America is on the brink of adopting colossally bad economic policies. Plans now being implemented do nothing to address the country’s long-term fiscal issues and will exacerbate the economy’s short-term woes. As ever, America’s economic mistakes will hurt not only Americans, but much of the rest of the world as well.
America’s political leaders now fall into three economic camps. One group denies economic reasoning and historical facts to claim that “big government” is the source of the economy’s weaknesses: less government spending, lower taxes and deregulation solve all problems. Another camp harbours the fantasy that all current and future promised old-age benefits can be financed only by taxing the rich. A last group – to which Obama seems to belong – believes it can buy credibility for long-term fiscal reform with short-term austerity, even if austerity threatens the feeble recovery: doing the wrong thing now signals willingness to do the right thing in the future.
All three camps endanger the economy.
The debt-ceiling fiasco that played out in July and early August is one of a series of events that have made crystalline the fact that America’s elected leaders are incapable of enacting sensible economic policies. To those leaders who thought that a US debt default was “no big deal,” the extreme volatility in financial markets since the fiasco should be eye-opening. Sometimes it takes a good drubbing to get a point across.
The full measure of the blame for the fiasco does not fall at the feet of the Tea Partiers and their Republican enablers. An equal share goes to the Obama administration for being unwilling or, perhaps, unable, to articulate a coherent alternative fiscal plan to the slash-and-burn approach of the opponents and for ignoring the recommendations of its own presidential commission on fiscal reform.
This essay answers the title question by sharply delineating between policies for long-term sustainability and those for short-term stimulus. These are very different problems that require very different policies.
First, let’s review. Rather than taking definitive action, the debt deal creates a “super committee” of twelve hardcore partisans selected from the same group of elected officials who brought us the debt debacle in the first place. That committee must deliver an additional $1.5 trillion in deficit reduction over ten years and return a package, approved by at least seven committee members, for Congress to vote up or down. Failure to reach agreement at either committee or Congressional levels triggers arbitrary across-the-board spending cuts. At this point, there is no consensus on whether deficit reduction will occur through spending cuts, revenue increases or a mix of the two – precisely the dispute that created the earlier debt-ceiling impasse. Prepare for Fiasco II.
One-and-a-half trillion dollars – 10 per cent of GDP – is a drop in the fiscal abyss. Estimates of the fiscal gap – the present value of the difference between all projected federal spending and revenues – vary widely, from five to fourteen times current GDP. Those numbers encapsulate America’s long-term fiscal problems. Evidently, the debt deal was not about making fiscal policy sustainable.
Remarkably absent from any of the discussions in Washington is the question of whether this deal constitutes good – or even sensible – policy. Sensible has been supplanted by desperate. Washington now struggles just to achieve minimal competence by avoiding government insolvency.
Here are some sensible steps toward long-run reform. Because communication is as important as the policies themselves, my prescription emphasises how to talk to the public.
1. Tell a story and offer a vision. Obama needs to clearly articulate the nature of the problems America faces, both in the near term and in the coming decades. How did America land in this predicament? The narrative is not only about the financial crisis and recession. It is about how Social Security was created during the Great Depression because Americans were poverty-stricken in their old age. And it is about how during the 1960s, when America was at the top of its game, Medicare and Medicaid were established to guarantee against what President Harry Truman called the “indignity of charity.”
These spending programs are the compassionate soul of a government for the people – not the offspring of an alien bureaucratic life form that aims to insinuate itself into people’s lives. The programs are also a social contract between the government and the people. A decision to break or modify that contract should not be taken lightly.
But Obama needs to be honest: although the programs were well-intentioned, they were funded in a pay-as-you-go fashion that relies on having many more workers than retirees. As the American population ages, that funding gets stretched to the point that in a few years revenues from taxes for Social Security and Medicare will not cover expenses. Something has to change.
Relying completely on taxes to finance ever-growing social programs is not viable: eventually higher tax rates discourage work effort and undermine the goal of raising revenues. Some mix of taxes and changes in payments to recipients must occur. This is where political negotiations come in.
