Ed Dolan's Econ Blog

As We Move into Budget Chaos, Just How Bad is our Fiscal Policy, Really?

Those of us who live in the United States woke Tuesday morning to a “partial government shutdown.” Partial means, roughly speaking, that air traffic controllers go to work but park rangers do not. The shutdown is the result of the failure of Congress to pass a budget—or in lieu of a budget, a continuing resolution—in time for the October 1 start of the 2014 fiscal year.

Even if the shutdown is resolved in the next few days, another round of chaos looms at mid-month, when Congress must authorize an increase in the debt ceiling in order for the government to continue making interest and principal payments on debts that the same Congress previously authorized the government to accumulate.

Many conservative Republicans say that measures like government shutdowns and debt-ceiling freezes are necessary because taxation and government spending are out of control and public debt is rapidly  becoming unsustainable. How much truth is there to those charges? Just how bad, really, is U.S. fiscal policy, and what should be done to fix it?

Some numbers

Let’s start with some international comparisons that will help put U.S. fiscal policy in context. The following charts use data from the OECD, a group of 30 wealthy democratic countries that is the best peer group for comparison with the United States. The charts include projections for 2013 based on partial data for the current year and forecasts for 2014. All of the OECD charts refer to government at all levels—local , regional and central. Comparison of the U.S. federal government with the central governments alone of other countries would be misleading because of the great differences in the degree of fiscal centralization. In any event, it is the total tax burden and total spending, not just the federal portion, that really matters for the economic welfare of individual citizens.

The first of the following charts shows levels of government outlays. Total government expenditures in the United States are a bit below the average for the OECD. At 39 percent of GDP for 2013, they much less than the 58 percent of Denmark, the highest, and somewhat above the 31 percent of Korea, the lowest. Government outlays increased as a percentage of GDP in all countries as the global financial crisis developed and have fallen since that time. The pattern of government outlays for the United States is in no way exceptional among its OECD peers, nor is it, as of 2013, much above its 20-year average.

The next chart shows levels of taxation. The pattern is very much the same. Denmark and Korea have the highest and lowest levels of taxation, respectively, as they did for outlays. The United States, again, is a bit below the average of its OECD peers. Taxes as a share of GDP increased in all countries as incomes dropped during the global crisis and have fallen since. On the whole, the level of taxation in the United States is not exceptionally high by the standards of other wealthy countries and is only slightly higher than its 20-year average.

The third chart shows annual budget balances. As of 2013, the U.S. deficit for all levels of government is somewhat greater than the OECD average, but not by much. The OECD’s greatest budget deficit for 2013 belongs to Japan. The best performer is Korea, whose budget shows a small surplus.

The numbers for budget balances are much more volatile than the underlying levels of taxes and spending. As the chart shows, in 2009, the annual deficit for all levels of U.S. government swelled to 11.9 percent of GDP, substantially more than the OECD average. In 2009, the U.S. deficit was greater than Japan’s, although two small OECD countries, Greece and Ireland, had even deeper deficits that year. Since its low point, the U.S. budget deficit has decreased by more than half, although it remains larger than its pre-crisis average.

To round out the picture, the next chart shows levels of government net debt—net in the sense that it adjusts both for government financial assets and for the portion of government debt held by the government itself, for example, in the United States, by the Social Security trust fund.

The pattern here is a different still than in earlier charts. The most-indebted OECD country, based on 2013 data, is again Japan, whose debt has soared dramatically since its long bout with deflation began in the mid-1990s. The least indebted country shown in the chart is Switzerland. (Actually, the least indebted OECD country is Norway, whose enormous oil revenue trust fund gives it net assets of 173 percent of GDP—a level of negative net debt that is literally off the chart. Norway is also off the previous chart with respect to its budget balance, which has a huge oil-fueled surplus.) In terms of government debt, the United States is well above the OECD average. Furthermore, U.S. debt has risen more rapidly than the OECD average during the crisis and is running well above its own 20-year historical norm.

Unlike the first two charts, which show little cause for alarm, the third and especially the fourth charts give a little more credibility to the concerns expressed by fiscal conservatives in Congress. However, they do not tell the whole story. To see what is really wrong with U.S. fiscal policy, we need to look deeper.

