Tuesday, November 16, 2010

No Fix For US Fiscal Policy without New Rules

A short time ago, I wrote that the EU needs better rules for fiscal policy. So does the United States. A new report from the Peterson-Pew Commission on Budget Reform provides an outline for such a set of rules. It is unfortunate that the Peterson-Pew report has been overshadowed by the almost simultaneous release of the draft co-chairs' report of the president's fiscal reform commission, because they complement one another. The mandate of the president's commission is to figure out a combination of tax reform and spending cuts that will get the deficit down to a sustainable level, whereas the Peterson-Pew report focuses on the rules needed to maintain sustainability over the long term.

The Peterson-Pew Commission  is a joint effort of the Peter G. Peterson Foundation and the Pew Charitable Trust. Its co-chairs are three former Congressmen, Bill Frenzel, Republican, Timothy Penny, Democrat, and Charlie Stenholm, a conservative Democrat and former member of the Blue Dog Coalition. The Commission has issued two reports. Red Ink Rising, December 2009, which documents the nature of the budget problem, and the just-released report, which is titled Getting Back in the Black.

In its new report, the Commission characterizes the problem in these terms (slightly paraphrased): "Budgets are created annually, without any kind of fiscal target guiding the process . . .  Increasingly there is no comprehensive action on the budget at all: rather, a series of short-term continuing resolutions followed by huge omnibus spending bills. . . .  The bulk of spending and revenue occurs on autopilot without annual review or any constraint on growth . . .  Lawmakers routinely continue programs that could not withstand rigorous evaluations of their costs and benefits."

To correct the situation, the Commission proposes a thorough revision of the rules of the game, consisting of two main components.

The first component is to set medium-term and longer-term fiscal policy targets. Working from a baseline scenario that is somewhat more pessimistic than the CBO baseline, the Commission suggests a medium-term debt target of 60 percent of GDP, to be achieved by 2018, with further reductions below that target for the longer term. The report is less explicit about deficit targets, but it is not hard to fill in the blanks. As I have explained elsewhere, achieving sustainability for the debt would require a moderate cyclically adjusted primary surplus, that is, a surplus on the budget when adjusted to take into account both interest expenditures and cyclical changes in tax revenues and expenditures. Keep in mind that as of 2009, the United States had a cyclically adjusted primary deficit of some 7 percent of GDP. That was the highest in the OECD except for Ireland, which is now teetering on the edge of the abyss. It is easy to see, then, that the Peterson-Pew target for the debt is an ambitious one.

The second component of the Commission's plan, and really the most important one, is a set of revisions to the budget process. In part, these aim to lengthen the time horizon of the budget process beyond its current one-year span. Even more important, they include tough automatic mechanisms that would come into play if targets are not being met. Failure to pass a budget consistent with targets would trigger automatic adjustments consisting 50 percent of across-the-board spending cuts and 50 percent of broad-based tax surcharges. The president would also be empowered to impose rescisions of excess spending.

The Commission's call for long-term budget rules and enforcement mechanisms is sound economic policy. The unfortunate thing is that many of these ideas have been tried before, without lasting success. The report details the history of past budget rules, including Gramm-Rudman-Hollings, the Budget Enforcement Act of 1990, PAYGO, the line item veto, and others. Some of these have met with temporary success, contributing to the period of relative fiscal soundness in the 1990s. However, three factors have undermined them all in the long run.

One factor is a U.S. Constitution that gives Congress preeminent authority in budget matters. The Supreme Court has tended to reject budget rules that give the president or others outside Congress the authority to impound, rescind, sequester, or override Congressional spending decisions in pursuit of broader economic policy goals.

A second factor is the inherently political nature of fiscal policy. With monetary policy, it is to some extent possible to spin off macroeconomic aspects to the central bank while leaving microeconomic financial regulation to others. It is much more difficult to do the same with fiscal policy, since every tax and spending decision has very specific microeconomic as well as macroeconomic impacts.

The third problem is the time-inconsistency between fiscal policy decisions geared to a two-year political cycle and the needs of fiscal sustainability averaged over a significantly longer business cycle. Fiscal sustainability becomes a political issue only during recessions, when current deficits are high. That is just the time it is most difficult to carry out the adjustments needed for long-run sustainability. When a period of expansion comes and deficits shrink, pressure for long-run sustainability evaporates, and nothing is done. Eventually the debt grows to a point where the country finds itself in a recession with no "fiscal space" to carry out needed countercyclical policy--exactly the situation we are in now.

In the end, I must say that I found the Peterson-Pew Commission's report to be more depressing than encouraging. The report is right to insist on the need for fiscal policy rules. Although there is room for discussion regarding the technical details of targets and processes, the Commission's ideas are on the whole sound. But how is our politically divided country going to get together on viable set of fiscal policy rules, when it has failed so often in the past? There seems to be no answer, either in this new report or anywhere else.

Follow this link to view or download a brief slide show presenting additional data and details from the Peterson-Pew Commission report.

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