Integral to the story must be an explicit statement of the vision that guides spending and tax reforms. What does the Obama government stand for?
2. Make the vision concrete. How does that vision translate into the objectives that fiscal reforms aim to achieve? Objectives might include improving the efficiency of the tax code, changing the wealth and income distributions, raising economic and employment growth, expanding investments in infrastructure and education, and stabilising government debt. Obama should tell us his objectives, couched in specific economic outcomes. When there are trade-offs among the objectives, explain how and why the policies make those trade-offs.
3. Propose a plan. Obama needs to establish a clear plan for stabilising the fiscal position in the long run. There is no unique way to do this, but whatever plan Obama puts forth – and put forth a plan he must, as delegating the details to Congress has repeatedly been disastrous – needs to be tied to the broad vision and specific objectives that the administration articulates.
4. Connect the plan to the vision. The administration should present the economic consequences of any proposed plan. This entails using economic models to project the likely outcomes for the objectives that the administration identifies. By emphasising the economic outcomes of a plan, the administration shifts the terms of the debate. In place of hysterics – big government destroys incentives; budget reforms dismantle Medicare – are facts, or at least educated guesses, about exactly how a plan will affect the things people care about.
This is where Obama can transcend the petty bickering that is the hallmark of recent fiscal debates in Washington. All sides make assertions with no factual or even logical bases – assertions designed to create fear, confusion and emotional reactions among voters. For Obama to take the intellectual high ground, he must weave the projected impacts of his proposal into the narrative about his vision and objectives.
5. Encourage independent scrutiny of the plan. Voters will be naturally sceptical about claims Obama makes for his plan. Outside scrutiny can allay the scepticism. Independent, as distinct from bipartisan, groups must scrutinise the plan. Bipartisan groups are political creatures; bipartisan means “please both parties.” Independent means “be honest, even if it pleases neither party.” Independent model-based analyses can assess the administration’s educated guesses about the economic impacts of the proposals and form the basis for constructive political debate. Model-based analyses make explicit how policies feed into objectives; this imposes discipline on policy discussions.
Because the idea of projecting the economic effects of fiscal plans and subjecting those projections to outside scrutiny is unusual, let me elaborate. Bringing modern economic analysis to bear on policy options has two aims. First, confronting policy-makers with the macroeconomic consequences of their choices allows them to weigh the trade-offs that their policies entail. Second, scientific analyses will remove from the debate recurring fiscal myths – for example, that cutting taxes raises revenues – to focus policy-makers on the substantive issues. Economic analyses should produce better policies, just as they do in central banks around the world.
Careful analyses take time and resources. Governments understand that designing a new weapons system requires research and development. Why do they fail to grasp that major overhauls of the tax code or of Social Security and Medicare ought not to be cobbled together by eleventh-hour political shenanigans?
Because independent scrutiny of model-based projections is a novel idea, no agencies now stand ready to perform the analysis. Who will do the work? A large group of credible economists outside the administration and Congress have been studying long-term fiscal matters for years. The government could launch a research project with teams headed by academic experts and staffed by talented economists and analysts. Teams would be tasked to study the economic consequences of alternative resolutions to the long-run fiscal sustainability problem and to present their findings to administration and Congressional audiences.
AMERICA is not in a fiscal crisis. It is in a political crisis that is creating inordinate uncertainty about future taxes and spending. Heightened uncertainty is distorting economic decisions: this is the message of Standard & Poor’s downgrade of US government debt. America’s fiscal problems have been decades in the making. People do not expect immediate solutions. But they do expect unambiguous signs of progress. Careful study of the problem and potential solutions is progress.
Achieving long-run sustainability is critical, but it’s not the most pressing economic problem that America faces today. Unemployment seems stuck at 9 per cent and long-term unemployment is at levels not seen since the Great Depression. Indicators now point to either a second recession or a Japanese-style prolonged period of economic stagnation.
What should Obama do about these immediate problems?
Economic conditions cry out for fiscal expansion – maybe lots of it. And monetary policy is poised to help.
