Nearly five years have passed since the great financial crisis that accompanied the collapses of Bear Stearns (March 2008) and Lehman Brothers (September 2008). After the application of substantial fiscal stimulus since 2009 in the United States and China and monetary stimulus in the form of quantitative easing (QE) in the United States, especially since late 2008 with substantial monetary support promised to periphery nations by the European Central Bank (ECB) since mid-2012, the focus has turned to the eventual withdrawal of stimulus. A lot is at stake. The global economy has been administered massive doses of stimulus and has grown dependent on fiscal and monetary stances that cannot continue indefinitely. That said, withdrawing stimulus too rapidly, as has been done in parts of southern Europe, could precipitate extreme economic weakness that will eventually force abandonment of austerity amid political turmoil. This process may already have begun in Italy and Spain, and it is certainly underway in Greece. Add to this some new research that challenges the advisability of fiscal austerity, and you have the makings of an intense debate over post-crisis macro policy. With luck, we will learn something; otherwise, we may be in for continued turbulence.
Key points in this Outlook:
- Fiscal austerity--or deficit cutting--is the subject of much current debate. As Europe proves, severe austerity can slow growth or lead to recession.
- Despite periodic slowdowns, the US economy is on a sustainable fiscal path. The deficit is projected to drop below 2.5 percent of GDP by 2017, below its 30-year average, helped partially by the sequestration budget cuts.
- Instead of pursuing short-term fiscal reform, as suggested in the president's recently released budget, Congress should focus on working toward long-term tax and entitlement reform.
It's spring. The United States is experiencing a "surprise" economic slowdown for the third year in a row. The third-annual US slowdown and onset of a recession in Europe have placed monetary policy and fiscal austerity under attack based on, of all things, empirical evidence. On the fiscal austerity front, the famous Carmen Reinhart and Kenneth Rogoff (R&R) claim that modal growth dropped sharply to -0.1 percent in countries where the debt-to-GDP ratio exceeds 90 percent has been showed to be seriously flawed.
An important paper by a trio of authors, after duplicating the R&R results and then correcting for some errors and adjusting for exclusion of available data and underweighting of summary statistics, finds that countries exceeding the 90 percent debt-to-GDP ratio experienced 2.2 percent growth, far higher than the R&R figure. When a category is added for countries with debt-to-GDP ratios above 120 percent, a statistical test of the hypothesis demonstrates that, relative to the debt-to-GDP 30-60 percent category, no significant difference exists in growth rates within the 60-90 percent category and even the 90-120 percent category. These debt-to-GDP ranges include the United States and most countries in Europe, where the fiscal austerity debate has been underway with some intensity since 2009.
As doubts about fiscal austerity have arisen, so too have doubts about a resumption of Federal Reserve tightening. US inflation is slowing and bond yields are falling, notwithstanding warnings from some Fed presidents that US inflation was about to pick up and force earlier Fed tightening and higher interest rates. Talk about a possible need for an earlier Fed tightening has once again, in spring 2013, coincided with the onset of slower growth that makes a bad idea of either talk or action concerning earlier Fed tightening.
Amidst all the uncertainty and discussion about the advisable path of post-crisis macro policy, the International Monetary Fund (IMF), World Bank, and G20 spring meetings have taken place in Washington, DC. Participants are unsure as to whether fiscal austerity is good, bad, or neutral, as seen in emerging doubts about the famous R&R dictum that modal growth slows sharply to -0.1 percent for countries with debt-to-GDP ratios above 90 percent.
The IMF, for its part, has for the second time in about six months expressed reservations about the advisability of fiscal austerity-that is, deficit cutting. Its semiannual Fiscal Monitor described as "tightening US policies at a pace that is too strong" the March 1 US sequester that amounted to a tiny spending cut (1.2 percent of overall federal outlays between now and the October 1 start of the next fiscal year). Underscoring the widespread confusion about the use of fiscal austerity, the IMF's Fiscal Monitor, after charging the United States with tightening fiscal policy too rapidly, singled it out as among the 10 countries with "the most severe fiscal problems," suggesting that it still needs to agree on medium-term deficit reduction targets.
The IMF Fiscal Monitor prescriptions for the United States are badly muddled and ignore significant changes in its fiscal stance. The decried sequester does cut annual spending next year by about $120 billion if it is not rescinded by a nervous and confused-no thanks to the IMF-Congress. Let us hope the sequester is left in place, providing as it does a modest $1.2 trillion worth of spending cuts (only about 2.5 percent of federal spending over the next decade).