Problem 1: U.S. fiscal policy is procyclical

As I have discussed at length in previous posts, it is not very useful to judge a country’s fiscal policy on the basis of its annual budget balance. The deficit or surplus for any given year is strongly sensitive to the effect of the business cycle as expressed through automatic stabilizers. Those are elements of tax and spending laws that move the budget automatically toward deficit when the economy contracts and toward surplus when it enjoys a boom. On the revenue side, the principle stabilizers are taxes on incomes and profits, while unemployment benefits and other income support programs are the main stabilizers on the spending side.

We can get a clearer picture of the posture of a country’s fiscal policy by making two adjustments to the annual budget balance. First, we adjust for the effects of automatic stabilizers by calculating the budget balance as it would look, assuming current tax and spending laws, if the economy were, to use the popular phrase, “at full employment,” or in wonk talk, if it had a zero output gap. That adjustment gives us the structural balance. Second, we should take out the part of government outlays that go to pay interest on the accumulated deficit. Doing so gives us the primary structural balance.

There are two sensible ways for a country to manage its primary structural budget balance. One is to follow a cyclically neutral fiscal policy—one that would hold the primary structural balance constant from year to year regardless of the state of the business cycle. If that were done, the annual balance would show a deficit during downturns and a surplus during booms, averaging out to a level that would prevent uncontrolled accumulation of debt over time. Chile is an example of a country that, by law, follows a cyclically neutral policy. The alternative is to follow a countercyclical policy. That would mean making discretionary tax cuts and spending increases during a downturn, followed by offsetting tax increases and spending restraint during the next upturn. Such a policy would, if properly executed, reduce the depth of recessions and prevent overheating during upturns, while maintaining a sustainable average balance over the cycle. Sweden is an example of a country that systematically follows a countercyclical fiscal policy.

The United States follows neither of these sensible alternatives. Instead, its fiscal policy in recent years has, for the most part, been procyclical. That means that it has cut taxes and increased spending during booms, thereby encouraging overheating, and then raised taxes and cut spending during periods of slack demand, slowing the recovery from slumps.

Two episodes of procyclical policy stand out clearly in the following chart. The upper line in the chart shows the U.S. output gap, positive when the economy is booming and negative when it is in a slump. The lower line shows the primary structural balance. A cyclically neutral policy would require the primary structural balance to stay constant from year to year. A countercyclical policy would require it to move toward surplus when the output gap is positive and into deficit when the output gap turns negative.

Instead, in the shaded bars, we see a policy that is procyclical. The years of prosperity from 2000 to 2007 were accompanied by a movement toward structural deficits—the result of large tax cuts combined with unfunded foreign wars. (Note that the recession of 2001 was so shallow that the output gap never moved into negative territory.) Then came a brief countercyclical interlude in 2008 and 2009, when first the Bush and then the Obama administrations undertook stimulus measures to mitigate the effects of the financial crisis. However, as soon as the economy had reached the trough of the cycle, in mid-2009, but while it was still experiencing a large, negative output gap, policy turned procyclical again. Spending cuts and tax increases began moving the structural balance back toward surplus. The result has been a slow recovery with hardly any narrowing of the negative output gap over the past four years.

I am at a loss to find a word that adequately describes this pattern of fiscal policy. The best I can come up with is stupid.

Problem 2: U.S. fiscal policy is unsustainable

The fourth of the above charts shows the U.S. net government debt growing toward 90 percent of GDP, a trajectory that some observers characterize as being unsustainable. Whether it is or not depends on just what we mean by the term. In an earlier post, I discussed three possible meanings for the sustainability of fiscal policy.

According to one perspective, a country’s debt is unsustainable if its current trajectory is such that the government will one day be unable to pay its bills. This meaning—sustainability as solvency—is nonsense, at least for a country like the United States, which has its own sovereign currency. If push comes to shove, such a country can always issue new money to pay its bills as they come due. Inflation, maybe; insolvency, definitely not. End of story.

The second perspective, which I call mathematical sustainability, hinges on the projected growth path for the future debt, given certain assumptions about tax and spending laws, the rate of growth of nominal GDP, and nominal interest rates. As detailed in the above-linked post and in this slideshow, the debt will be mathematically sustainable for a country with a nominal interest rate that is higher than its rate of growth only if it maintains a small primary structural surplus.