To understand how monetary policy can help, we need a little economics. In normal times, when the interest rate that monetary policy sets is well away from its lower bound of zero, the central bank actively adjusts the policy rate to achieve a targeted rate of inflation. Fiscal expansions – increases in government spending or cuts in taxes – increase demand for goods and services and eventually increase overall inflation. Monetary policy responds to higher inflation by sharply raising the policy rate and, therefore, the real (after adjusting for inflation) interest rate. Higher real interest rates discourage consumption and investment to attenuate the fiscally induced rise in demand. Although fiscal expansions do raise output and employment, in normal times those increases tend to be modest.
Times have not been normal in America for the past three years. The Fed’s policy rate has been essentially zero since December 2008. When monetary policy makes the interest rate unresponsive to inflation, it amplifies fiscal policy’s impacts on the economy. By fixing the interest rate, monetary policy allows higher inflation to transmit into lower real interest rates. Instead of attenuating the demand stimulus of a fiscal expansion, monetary policy reinforces it: lower real rates encourage greater consumption and investment demand and they depreciate the exchange rate to raise net exports.
At its last meeting, the Federal Reserve announced that it anticipates that persistently weak economic conditions justify keeping the federal funds rate at its current historically low level “at least through mid 2013.” This revelation is stunning, not only in its pessimism, but also in its virtually unconditional commitment to keep the funds rate constant regardless of inflation developments. The announcement can be understood as the Fed doing its best to make the ground fertile for fiscal expansion to have large effects on economic activity.
Seen in this light, the debt deal’s $2.4 trillion fiscal contraction ($900 billion enacted, $1.5 trillion promised) is galactically stupid. American policy-makers are planting fiscal kudzu in the Fed’s fertile ground.
Fiscal consolidation is stupid because, unfortunately, economic reasoning is symmetric. Fiscal contraction reduces demand and inflation. With the Fed’s policy rate stuck at zero, lower inflation translates into higher real interest rates that will exacerbate the decline in demand. Washington’s twisted political atmosphere, created by fiscal-austerity Kool-Aid drinkers, renders the president and Congress incapable of capitalising on the opportunity the Fed is presenting.
Once past this politically manufactured “crisis” stage, the United States needs to reform its monetary–fiscal policy framework. More accurately, the United States needs to develop a coherent monetary–fiscal framework. That means, among other things, rethinking the artifice of placing monetary and fiscal policies in separate boxes, pretending that they can operate independently. Separate policy boxes work only if the political process reliably delivers the necessary fiscal adjustments.
Developing a framework raises many questions. Does it make sense to have an independent central bank but an utterly politicised fiscal authority? Are there aspects of fiscal policy – for example, a target debt–GDP ratio – that can be depoliticised and grounded in sound economic reasoning? Should America follow countries like Sweden in establishing an independent fiscal policy council with a public forum for questioning and criticising the government’s fiscal plans? Should fiscal policy obey rules that depend on the state of the economy? What structural policy reforms can insure against a rerun of fiscal gridlock?
Things could be worse for the United States: it could be a member of the European Monetary Union. Europe has taken the policy boxes to an extreme with sovereign fiscal authorities in each country but a single, independent euro-wide monetary authority. Whereas US policies are plagued by unarticulated objectives, European policies suffer from mutually inconsistent objectives. Those objectives include: a euro-wide inflation target, no sovereign debt default, no exit from the union, and no supranational fiscal institution in parallel to the European Central Bank. Those objectives place the full weight of fiscal adjustments either on member states or on the ECB’s willingness to buy troubled nations’ sovereign debt. Because troubled member governments seem politically unable to make the required fiscal adjustments, the ECB has stepped into the void. But this surely threatens both the inflation target and the ECB’s independence.
Obama’s political advisers are now debating what Obama should do. Should the president pursue his centrist, milquetoast, stand-for-everything bipartisanship? Or should he shift toward making policy proposals that he feels are “right,” even if they are unlikely to pass Congress? I don’t know what makes good politics. But I’ve tried to lay out good economic policy. And sometimes good policy is good politics. •
