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A Solution to Fiscal Procyclicality:
The Structural Budget Institutions
Pioneered by Chile
Jeffrey Frankel
Harvard University
Fiscal Policy and Macroeconomic Performance
Fourteenth Annual Conference of the Central Bank of Chile
October 21-22, 2010, Santiago
Three stories of the past decade:
set in the U.S., Europe, and Chile
2
Story #1: A decade of US fiscal policy
• When the Bush administration took office
– in January 2001,
– it forecast a decade of $5 trillion in cumulative budget surpluses.
• One component of this over-optimistic forecast:
An incoming political appointee at OMB raised an obscure parameter
– labor’s share of income – from its technocratic (CEA) estimate.
3
Budget forecasts by the Bush White House
subsequently had to be revised down every year
400
300
200
US$ bn
100
0
-100
-200
-300
-400
-500
Jan.
2001
Source: OMB
Aug.
2001
Jan.
2002
2002
Aug.
2002
Jan.
2003
2003
2004
Aug.
2003
Jan.
2004
4
US fiscal policy over the past decade, continued
• The forecasted surpluses helped Bush launch
a 10-year path of irresponsible fiscal policy:
– tax cuts
– & accelerated spending
• > twice Clinton’s rate of spending growth.
• The results:
– a cumulative $5 trillion in decade budget deficits.
– Today, in 2010, despite high unemployment,
Washington feels constrained by its debt
to withdrawal fiscal stimulus.
5
Story #2: A decade of
fiscal policy in Euroland
• Many have proposed fiscal rules to overcome
the political tendency toward budget deficits:
– the occasional U.S. proposals
for a Balanced Budget Amendment (deficit = 0);
– or the budget ceilings that supposedly constrain euro
members under the Stability & Growth Pact
(deficits < 3 % of GDP );
– and other rules in other countries.
6
But the SGP has failed
• The fiscal limits were widely violated
– by big countries
• France, Germany and Italy
– and small
• “PIGs”,
– until the Greek debt crisis of 2010
• when the budget rules’ failure
could no longer be papered over.
• Sovereign spreads shot up for Greece,
– & Portugal & the others
– below spreads for Chile & some other emerging markets.
• Credit ratings marked down below “A”
– while Chile’s ratings had moved above “A”.
7
Sovereign spreads for 5 euro countries
shot up in the 1st half of 2010
8
Ratings for “Advanced Economies”
Ratings for “Emerging Economies”
9
The design of budget rules
• The SGP was too rigid to allow the need for deficits
in recessions, counterbalanced by surpluses in good times.
• “Tougher” constraints on fiscal policy do not
always increase effective budget discipline -– countries often violate the rules --
• especially when a target that might have been reasonable
ex ante, such as an unconditionally balanced budget,
becomes unreasonable after an unexpected shock,
– such as a severe fall in export prices or national output.
• In an extreme set-up, a rule that is too rigid, so rigid that
official claims that it will be sustained are not credible,
might even lead to looser fiscal outcomes
– than if a more moderate or flexible rule had been specified at the outset.
• Neut & Velasco (2003).
10
The design of budget rules, continued
• Obvious solution:
specify budget targets in structural terms – conditional on GDP
& other macroeconomic determinants.
• The difficulty:
Identifying what is structural vs. what is cyclical
– is hard
– and is prone to wishful thinking.
• Thus specifying the budget rule in structural terms
does not solve the problem, if politicians
are the ones who judge what is structural.
11
Story #3: A decade of Chilean fiscal policy
• In 2000 Chile instituted its structural budget rule.
• The institution was formalized in law in 2006.
• The structural budget deficit must be zero,
– originally BS > 1% of GDP, then cut to ½ %, then 0 -– where structural is defined by output & copper price
equal to their long-run trend values.
• I.e., in a boom the government can only spend
increased revenues that are deemed permanent;
any temporary copper bonanzas must be saved
– and vice versa.
12
The crucial institutional innovation in Chile
• How has Chile avoided over-optimistic official forecasts?
– especially the historic pattern of
over-exuberance in commodity booms?
• The estimation of the long-term path
for GDP & the copper price
-- and so how much of a copper bonanza can be spent -is made by two panels of independent experts,
– and thus is insulated from political pressure & wishful thinking.