On those grounds, one can argue that the current U.S. primary structural balance of -4.0 percent of GDP (by OECD calculations) is unsustainable. However, that conclusion is open to debate. The OECD may overstate the primary structural deficit. Existing policies may already be moving the primary structural balance toward surplus. Or, it may be, as adherents of modern monetary theory argue, that the Fed and the Treasury, working together, could permanently hold the nominal rate of interest on government debt below the nominal rate of growth. In that case, any level of deficit becomes mathematically sustainable.

In my view, as far as U.S. fiscal policy is concerned, the issue of mathematical sustainability moot. I am much more concerned with a third perspective, which I call functional sustainability. We can say that a country’s fiscal policy is functionally sustainable if and only if it has a set of rules and decision-making procedures that adjust fiscal parameters over time to serve some rational public purpose.

There is no one formula for functional sustainability. Swedish countercyclical fiscal rules and Chilean cyclically neutral rules both fit. For that matter, even a procyclical rule, like the annually balanced budget amendments put forth in many variants by Congressional Republicans, would fit the definition of functional sustainability, although such a rule would, in my view, be harmful to the economy. Furthermore, functional sustainability could be consistent with any point of view regarding the size and role of government. It could be adapted to a big government with a generous social safety net; a big government with a strong defense establishment; or a small government limited to protecting property and enforcing the rule of law.

What we have now, however, is neither rational nor sustainable or functional. In an earlier post I wrote,

The trouble is that we don’t have any workable fiscal policy rules at all. As Herbert Stein observed almost 30 years ago, “We have no long-run budget policy—no policy for the size of deficits and for the rate of growth of the public debt over a period of years.”  Each year, according to Stein, the president and Congress make short-term budgetary decisions that are wholly inconsistent with their declared long-run goals, hoping “that something will happen or be done before the long-run arises, but not yet.” It would be hard to find a better characterization of a fiscal policy that is functionally unsustainable.

Since that time, unbelievably, things have gotten worse. Forget long-run goals. Our current Congress can’t even follow its own short-run rulebook, which calls for continuing resolutions if a budget is not passed on time and for giving authority to the Treasury to borrow money to make payments on debt instruments that carry the “full faith and credit” of the government—whatever that means these days.

The bottom line

So what is the bottom line? Is the United States in such a deep fiscal hole that it could not possibly get out?  Not really. By comparison with its peers in the club of wealthy democracies, our spending, taxes, deficit, and even our debt are in the middling to moderate range. This is a problem that could be resolved.

What we seem to lack is the political ability to move forward. If only we had an orderly, rational, stable government like that of, say, Italy. Then the president would be able to dissolve Congress and call new elections for all 100 Senators and all 436 members of the House. Next, both chambers could adopt new rules under which any matter before them could be put to a straight, up-or-down, majority vote. Finally, the new Congress could elect a new president. What a great idea! Sadly, it is not to be.


5 Responses to “As We Move into Budget Chaos, Just How Bad is our Fiscal Policy, Really?”

windrivenOctober 8th, 2013 at 11:32 am

Dr. Dolan, I have read a bit on MMT but remain skeptical. Is there a text that you could recommend that might convince me that MMT is more than smoke and mirrors?

It seems to me that QE is an exercise in MMT. The effectiveness of QE in the overall economy strikes me as ambiguous (and the rise in GDP not at all proportionate) though the perspective of time may improve that opinion. But M2 has been rising much faster than GDP with the inevitable consequence of debasing the currency.

If, as the world economy stabilizes and QE is unwound, Treasuries rates rise to more realistic numbers we are going to be in some trouble. If Treasuries rise to just 5% – not at all uncommon historically and not unexpected with a boated currency – the cost of servicing our 17 trillion national debt will be more than the current defense budget! At our current anemic growth rate we will be hard pressed to grow our way out.

wmalexmannOctober 22nd, 2013 at 4:54 am

It is clear that US budget policy has long had a structural deficit and that policies have often been pro cyclical, but how is the OECD measuring the output gap and the natural rate of unemployment? Seems like there might be or might have been some room for disagreement about full employment in the US.

crybabyboy555March 7th, 2014 at 9:50 am

Horseface Mcdinkleman you are the president of New Uganda home of mass killings by volcano b\c beef jerky is useful in knife battles…