Experts Blog: Fiscal Balance And Credibility

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A crucial question is whether President Obama's policies will restore confidence in the government's commitment to taking politically unpopular steps to help the economy. Putting aside disputes about the effectiveness of one form or another of the stimulus legislation, does it bolster confidence for Obama to say that he can keep taxes low, maintain social benefits, and put the budget on a path toward fiscal balance? Even if he has no choice politically, is there a cost to the economy to maintain this posture? Are there economic benefits to taking this line, even if the facts suggest it will be impossible? - NationalJournal.com's John Maggs


Gary Burtless, Chair in Economic Studies, Brookings Institution: I may have missed the memo in which the President promised he would keep everyone's taxes low, maintain social benefits, and put the budget on a path toward fiscal rectitude. Because the President obtained his office as a result of a political campaign that lasted nearly two years, it's likely he said a couple of things that can be interpreted as mutually inconsistent. Still, I don't think President Obama promised to keep taxes low for every taxpayer or said benefits would be fully preserved for every current and future recipient. In fact, I recall him campaigning to repeal or let lapse some tax cuts of the Bush Administration and to increase Social Security payroll taxes on high-wage workers. These proposed tax hikes will not eliminate the long-term budget imbalance, but they contradict the notion that the President entered office pledging to keep taxes low on everyone.

In the short run, there is a clear advantage to emphasizing fiscal stimulus rather than long-term fiscal restraint. In an era of historically low yields on short-term Treasury debt, the Federal Reserve has less scope for using monetary policy to engineer a recovery from the recession. This increases the pressure on Congress and the President to boost aggregate demand through fiscal expansion. If the policy tools of the Federal Reserve are less potent in the current recession than they were in earlier recessions, we will have to rely on other policy tools. The most potent of these is stimulative fiscal policy.


As the nation recovers from recession it will be increasingly important to assure investors that the government's long-term budget is on a sustainable path. The component of the budget that makes this unbelievable is the health care budget - - expenditures on Medicare, medicaid, veterans' and government employee health benefits. The expected growth of spending on these items represents an overwhelming fraction of the federal government's future budget problem. If public and private spending on health care were subject to rational restraints, the nation's long-term budget problem would disappear or seem manageable. For that reason, reform of health insurance and of the health care system more generally is the first order of business for ensuring that the future federal budget will be both sustainable and affordable. As I recall the recent campaign, candidate Barack Obama stressed repeatedly the importance of reigning in health care costs. If the President and Congress succeed in doing this, their efforts will go a long way toward fixing the nation's long-term budget problem.



Jeffrey Frankel, Professor of Capital Formation and Growth, Harvard University: The trick is to combine substantial effective short-run fiscal stimulus in 2009 and, probably, 2010, with a return to fiscal sustainability in the longer run -- and preferably not to wait until the long run has arrived to put in place specific measures that will move operate in this direction. The motivation is not just to try to prevent a fiscal disaster five or ten years from now (with dollar crash), but also to make sure that an incipient recovery (say, a year from now) is not aborted by a rapid rise in long term real interest rates. Only by beginning relatively soon to restore some degree of long-run fiscal credibility can we keep long term interest rates as low as they are today.


One concrete example of the sort of desired policy measures: The government should commit now to let the Bush tax-cuts-for-the-rich, such as the abolition of the estate tax, expire on schedule in 2011. Another example: President Obama's commitment to address global climate change and other environmental matters should be embodied in a formula: "Spend green now, tax green in the future." Today's tax cuts -- especially for low-income workers (elimination of payroll tax for the lowest income Americans, refundable per-child tax credit, expansion of the EITC) and the middle class (fix the AMT) -- should be offset by legislation that would raise energy taxes in the longer run. And of course the current increase in spending should meet the twin goals of cost-effectiveness and well-targeted for stimulating demand in the present. For the longer-run a very small increase in the retirement age plus a move to progressive indexation of social security benefits would go a long way to meeting the huge future deficits associated with the retirement of the baby boom generation. Another good idea would be eventually to bring back the spending caps and PAYGO provisions that Presidents G. H. W. Bush and Bill Clinton used effectively to eliminate deficits during the course of the 1990s. Of course none of these measures would be popular politically -- least of all the energy taxes. But I believe the electorate understands that we are in a state of emergency (especially economic, but also with respect to foreign policy and the global environment), and is willing to make necessary sacrifices if President Obama calls on it to do so.



