The Chairman Weighs in on Fiscal Rules

Fed Chairman Ben Bernanke made a hard-hitting speech this evening about fiscal sustainability and fiscal rules. That Bernanke made the speech at all is noteworthy: the Fed is cautious about stepping too far into the world of fiscal policy. But it is beyond obvious that our fiscal policies have a profound effect on jobs and growth—the very things the Fed is trying to manage through both typical and extraordinary policy channels. Trying to act disinterested about the direction of fiscal policy is like the front driver in a fire truck ignoring what direction the back driver is turning.

The Chairman emphasized, as we have in our growing Announcement Effect Club (Bernanke was one of the first members) that putting a policy reforms in place that would not be phased in for a number of years, would “not only help secure longer-term economic and financial stability, they could also improve the near-term economic outlook.”

On the sustainability front the bottom line is—no surprise here—that current policy is unsustainable. Either changes will have to be made voluntarily, or they will be forced upon us.

The major question addressed in the speech is to what extent fiscal rules can be employed to help bring about more sane fiscal policies. The main points include:
  • Targets based on factors Congress controls (tax and spending) rather than those it does not (economic performance) are more effective.
  • Spending caps and pay-as-you-go were helpful in the past.  (Bernanke points out however, as we have here and here, that the current form of PAYGO is pathetically weak (our words not his) because of the many exemptions.) But even at its best, PAYGO only requires that you tread water, not actually make any fiscal improvements.
  • Fiscal rules have helped in other nations including Switzerland, Sweden, Finland, the Netherlands and Canada. (Many of which are profiled in our Fiscal Turnaround paper.)  
  • Roughly 80 countries currently use Fiscal Rules.
The Bernanke Principles for the most effective rules include:
  1. The best rules are transparent and make tradeoffs clearer to both policymakers and the public.
  2. Rules must be strong enough to make a difference. For example, PAYGO rules in their current form are not strong enough to make improvements to the situation. (CRFB thought – maybe we need a “SuperPAYGO?”)
    • Bernanke says “In the current U.S. context, we should consider adopting a rule, or at least a clearly articulated plan, consistent with achieving long-term fiscal sustainability. Admittedly, an important difficulty with developing rules for long-term fiscal sustainability in the United States is that, given the importance of health-care spending in the federal budget, the CBO would need to forecast health-care costs and the potential effects of alternative policy measures on those costs well into the future. Such forecasting is very difficult. However, any plan to address long-term U.S. fiscal issues, whether or not in the context of a fiscal rule, would have to contend with forecast uncertainties.”
  3. Rules need to be tied to variables policymakers control such as spending and tax levels. 
  4. Bottom line, no matter the rule, it boils down to political will. The public’s role in holding policymakers accountable for sticking to the rules is critical. (Got if folks? – we have an election coming and asking candidates to give you tax cuts, spending increases, and a balanced budget isn’t going to do the trick.) 
Not surprisingly, we loved the speech. Very CRFBish.