Category Archives: budget

Fiscal Education for the G-7

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As the G-7 Leaders gather in Ise-Shima, Japan, on May 26-27, the still fragile global economy is on their minds.  They would like a road map to address stagnant growth. Their approach should be to talk less about currency wars and more about fiscal policy.

Fiscal policy vs. monetary policy

Under the conditions that have prevailed in most major countries over the last ten years, we have reason to think that fiscal policy is a more powerful tool for affecting the level of economic activity, as compared to monetary policy.  The explanation can be found in elementary macroeconomics textbooks and has been confirmed in recent empirical research:  the effects of fiscal stimulus are not likely to be limited, as in more normal times, by driving up interest rates, crowding out private demand, running into capacity constraints, provoking excessive inflation, or overheating in other ways.  Despite the power of fiscal policy under recent conditions, economists continue to lavish more attention on monetary policy.  Why?

Sometimes I think the honest reason we economics professors are attracted to monetary policy is that central bankers tend to be like us, with PhDs, and to hold nice conferences.

The reason that one usually hears, however, is that fiscal policy is “politically constrained.”   This is an accurate statement, but not a good reason for us to give up on it.  Indeed, if the political process gets fiscal policy wrong, which it does, that is all the more reason for economists to offer their contributions.

Of course if one is a central banker, or is advising a central banker, then one must concentrate on the job at hand, which is monetary policy.  But precisely because there is a limit to what central bankers can say about fiscal policy, there is more need for the rest of us to do it.

The heyday of activist fiscal policy was 50 years ago. The position “we are all Keynesians now” was attributed to Milton Friedman in 1965 and to Richard Nixon in 1971.  In the late 20th century, most advanced countries managed to pursue countercyclical fiscal policy on average: generally reining in spending or raising taxes during periods of economic expansion and enacting fiscal stimulus during recessions. The result on average was to smooth out the business cycle (as Keynes had intended).  It was the developing countries that tended to follow procyclical or destabilizing policies.

Leaders forget how to do counter-cyclical fiscal policy in the US, Europe and Japan

After 2000, however, some countries broke out of their familiar patterns. Too many political leaders in advanced countries pursued procyclical budgetary policies: they sought fiscal stimulus at times when the economy was already booming, thereby exaggerating the upswing, followed by fiscal austerity when the economy turns down, thereby exacerbating the recession.

Consider mistakes in fiscal policy made by leaders in three parts of the world — the US, Europe, and Japan.

US President George W. Bush began the century by throwing away the large fiscal surpluses that he had inherited from Bill Clinton, and then continued with big tax cuts and rapid spending increases even during 2003-07, as the economy reached its peak.  It was during this period that Vice President Cheney reportedly said “Reagan proved that deficits don’t matter.”

Predictably, the rising debt left the government feeling less able to enact fiscal stimulus when it was really needed, after the Great Recession hit in December 2007.  At precisely the wrong time, Republicans “got religion” deciding that deficits were bad after all.  Thus when President  Barack Obama took office in January 2009, with the economy in freefall, the opposition party voted against his fiscal stimulus.  Fortunately they failed then, and the stimulus was able to make a big contribution to reversing the freefall in the economy in 2009.  But having regained the Congress in 2011, they did succeed in blocking Obama’s further attempts to stimulate the still-weak economy for three years. The Republicans appear to be consistently procyclical.

Greece is the “poster boy” of an advanced country that unhappily switched to a systematically procyclical fiscal policy after the turn of the current century.  Its first mistake was to run excessive budget deficits during the expansionary period 2003-08 (like the Bush Administration).  Then, as if operating under the theory that “two wrongs make a right,” Greece was induced after its crisis hit to adopt tight austerity in 2010, which greatly worsened the fall in GDP. The goal was to restore its debt/GDP ratio to a sustainable path; but instead the ratio rose at a sharply accelerated rate, because of the fall in GDP.

Europeans suffer even more than other countries from basing their budget plans on official forecasts that are unnecessarily biased, which can lead to procyclical fiscal policy.   Before 2008, not just Greece, but all euro members were overly optimistic in their forecast and so at times “unexpectedly” exceeded the 3% ceilings on their budget deficits.  After 2008, qualitatively similar stories of procyclical fiscal contraction, leading to falling income and accelerating debt/GDP, also held in Ireland, Portugal, Spain and Italy.

The native land of austerity philosophy is, of course, Germany.  The Germans had (reluctantly) gone along with an agreement at the London G-20 Leaders Summit of April 2009 that the US, China, and other major countries would expand demand in order to address the Great Recession.  But when the Greek crisis hit at the end of that year, the Germans reverted to their deeply held beliefs in fiscal rectitude.

At first the IMF went along with the other members of the troika in believing — or at least pretending to believe — that fiscal discipline in the European periphery countries would not greatly damage their GDPs and thus could restore their debt/GDP ratios to sustainable paths.  But in January 2013, Fund Chief Economist Olivier Blanchard released a paper that was widely interpreted as a mea culpa.  It concluded that fiscal multipliers were much higher than the IMF (among other forecasters) had thought, suggesting that the austerity programs might have been excessive.  This conclusion was based on a statistical finding that the countries which had attempted the biggest fiscal retrenchment in response to the crisis turned out to experience the most damage to GDP relative to what the IMF forecasters had expected. Today, IMF Managing Director Christine Lagarde explains to the Germans that Greece cannot achieve the elusive path of a sustainable debt/GDP ratio if it is not given further debt relief and is instead told to run primary budget surpluses of 3 ½ percent of GDP.