James K. Galbraith, Professor of Economics, University of Texas: I believe the President's economic team is acting and speaking in good faith.  This is in distinct contrast to the previous administration, which had few if any discernible fixed beliefs.


The new administration has not formally spelled out an economic analysis, nor a full-fledged policy vision.  But it's reasonably clear that they are proceeding on two tracks. 


First, they believe that we are in a business-cycle downturn, a recession -  a  severe one, but still basically an ordinary recession.   This belief implies that the economy will eventually start to recover, even if nothing is done.   (The President said today that the economy is in for "a tough several months.")   They believe that  the  "stimulus package" will help assist this normal process.  That is the purpose of the package.  Its  relatively modest size reflects this belief. So does the emphasis on programs that can be put into effect and spent out within two years.


Second, the administration believes that we face a banking problem that is, essentially,  a blockage of the "flow" of credit.  Unblocking the flow is the object of their banking policy.  They seem to believe that banks will extend new loans if (a) they are given funds to do so, either by recapitalization or asset purchases, and (b) if they are told to do so, as a condition of federal aid.  So the banking plan, which has not yet been presented, will probably combine new funds for banks with conditions that insist on more lending.


These two beliefs -  in the natural resilience of the underlying economy and in the capacity of policy to "unblock" credit flows -  together permit the economic team to believe that the fiscal deficit can be made to decline again, within a few years. Growth and eventual fiscal discipline - something promised for later action -  are together supposed to achieve this.  The precedent for this belief is obvious: it is exactly what did happen in the late 1990s.  At that time, a credit boom produced full employment, stable prices, and budget surpluses - at least for a short while. As a matter of economics, there is nothing intrinsically impossible about this result.


But is it likely?  That is the issue.  I believe not.  In my view, this is not an ordinary post-war business cycle recession.  This is the first slump since the 1930s that involves a whole-sale collapse of the global financial system.  The major banks are not merely in trouble.  They are in deep, deep trouble.  This problem will not be repaired easily, and until it is, there will not be a sustained economic expansion - in my view. 


As an approach to the banking problem, the metaphor of "credit flow" is also mistaken.  Credit is not a flow.  Banks don't need to have money put in, in order to have money come out.  Rather, they lend when they want to: loans create deposits, not the other way around. Perhaps you can force banks to appear "willing to lend."  But even if you can do that, you cannot force borrowers to borrow. And you cannot make them creditworthy if they are not. In a debt-deflation and liquidity trap, everyone wants to hold cash, and very few anyway have the collateral to support loans.  For these reasons, the credit-flow strategy probably cannot be made to work. 


If the credit-flow strategy won't work, then fiscal multipliers will probably be smaller than the historical estimates everyone has been discussing in recent days suggest.  Thus the fiscal package will have less effect on real activity, than comparably-sized packages in the past. And the slump will be deeper, and more persistent, than the administration's forecasting model predicts.


This glum scenario leads me to argue that this fiscal package is a good start, but only a start. Action should be swift, but expectations should be low.  People should accept the possibility that the slump will go on for much longer than "several months." That the budget will not return toward balance any time soon.  And that further significant steps will be required, and perhaps quite quickly, as the economy continues to unravel.  


The administration and Congress should not waste time dickering over the details of this package. Rather, they should enact it quickly, get things moving, and then come back to discuss the next steps.  In my view, the crisis isn't going away, and we are going to be thinking about it and dealing with it for many months, even years, into the future. 


To repeat: None of this is to criticize the new economic team's "credibility."  They are working from a model they believe in.  What we have, is an honest disagreement over whether it's the right model, for the crisis we are in.  

*****
Let me add to this, three comments on the previous interventions.  First, even if you accept the need to return eventually toward "fiscal balance" there is absolutely nothing wrong with deferring action on that front until later.  No law of economics requires that all decisions be taken at once.  So it's not a fair criticism of this package that it fails to deal with those issues.


Second, putting measures to cut spending and raise taxes into the budget this year - offsetting the fiscal stimulus just a few months after enacting it - would be a serious policy mistake. It would imply confidence that the crisis can, in fact, be overcome by the first stimulus package, and that the banking measures (which, to repeat, have not yet been presented) will work.  Neither seems likely to me.  