The United States has actually made substantial progress toward deficit reduction in 2013, though one wonders why the IMF has failed to note it. On January 2, as part of an agreement to avert the sharpest austerity that would have been triggered by the "fiscal cliff," Congress did pass a total of about $180 billion of annual tax increases. The result is that, by the 2014 fiscal year, the fully phased-in sequester, along with the January 2013 tax increases, will cut the US deficit-already on a downward path-from $1,089 billion in 2012 to $845 billion in 2013, and then further to $615 billion in 2014. In terms of the deficit-to-GDP ratio, that is 7 percent in 2012, down to 5 percent in 2013, and down further to 3.7 percent in 2014. (See figure 1). That is substantial progress, especially when compared with the G7 average ratio of deficits-to-GDP, which is projected to be -4.0 for 2014. One wonders about the IMF's call for further US medium-term deficit reduction.
The years 2015-17 look even better, with Congressional Budget Office (CBO)-projected deficits averaging just 2.5 percent of GDP, close to the 30-year average of 3.4 percent and well below the projected G10 average of 3.5 percent. The US debt-to-GDP ratio stabilizes at about 75 percent on a slight negative trajectory from 77 percent in 2014 down to 73.1 percent in 2018.
The United States is above the R&R 90 percent gross debt threshold, which has been called seriously into question, but net debt remains in the mid-70 percent range. The CBO projects a modest post-2018 rise in the debt-to-GDP ratio (figure 2), due largely to a somewhat-unlikely assumed rise in the interest cost on US federal debt. The US debt-to-GDP ratio will start to rise again after 2023, a signal of the still-unmet needs to reform overly generous entitlement programs and to pass tax reform (lower marginal tax rates financed by loophole closing) to boost growth. American fiscal austerity has been moderate and probably, at the current pace of deficit reduction of about $300 billion per year over the next half decade, has proceeded far enough for now.
Fiscal austerity in Europe-especially in southern Europe-remains too severe. Europe is in recession. The February Italian elections resulted in over 50 percent of votes being cast for anti-austerity candidates, and Italy has yet to form a government. Greece is in a severe recession, and youth unemployment in Spain is over 50 percent.
The President's Flawed Budget Proposal
Despite the confusion over the proper stance of fiscal policy engendered by the IMF's badly flawed Fiscal Monitor and the discovery that the R&R finding sharply overstates the dangers of rising debt-to-GDP ratios, it is important to remember one thing: the United States is on a sustainable fiscal path after enacting annual deficit reductions of about $300 billion per year since the start of 2013. And, with inflation in the United States having trended gradually downward along with inflation expectations, the Fed does not need to contemplate removal of QE for at least another year. The most serious debate this year will be over the 2014 budget.
The president's 2014 budget proposal does not advance the fiscal debate. It includes an alleged $1.8 trillion in deficit reduction over 10 years, $1.1 trillion of which is used to offset the $1.1 trillion in cuts already achieved by the sequester, which the president employed shameless scare tactics to derail. In other words, the president, having once already failed to scare Congress and the public into rescinding the sequester, wants to try again. The sequester will certainly be blamed for the US slowdown, but there is no limit to the efforts being put forward to derail it. House Minority Leader Steny Hoyer (D-MD) has gone so far as to suggest that the tragic Boston Marathon bombings on April 15 were due to the sequester, under which no cuts related to security had even been enacted.
After using $1.1 trillion of alleged $1.8 trillion in deficit reduction measures over 10 years, the president's budget is left with $700 billion in claimed net deficit reduction. However, the president simply assumes that about $1.4 trillion of his $1.8 trillion in claimed savings will come from winding down the wars in Iraq and Afghanistan.
No one believes the $1.4 trillion phantom savings number. The actual net deficit reduction proposed is more like zero. Without the proposed $563 billion in additional taxes on the wealthy, which Republicans have already rejected, the deficit actually rises under the president's budget. Its best parts are a cigarette tax boost of $78 billion, along with savings from reindexing Social Security inflation adjustments worth $230 billion, both over 10 years. Even so, liberal Democrats strongly oppose the latter move.
The president's budget is, in fact, a step backward on the road to sustainable fiscal policy. The $180 billion of tax increases already enacted this year, coupled with the $120 billion in spending cuts embodied in the sequester, have put the US budget onto a sustainable path that leaves the US debt-to-GDP ratio at or below 75 percent. The budget path already achieved during the first quarter of this year is better than what the president proposes.
Moving forward, it is important for the US Congress to take yes for an answer to the question of whether it has already achieved substantial deficit reduction. Perhaps by accident, Congress has in fact reduced the US budget deficit by enough to enable working at long-term fiscal reform, including the aforementioned reform of the tax and entitlement systems over the next year.
