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Magazine / WEALTH OF NATIONS

No Automatic Fix For Fiscal Policy

You don't need to balance the budget to stabilize the debt ratio. But you do need to start taking action promptly.

December 19, 2009

"Under reasonable assumptions," says a new report from the Peterson-Pew Commission on Budget Reform, the public debt of the United States, which currently stands at 53 percent of its gross domestic product, "is projected to grow steadily, reaching 85 percent of GDP by 2018, 100 percent by 2022, and 200 percent in 2038. However, before the debt reached such high levels, the United States would almost certainly experience a debt-driven crisis."

The commission's report, "Red Ink Rising," is certainly correct about the unsustainability of U.S. fiscal policy. You can quarrel over the details of its forecasts, of course. If you look at projected deficits on a "current law" basis -- a favorite gimmick of all administrations -- the problem looks far less difficult because current law takes credit for sunsets in spending programs and preset tax increases (through automatic expansion of the alternative minimum tax, for instance). Provisions like this are always neutralized before they take effect, however. The commission's "current policy" baseline, give or take the odd quibble, is the right measure of the fiscal trajectory.

And the trajectory is indeed scary. True, the debt-to-GDP ratio exceeded 100 percent for a short while after 1945, but that situation was understood to be exceptional and temporary. Rapid growth -- faster than one can reasonably expect to see over the next few decades -- helped bring the debt ratio back down. Demographic forces were also pushing the correct way. Over the next 30 years, the demographic pressure on Medicare and Social Security worsens the fiscal picture.

 

The fiscal trend, if allowed to continue, takes the economy into entirely uncharted territory -- whether you consider U.S. history or the experience of other countries. The only questions are these: First, will Congress act on its own initiative to get off that path or will another economic crisis intervene before it does? Second, if Congress persistently fails to act, when will the crisis come?

Nobody knows the answer to the second question. This week, Greece and other debt-burdened European nations were struggling to contain a crisis of confidence provoked by the recent collapse of Dubai World -- a seemingly unrelated event that turned the financial markets' attention to the issue of sovereign debt. The timing of emergencies such as this is unpredictable. All one can say is that unless policy changes first, it is a question of when, not whether.

The danger is that debating targets and enforcement mechanisms will crowd out discussion of specific spending cuts and tax increases.

The Obama administration has promised that its next budget will confront the long-term fiscal problem, and the commission's report provides some useful advice. It suggests one possible approach to solving the problem and offers some benchmarks for judging what the administration comes up with in February. But the commission chose not to grapple with the key question of how, precisely, the government can best close the gap between projected spending and revenues.

The United States needs to start discussing specific spending cuts and tax increases. The commission is quite right that both will be required. But the issue will remain abstract and artificial -- and, above all, will not be acted on -- until real, live, deficit-reducing policies are on the table.

The commission makes four main proposals for policy makers. First, commit to stabilizing the debt -- at 60 percent of GDP -- over the medium term. Second, develop a plan ("we do not recommend a specific mix") to cut projected annual deficits from 6 percent to about 2 percent of GDP; this would be sufficient to stabilize the debt ratio. Third, set annual debt targets with an automatic enforcement mechanism to trigger a surtax and broad spending cuts if the debt-ratio ceilings are breached. Fourth, make a commitment to reduce the debt ratio further in the longer term.

Why 60 percent? A fair question. Many countries have debts in excess of that ratio and appear to be doing quite well. The commission argues -- rather weakly, I think -- that 60 percent has become an internationally recognized standard. The European Union, under the requirements of its Stability and Growth Pact, adopted 60 percent as its debt-ratio benchmark. The International Monetary Fund has endorsed that standard as well. Maybe so, but the number is still essentially arbitrary.

And that is a pity because setting an arbitrary goal instantly undermines any plan. Why make sacrifices to get the debt ratio to 60 percent, if 70 percent would do just as well? Because the IMF says so? I doubt that argument would cut much ice on Capitol Hill or with the public. A more defensible goal is to get the debt ratio off a perpetually rising path and to do so as promptly as possible. But designing a system of enforceable targets around that subtler aim gets a little complicated. The trade-off is between enshrining an arbitrary number that people can at least understand, and framing a more sophisticated target that lacks clarity and political punch.

One advantage of the Peterson-Pew proposals is that they convey a good sense of the scale of the task. The commission advocates making the commitment now, but it recommends delaying action to until 2012 and then ramping up gradually, for fear of stifling the recovery. This makes sense. Also, timing aside, the projected path for the deficit under this plan is perfectly feasible.

In particular, you don't need to balance the budget to stabilize the total debt ratio at 60 percent. On the commission's suggested schedule, the annual deficit would come in at 5 percent of GDP in 2012 (compared with just under 6 percent in the baseline), a little under 4 percent in 2013, 3 percent in 2014, 2 percent in 2015, declining to zero in 2018 -- giving an average of about 2 percent between 2012 and 2018.

This would require a significant effort, but hardly a superhuman one. As the report points out, many other countries (unfortunately, typically under duress) have made much larger fiscal adjustments. But a gentle glide path of this kind does require starting promptly -- first with a credible commitment, then with hard budget actions -- and maintaining steady progress.

Credibility is the key, and that is my main doubt about the commission's suggested approach. Assume, optimistically, that the debt-ratio target commanded strong support among lawmakers and voters. Even then, could Congress and the executive branch promise to take steady multiyear action on the budget and be believed? My answer would be no.

The commission wants both branches to tie their own hands, with a statutory debt-ratio target and the automatic trigger mechanism to rain down tax increases and spending cuts if the debt ceilings are breached. But as a practical matter, the government cannot limit its options this way. Short of a constitutional amendment, no matter what any previous Congress or administration has said or done, the government can always postpone fiscal consolidation for another year if it chooses to.

The commission recognizes this argument. Previous automatic policy changes often failed, the report concedes, because too many programs were exempt from the trigger and bypassing the restrictions was too easy. "The goal of an enforcement mechanism is to be punitive enough to cause lawmakers to act, but realistic enough that it can be enacted if necessary as a last resort." Yes, but this is a difficult balance to strike.

"Our enforcement mechanism," the commission says, "applies across the board to spending programs and revenue alike. Applying automatic changes to both sides of the fiscal ledger will increase the base for savings, lessening the impact on programs and spending, and will require across-the-board sacrifices from program beneficiaries and taxpayers."

As I mentioned in a previous column, structural remedies of this sort have sometimes helped, for a while at least. I am not against them. But the danger is that debating the form of the statutory target and the enforcement mechanism will crowd out the more important discussion of the spending cuts and tax increases that will be needed. This approach risks delaying the start of fiscal consolidation, heightening the danger of an intervening crisis, and making the job that much harder in the end.

When it comes to credibility, serious consideration of a value-added tax, or a carbon tax, or a comprehensive (base-broadening, rate-flattening) reform of the income tax, or an increase in the retirement age, and preferably all four, would be worth a dozen automatic trigger mechanisms.

If the country is not yet ready to discuss options of that sort -- and apparently it is not -- nobody will expect the targets and triggers that the commission advocates to stick. Equally, when the country finally is ready to discuss higher taxes and lower public spending, the need for statutory targets and triggers will be relatively unimportant. To be sure, the country can do both: look hard at the options, bringing them into the realm of the thinkable, while adopting targets and triggers as well. That is fine -- so long as talking about targets and triggers does not further delay the conversation that really matters.

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