It would be much better to wait until the crisis has been in fact overcome - until clear evidence of strong growth and a new credit expansion turns up in the data -  and then to take whatever measures seem appropriate to reduce the force of fiscal expansion.  In my view, that could be a long time coming, but cutting back on growth measures prematurely only works to guarantee a long depression. 


Third, contrary to Alan Auerbach, there is nothing intrinsically unsustainable about deficits of six percent of GDP.  The government ran larger deficits at the end of the only previously comparable crisis - that is, during World War II - and sustained them for years.  Admittedly doing so involved drastic measures.  But if drastic measures are necessary, they should be used.   The crisis to be avoided is not some scary figure in the public accounts, but a sustained period of high unemployment, low output, depressed profits and financial collapse.  


My colleagues' procedure amount to assuming that the latter will not happen, and then focusing obsessively on the former. It would be great if they were right -  that prosperity is just around the corner.  But they haven't tried to argue that case.  And in the crisis we're in, false optimism isn't helpful at all.



Isabel Sawhill, Senior Fellow, Brookings Institution: The most precious asset any President has is trust. So far, he has said all the right things about the need to balance short-run stimulus with long-term restraint. But this approach hasn't been embedded in the stimulus package and Alan Auerbach's argument calling for an elimination of any permanent measures from the package is exactly right, in my view. Since that doesn't seem to be in the cards, all eyes are on the next shoe to drop - the President's first budget. A group of a dozen experts, including three former heads of CBO, recently called for the President to submit a budget that focuses not just on short-term measures but also on the need for long-term restraint, including tax and entitlement reform. We hope our pleas will not be in vain.



Charles Calomiris, Professor of Financial Institutions, Columbia University: Abraham Lincoln cautioned politicians against thinking that they could make a career from fooling people. The American people are not so foolish as to believe that they can have the package of benefits that the government has promised them without huge increases in tax burdens. We knew that before the recent collapse in wealth, which has made the unpleasant arithmetic of entitlements even worse. A politician that persists in telling the American people otherwise will do nothing for consumer or business confidence, but he will succeed in making himself a laughing stock.



Bob McIntyre: I know it's bad form to fight the hypothesis, but I don't believe that Obama has said that "he can keep taxes low [and] maintain social benefits" and still restore fiscal balance.   Instead, he says, among other things, that he wants to:   (1) address the Medicare and Medicaid problem by reducing health outlays in the long run (by rationalizing the heath insurance system, etc.);   (2) keep Social Security solvent through relatively small adjustments (such as extending payroll taxes to higher incomes);   (3) increase taxes on wealthy people and crack down on corporate tax avoidance/evasion; and   (4) impose some kind of carbon tax or cap-and-trade system, either of which could raise large amounts of revenue.   So contrary to the hypothesis, once we get past the economic crisis, Obama seems to favor the tried and true ways to get to fiscal balance: reduce spending and increase taxes. Whether he can achieve that, of course, is the big question.




Alan J. Auerbach, Robert D. Burch Professor of Economics and Law and Director of UC Berkeley's Burch Center of Tax Policy and Public Finance: Based on the most recent projections by the Congressional Budget Office and the Trustees of Social Security and Medicare, the U.S. federal government faces a permanent long-run fiscal gap of roughly 6 percent of GDP, even under the very optimistic assumptions of the CBO baseline, including repeal of the Bush tax cuts in 2011, slow growth of discretionary spending, and no permanent adoption of any of the tax provisions contained in the stimulus package currently working its way through Congress.


There is NO WAY that the current fiscal path can be sustained. But actions speak louder than words, so President Obama will be judged more by the steps he takes to address - or to fail to address - the fiscal imbalance than by any reassurances he might offer.   A modest but helpful first step in the right direction would be a fiscal Hippocratic Oath to avoid commitments to any permanent tax cuts or spending increases in connection with the stimulus package. After that, the serious work will need to begin. With a multitude of tax provisions set to expire in the near future, decisions about the future of the tax system cannot be avoided. Let us hope that President Obama seizes the opportunity these circumstances present to begin the necessary fiscal course adjustments.

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Cyra Master

Cyra Master is a W.E.B. Du Bois fellow at the Atlantic. Previously, she was an editor at the nonprofit Center for Law and Social Policy and was a reporter for the New Hampshire Eagle Tribune. She is a graduate of Emerson College.
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