Avoid Deficit-Cut Recrimination
The recent measures leave Congress in an unusual position. Clearly, raising taxes and cutting spending in 2013 has been neither satisfying nor fun. It is has not been satisfying because US deficits have been sustainable in the sense that no long-promised bond market collapse has ensued from inaction and so no sense of rescue has attached to deficit reduction. After four years of comforting boosts of government spending and tax cuts resulting in deficits approaching 8 to 9 percent of GDP-levels never seen in peacetime America-interest rates remain close to all-time lows, notwithstanding the cries of critics. The share of revenue going to pay interest on federal debt is close to a record low at about 1.4 percent. Why then, many in Congress will ask, endure the real pain of further boosting taxes or cutting spending?
The White House effort to attribute all bad economic-not to mention social-outcomes to the sequester is a prelude to another year of fractious and unproductive debate in Washington about how to reduce deficits. It is necessary to remember that placing the United States on a sustainable fiscal path after four years of trillion-dollar deficits will have consequences in the short term. Coupled with a "tax" of about $90 billion from higher oil prices, the total of fiscal and oil drag prior to sequester is about $270 billion, and $45 billion in 2013 sequester raised that to $315 billion, or nearly 2 percent of GDP. That drag needs to be contrasted with average fiscal thrust of nearly 3 percentage points of GDP over 2009-12.
The "fiscal swing" of 5 percentage points of average 2009-12 fiscal thrust of 3 percent of GDP to 2013's 2 percent of GDP drag means that a sharp US slowdown may occur in mid-2013, notwithstanding the heartening signs of growth in the housing sector and a strong push from rising stock prices, all occurring while interest rates remain remarkably low. Still, Congress should not try to reverse deficit reduction progress as the president's budget has in effect suggested. Sequestration will be blamed for any slowdown, but really the cause will be a swing from steady previous stimulus to about $225 billion of fiscal drag along with some bad luck supplied by about $90 billion in higher energy costs.
The signs of a mid-2013 growth slowdown have already begun to appear. Weaker employment growth coupled with slowing factory activity and falling retail sales have contributed to a sharp rise in negative surprises much like the ones appearing in the 2010-12 period that spawned a midyear swoon. (See figure 3.)
The swoon carries three manageable risks. First, it reduces growth of GDP-the tax base. Second, it raises the burden of already overburdened monetary policy to sustain growth during contractions. And third, the slowdown will produce nasty recriminations about the deficit reduction already achieved in 2013 and in turn will further inflame the parties and passions that prevent deficit reduction. Republicans will decry the January 2013 tax increases as crippling the economy and vow to allow no more. Democrats will decry the sequester spending cuts and vow to allow no more spending cuts without tax increases. The president has already proposed rescinding the sequester. The reality the current weak economy is demonstrating is that further tax increases to replace the deficit reduction by the sequester as proposed by the president would weaken the economy even further.
It is probably best to face the reality that we shall reach September, the eve of the next fiscal year, having made no further progress on deficit reduction, largely because there is no powerful need for it. A continuing-resolution-postponed debt ceiling will loom again, and cries of "disaster" will return. Eventually, fiscal year 2014 will proceed without a budget but with a series of contentious continuing resolutions.
Although frustrating, the American battle over the deficit has placed us on a sustainable path for fiscal policy with work still left to be done on tax reform and entitlement reform. The R&R 90 percent debt-to-GDP "cliff" after which growth is supposed to slow sharply has been largely removed. Measures to reduce deficits to levels that imply a stable-to-modestly-falling US debt-to-GDP ratio have already been taken and the Treasury can still borrow at an interest cost amounting to just 1.4 percent of GDP, but this is not the time to even consider reversing the progress already achieved by rescinding the sequester, especially if, as the president proposes, the replacement would be further tax increases.
Finally, the easing of the R&R 90 percent debt-to-GDP fiscal cliff means that the target for achieving a zero-deficit balanced budget over the next decade is unnecessarily harsh. The macro aspects of US fiscal policy are well-
balanced-for now. Micro aspects, including reforms of tax and entitlement programs should be legislated over the next two years to place those programs on a truly sustainable path over the coming decades. Then, we can get back to concentrating on growing the economy.
1. Carmen Reinhart and Kenneth Rogoff, "Growth in a Time of Debt," American Economic Review, 100, no. 2 (May 2010): 573-78.
2. Thomas Herndon, Michael Ash, and Robert Pollin, "Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff," Political Economy Research Institute Working Paper Series, no. 322, April 2013.
3. These figures refer to net (publicly held) federal debt and differ from IMF statistics that refer to gross debt of all public entities.
4. Jake Sherman, "Boston Marathon Bombing: Congress Reacts, Dems Talk Sequester," Politico, April 16, 2013, www.politico.com/story/2013/04/boston-marathon-bombing-congress-reacts-90136.html.