Now to Japan, host of this week’s G-7 meeting.  In April 2014, even though the economy had been so weak that the Bank of Japan had been pursuing aggressive quantitative easing, Prime Minister Abe went ahead with a planned increase in the consumption tax (from 5% to 8%).  As many had predicted, Japan immediately went back into recession.  Even though the first arrow of Abenomics, the monetary stimulus, had been fired appropriately, it was evidently less powerful than the second arrow, fiscal policy, which unfortunately had been fired in the wrong direction.

Prime Minister Abe has indicated that he is sticking with his plan to go ahead with a further rise in the consumption tax (to 10%), scheduled for April 2017.  It is easy to see why Japanese officials worry about the country’s huge national debt.  But, as near-zero interest rates signal, creditworthiness is not the current problem; weakness in the economy is.  A more effective way of addressing the long-run sustainability of the debt is to announce a 20-year path of very small annual increases in the consumption tax, calculated so as to demonstrate to investors that the ratio of debt to GDP will come down in the long term.

Developing countries

Not all is bleak on the country scoreboard of cyclicality.  Some developing countries did achieve countercyclicalfiscal policy after 2000.  They took advantage of the boom years to run budget surpluses, pay down debt and build up reserves, which allowed them the fiscal space to ease up when the 2008-09 crisis hit.  Chile is the poster boy of those who “graduated” from procyclicality. Others include Botswana, Malaysia, Indonesia, and Korea.  China’s 2009 stimulus was very countercyclical.

Unfortunately some, like Thailand, who achieved countercyclicality in the last decade, have suffered backsliding since then.  Brazil, for example, failed to take advantage of the renewed commodity boom of 2010-11 to eliminate its budget deficit, which explains much of the mess it is in today now that commodity prices have fallen.

Politicians everywhere might improve their game if they re-read their introductory macroeconomics textbooks.

[This is an extended version of a column appearing at Project Syndicate.  Comments can be posted there or at Econbrowser.]

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Forecasting 2016 Economic Developments & Candidates’ Reactions

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     As the new year starts, Politico asks a set of economists for forecasts.  Prognostication from 23 appears at “Could the Economy Tank in 2016?

By the way, I think my forecast last time, two years ago, turned out to hold up pretty well:

Something important will get better in 2014: Fiscal policy will stop hurting the economyThe biggest impediment to economic expansion over the last three years has been destructive budget policy coming out of the CongressThere are good grounds for optimism in 2014. For the first time in four years, Congress will probably not inflict contractionary fiscal policy on the American people. If the government sector stops making a negative contribution, that will show up as economic growth.”

This time I focused on the following question from Politico:

Q: How will the 2016 presidential candidates have to adapt to economic realities and unforeseen developments in the coming year, such as the risk of recession, as they make the case to voters about their own economic visions?

A:  Recessions are not forecastable.  A downturn is no more likely in 2016 than in a typical year, nor less likely.

The next president will, like his or her predecessors, have to shift gears from the campaign and adjust to a very different set of developments and realities upon taking office.  But this is because of politics, not mainly because of uncertainty regarding what lies ahead.   The adjustment process will not begin until after the election, even if major new developments in the domestic or global economy take place during 2016.  The polite way to phrase it is to observe that “politicians campaign in poetry and govern in prose.”

Republican nominees, for example, always promise to cut taxes, increase military spending, protect seniors, and yet to run a strong budget balance, even though that combination is arithmetically impossible.  Democratic nominees too make unrealistic claims about how they will be able to combine spending increases with budget discipline.   Unforeseen disasters – financial, economic, national security – do not cause candidates to rethink their plans, but only to double down.   It is only after they take office that they are forced to confront the arithmetic, and sometimes they can postpone facing up to it for several years.

Some presidents adjust to fiscal realities immediately, during the presidential transition (Bill Clinton), some after a year or two of fiscal failure (Ronald Reagan and George H.W. Bush), and some later still (George W. Bush).   But none do it before the election.

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Gas Taxes and Oil Subsidies: Time for Reform

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World oil prices have been highly volatile during the last decade.   Over the past year they have fallen more than 50%.

Should we root for prices to go up, down, or stay the same?   The economic effects of falling oil prices are negative overall for oil-exporting countries, of course, and positive for oil-importing countries.  The US is now surprisingly close to energy self-sufficiency, so that the macroeconomic effects roughly net out to zero.  But what about effects that are not directly economic?   If we care about environmental and other externalities, should we want oil prices to go up or down?  Up, because that will discourage oil consumption?  Or down because that will discourage oil production?

The answer is that countries should seek to do both: lower the price paid to oil producers and raise the price paid by oil consumers.  How?   By cutting subsidies to oil and refined products or raising taxes on them.   Many emerging market countries have taken advantage of the last year of falling oil prices to implement such reforms.  The US should do it too.

