It's Summerstime in the Fiscal Policy World
Larry Summers, the Administration's top economist (and former CRFB board member), has an op-ed in the Financial Times today, looking at why the current debate in Congress muddies the fiscal waters.
In his op-ed, he suggests a more comprehensive way of thinking about our real fiscal choices: our challenges are not a matter of a simple choice between "jobs" and "deficits"; and supporting recovery in the short-term yet calling for deficit reduction in the medium- and long-run is an appropriate rather than a "mixed" message about fiscal responsibility.
In his view, while budget deficits are unproductive, if not harmful, during economic expansions, right now with interest rates close to zero and the unemployment rate at 9.5%, expansionary fiscal policy can have a powerful, positive effect on the economy. Also, since it boosts economic growth, it will help with reducing deficits in the medium-term.
However, in his view (and ours), there is most certainly a cost. Running budget deficits (especially high budget deficits) will have a cost to the economy--and the taxpayer--through the debt channel. Budget deficits if not offset translate into debt accumulation. And our debt has to be paid for somehow, somewhere, sometime, managed normally through interest payments on debt held. And there are many ways in which our budget deficits are financed: foreigners might buy more debt (or not), our domestic bond vigilantes might buy more debt (or not). To keep buyers coming to the Treasury auction table, higher interest rates might be needed, especially if the private economy looks more appealing as the economy runs closer to the full employment of people, buildings, and machines. Our government might be tempted to inflate some of the debt away--which doesn't work for long, by the way. In this process, other government priorities might be crowded out. None of these situations can be sustained for long and we don't want to go there.
So how do we avoid the costs of higher debt? In other words, what do we do to balance our short-term needs with our need to get the budget on a sustainable track? Dr. Summers points out that deficit reduction is important when the economy is on stronger footing, and it can have positive effects on the economy:
There is a very strong presumption that there are likely to be beneficial effects from the expectation that budget deficits will be reduced after an economy has recovered and is no longer demand-constrained. Not least of these are increased confidence and reduced capital costs that encourage investment, even before the deficit is reduced. Such impacts are likely to be particularly important when prospective deficits are large and raise substantial questions about sustainability or even creditworthiness.
This statement re-affirms his membership in the Announcement Effect Club and brings us to an important point. We can't have significant medium-term deficit reduction without relatively strong economic growth, and considering our future fiscal situation, we can't have robust economic growth in the long-term without deficit reduction. By announcing a deficit reduction plan now that will take effect when the economy recovers, we can increase short term economic growth, and this increased growth will further cut into our deficit. We have expanded on this point in the past.
Alan Blinder, in an op-ed in The Wall Street Journal, suggests stimulating the economy in a deficit-neutral way by letting the upper-income tax cuts expire and using the money saved over the next two years to finance further stimulus efforts. Citing multiplier calculations by Mark Zandi, Blinder estimates that "trading" upper-income tax cuts for unemployment benefits would add $100 billion to aggregate demand and one million jobs to the economy over the next two years. Even if the numbers are high, he says, the stimulative effects of unemployment benefits would certainly be higher than those of the tax cuts, since high earners save much more of their income than unemployed workers.
Summers gives the Administration credit for making recommendations to put the U.S. on a more sustainable fiscal path in the medium-term. The policies he cites are the three year freeze on non-security discretionary spending, the expiration of upper income tax cuts, the health care law, and the formation of the fiscal commission. While these are positive steps, there is still much more to be done, especially since the President's 2011 budget would put public debt at 90 percent by 2020. The freeze is good, but it should be expanded to all discretionary spending and actual cuts should be considered. The expiration of the upper income tax cuts translates as "extending the tax cuts for everyone making under $250,000 at a staggering cost"; instead the costs should be offset. Limiting the roughly $1 trillion in individual and corporate tax expenditures would be one good approach. The jury is still out on the health care law over the longer-term (see our analysis here), though it seems that if Congress sticks to their guns, it will have quite a positive effect over the long term (though much more will still need to be done). Finally, while its work could prove to be extraordinary useful for America's fiscal future, it is far from clear whether the fiscal commission will even be able to agree on recommendations to reduce medium-term and long-term deficits -- although we certainly do hope they will succeed. It would help if the President was doing more to elevate the importance of the Commission's work.
We think that Summers has it right in terms of the timing of fiscal policy. There are certainly differences in opinion over the right mix of stimulus and deficit reduction, but it is clear that we can't get our deficits under control by mid-decade with weak growth and we won't be able to have strong growth later on if our debt is rising rapidly. The announcement effect of a deficit reduction plan takes advantage of this feedback starting this year. The Administration, and the Congress for that matter, should get working on a plan that would truly put the country on a fiscally sustainable path. Everything should be on the table and everyone should be at the table.