates => TB More crowding out.

• Portfolio crowding out: BD => Debt rising over time => i More crowding out.

• Debt Dynamics: A path of ever-rising Debt/GDP is explosive.

Some important macro models, continued

• Incentive effects of taxes:– Elementary economics: tax distort incentives

• e.g., high marginal tax rates on income.

– “Laffer curve” (which usually fails):

t => GDP so much that total tax revenue (= t x GDP) goes up rather than down.

• Barro’s “Ricardian debt neutrality”: BD => S => NS unchanged .(Another economic theory that fails.)

Appendix III: 3 pieces of evidence to support the claim that US “fiscal conservatives” are not:

• (i) The voting pattern among the 258 Congressmen who signed an unconditional pledge not to raise taxes:– 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.

(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 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 $

Appendix IV: The long-term US 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 V

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

• that has been in effect for the last year• and is scheduled for a quantum leap at the end of 2012;

• what form should it take?

U.S. fiscal stimulus in 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 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.

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.

Appendix VIThe procylicality of fiscal policy:

More on optimism bias & the case of Chile

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Ten econometric findings regarding bias toward optimism in official budget forecasts.

Frankel, 2011, “Over-Optimism in Forecasts by Official Budget Agencies and Its Implications.” Oxford Review of Economic Policy.  

• Official forecasts of budgets & GDP in a sample of 33 countries are overly optimistic on average.

• The bias toward optimism is:– stronger the longer the forecast horizon.– greater in booms– Greater among governments

that are under budget rules (SGP).

• Chile’s official forecasts are not overly optimistic.– Chile has apparently avoided the problem of official

forecasts that unrealistically extrapolate in boom times.•

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10 econometric findings regarding bias toward optimism in official budget forecasts, continued.

• The key macroeconomic input for budget forecasting in most countries: GDP. In Chile: the copper price.

• Real copper prices mean-revert – in the long run, – but this is not always readily perceived.

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Official forecasts of budgets & GDP are overly optimistic on average

in a sample of 33 countries • (1) Government forecasts of the budget balance (App. Table 1)

– The average across all countries is an upward bias of :

• 0.2% of GDP at the 1-year horizon,

• 0.8% of GDP 2 years ahead,

• and a hefty 1.5% at 3 years ahead.

• (2) Government forecasts of the GDP growth rate (App.Table 2)

– The average across all countries is an upward bias of :

• 0.4 % when looking 1 year ahead,

• 1.1 % at the 2-year horizon,

• and 1.8% at 3 years.

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• The bias appears in US & other advanced countries. – Chile on average under-forecast its growth rate.

• The sample of 33 countries:– 26 from Europe (of which, 16 € members)

– 1 other major advanced country (US), and

– 3 advanced commodity-exporters (Australia, Canada, & NZ),

– 3 middle-sized emerging market commodity-exporters (Chile, Mexico & South Africa).

Official forecasts are overly optimistic, continued

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Budget balance forecast error as % of GDP, Full dataset

(1) (2) (3)

One year ahead

Two years ahead

Three years ahead

GDP relative to trend

0.093***(0.019)

0.258***(0.040)

0.289***(0.063)

Constant 0.201 0.649*** 1.364***(0.197) (0.231) (0.348)

Observations 398 300 179Variable is lagged so that it lines up with the year in which the forecast was made.

*** p<0.01 Robust standard errors in parentheses, clustered by country.

Official budget forecasts are biasedmore if GDP is currently high & especially at longer horizons

33 countries

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Budget balance forecast error as a % of GDP, Full Dataset(1) (2) (3) (4)

One year ahead

Two years ahead

One year ahead

Two years ahead

SGPdummy 0.658 0.905** 0.407 0.276(0.398) (0.406) (0.355) (0.438)

SGP dummy * (GDP - trend)

0.189**(0.0828)

0.497***(0.107)

Constant 0.033 0.466* 0.033 0.466*(0.228) (0.248) (0.229) (0.249)

Observations 399 300 398 300

(6) Official budget forecasts are more optimistically biasedin countries subject to a budget deficit rule (SGP)

*** p<0.01, ** p<0.05, * p<0.1 Robust standard errors in parentheses, clustered by country.

33 countries

Poll ratings of Chile’s President over time

Chart source: Eduardo Engel, Christopher Neilson & Rodrigo Valdés, “Fiscal Rules as Social Policy,” Commodities Workshop, World Bank, Sept. 17, 2009

In 2009, the popularity of the Socialist President of Chile Michelle Bachelet rose sharply (both with respect to handling of the economy and overall),

to the highest levels since the restoration of democracy 20 years earlier. More remarkable: the rise in the polls, from very low to very high, came just as the economy moved from rapid growth to slow growth -- not the usual pattern. Why?

And the Finance Minister?: August 2009

Chart source: Eduardo Engel, Christopher Neilson & Rodrigo Valdés, “Fiscal Rules as Social Policy,” Commodities Workshop, World Bank, Sept. 17, 2009

Poll ratings of Chile’s Presidents

and Finance Ministers

In August 2009, the popularity of the Finance Minister, Andres Velasco,

ranked behind only President Bachelet,

higher than any other minister since democracy. Why?

Copyright 2007 Jeffrey Frankel, unless otherwise noted

Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Chile’s structural budget rule

• Government must set a fiscal target: – In booms, can only spend structural revenue,

• must save the cyclical component.

– Structural ≡ economy at full employment & price of copper at its long-run level

– Under Bachelet, structural deficit target was 0.

• Estimates of structural vs. cyclical are made by commissions of experts, not politicians, which avoids wishful thinking.– In other countries, official fiscal forecasts have optimism bias.

JF, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” 2011.

In 2008, a copper price spike had looked permanent to many.In 2009, the price reverted toward its long run trend.

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Application to other countries

• Any country could adopt the Chilean mechanism,– not just commodity-exporters.

• Suggestion: give the panels more institutional independence– as is familiar from central banking:

• laws protecting them from being fired.