Congress continues to shamefully evade its responsibility to fund the Federal Highway Trust Fund.  On July 30 it punted with a 3-month stop-gap measure, the 35th time since 2009 that it has kicked the gas-can down the road!  There is little disagreement that the nation’s roads and bridges are crumbling and that the national transportation infrastructure requires a renewal of spending on investment and maintenance.  The reason for the repeated failure to put the highway fund on a sound basis for the longer term is the question of how to pay for it.  The obvious answer is, in part, an increase in America’s gasoline taxes, as economists have long urged.  The federal gas tax has been stuck at 18.4 cents a gallon since 1993, the lowest among advanced countries.  Ideally the tax rate would be put on a gradually rising future path.

Fuel pricing is a striking exception to the general rule that if the government has only one policy instrument it can achieve only one policy objective.   A reduction in subsidies or increase in taxes in the oil sector could help accomplish objectives in at least six areas at the same time:

  1. The budget. It is estimated that energy subsidy reform globally (including coal and natural gas along with oil) would offer a fiscal dividend of $3 trillion per year. The money that is saved can either be used to reduce budget deficits or recycled to fund desirable spending, such as US highway construction and maintenance, or cuts in distortionary taxes, e.g., on wages of lower-income workers.
  2. Pollution and its adverse health effects.   Outdoor air-pollution causes an estimated annual 3.2 million premature deaths worldwide.  A gas tax is a more efficient way to address the environmental impact of the automobile than alternatives such as CAFÉ standards which mandate fuel economy for classes of cars.
  3. Greenhouse gas emissions, which lead to global climate change.
  4. Traffic congestion and traffic accidents.
  5. National security.   If the retail price of fuel is low, domestic consumption will be high.  High oil consumption leaves a country vulnerable to oil market disruptions arising, for example, from instability in the Middle East.  If gas taxes are high and consumption low, as in Europe, then fluctuations in the world price of oil have a smaller effect domestically.   It is ironic that U.S. subsidies to oil production have often been sold on nationalsecurity grounds; in fact a policy to “drain Americafirst” reduces self-sufficiency in the longer run.
  6. Income distribution.  Fuel subsidies are often misleadingly sold in the name of improving income distribution.  The reality is more nearly the opposite.  Worldwide, fossil-fuel subsidies are regressive: far less than 20%  of them benefit the poorest 20% of the population.  Poor people aren’t the ones who do most of the driving; rather they tend to take public transportation (or walk).   As to producer subsidies, owners of US oil companies don’t need the money as much as construction workers do.

The conventional wisdom in American politics is that it is impossible to increase the gas tax or even to discuss the proposal.   But other countries have political constraints too.  Indeed some governments in developing countries in the past faced civil unrest or even overthrow unless they kept prices of fuel and food artificially low.  Yet some of them have managed to overcome these political obstacles over the last year.  The list of those that have recently reduced or ended fuel subsidies includes Egypt, Ghana, India, Indonesia, Malaysia, Mexico, Morocco, and the United Arab Emirates which abolished subsidies to transportation fuel subsidies effective August 1.

Besides raising taxes on fuel consumption, the US should also stop some of its subsidies to oil production.  Oil companies can “expense” (immediately deduct from their tax liability) a high percentage of their drilling costs, which other industries cannot do with their investments.  Most politicians know that sound economics would call for this benefit to be eliminated.  But they haven’t been ab le to summon the political will.  Among the other benefits given to the oil industry, it has often been able to drill on federal land and offshore without paying the full market rate for the leases.

Those politicians who complain the loudest about the evils of government handouts are often the biggest supporters of handouts in the oil sector. Political contributions and lobbying from the industry must be part of the explanation.  Even so, it is surprising that self-described fiscal conservatives see more political mileage in closing the Export-Import Bank – which earns a profit for the US Treasury while it supports exports – than in ending oil subsidies, which cost the Treasury a great deal.   ‘

A recent study from the IMF estimated that global energy subsidies at either the producer or consumer end are running more than $5 trillion per year.  (Petroleum subsidies account for about $1 ½ trillion of that. A lot also goes to coal, which does even more environmental damage than oil.)  US fossil fuel subsidies have been conservatively estimated at $37 billion per year, not including the cost of environmental externalities.

Leaders in emerging market countries have now recognized something that American politicians have apparently missed, that this is the best time to implement such reforms.  Oil prices have recently fallen to around $50 a barrel – down from a level well over $100 a barrel in the summer of 2014. So governments that act now can reduce energy subsidies or increase taxes without consumers seeing an increase in the retail price from one year to the next.

For the US and other advanced countries it is also a good time for fuel price reform from the standpoint of macroeconomic policy.  In the past, countries had to worry that a rising fuel tax could become built into uncomfortably high inflation rates.  Currently, however, central bankers are not worried about inflation except in the sense that they are trying to get it to be a little higher.

Congress will have to come back to highway funding in September. If other countries have found that the “politically impossible” has suddenly turned out to be possible, why not the United States?

[A shorter version of this column was published at Project Syndicate.  Comments can be posted there.]

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