• Other countries could usefully emulate Chile’s innovation
– or in other ways delegate to independent agencies
estimation of structural budget deficit paths.
13
The Pay-off
• Chile’s fiscal position strengthened immediately:
– Public saving rose from 2.5 % of GDP in 2000 to 7.9 % in 2005
– allowing national saving to rise from 21 % to 24 %.
• Government debt fell sharply as a share of GDP
and the sovereign spread gradually declined.
• By 2006, Chile achieved a sovereign debt rating of A,
– several notches ahead of Latin American peers.
• By 2007 it had become a net creditor.
• By 2010, Chile’s sovereign rating had climbed to A+,
– ahead of some advanced countries:
– Israel & Korea (A), let alone Iceland (BBB-) or Greece (BB+).
• => It was able to respond to the 2008-09 & 2010 shocks
– via fiscal expansion.
14
• In 2008, with copper prices spiking up,
the government of President Bachelet was
under intense pressure to spend the revenue.
– She & Fin.Min.Velasco held to the rule, saving most of it.
– Their popularity ratings reached historic lows.
• When the recession hit and the copper price came
back down, the government increased spending,
mitigating the downturn.
– Bachelet & Velasco’s popularity
reached historic highs in 2009.
15
Three big themes of the last decade
1. The importance of volatile-priced minerals
–
and other commodities.
2. The importance of institutions
–
e.g., for setting fiscal policy.
3. The importance of emerging market countries
–
–
–
as a possible new source of lessons,
reversing the historic roles
in which only advanced countries had been models.
16
Previously, fiscal policy tended to be
procyclical in developing countries:
• Governments would raise spending in booms;
• and then be forced to cut back in downturns.
• Kaminsky, Reinhart & Vegh (2004), Talvi & Végh (2005),
Alesina, Campante & Tabellini (2008), Mendoza & Oviedo (2006),
Ilzetski & Vegh (2008) and Medas & Zakharova (2009).
• Especially Latin American commodity-producers.
• Gavin & Perotti (1997), Calderón & Schmidt-Hebbel (2003) and Perry (2003).
17
Correlations between Gov.t Spending & GDP
procyclical
Kaminsky, Reinhart & Vegh (2004)
countercyclical
G always used to be pro-cyclical
for most developing countries.
18
The historic role reversal
• Over the last decade many emerging market countries
finally developed countercyclical fiscal policies:
• They took advantage of the boom years 2003-2008
– to run budget primary surpluses.
– By 2007, Latin America had reduced its debt to 33% of GDP,
• as compared to 63 % in the United States.
• Debt levels among top-20 rich countries (debt/GDP ratios ≈ 80%)
are now twice those of the top-20 emerging markets
.
• Some emerging markets have earned credit ratings
higher than some so-called advanced countries.
19
Ten econometric findings
regarding bias toward optimism
in official budget forecasts.
•
Official forecasts of budgets & GDP in a sample
of 33 countries are overly optimistic on average.
The bias toward optimism is:
•
–
–
–
stronger the longer the forecast horizon.
greater among European governments
that are under the budget rules in the SGP.
greater at the extremes of the business cycle,
•
•
particularly in booms.
The key macroeconomic input for budget forecasting in
most countries: GDP.
In Chile: the copper price. 20
10 econometric findings regarding bias toward
optimism in official budget forecasts, continued.
•
Real copper prices mean-revert in the long run,
–
–
but this is not always readily perceived.
A mere 30 years of data cannot reject a random walk.
•
Uncertainty (option-implied volatility) is higher when
copper prices are toward the top of the cycle.
•
Chile’s official forecasts are not overly optimistic.
•
Chile has apparently avoided the problem of official
forecasts that unrealistically extrapolate in boom times.
21
Official forecasts of budgets & GDP are
overly optimistic on average
in a sample of 33 countries
• (1) Government forecasts of the budget balance (App. Table 1)
– The average across all countries is an upward bias of:
• 0.2% of GDP at the 1-year horizon,
• 0.8% of GDP 2 years ahead,
• and a hefty 1.5% at 3 years ahead.
• (2) Government forecasts of the GDP growth rate (App.Table 2)
– The average across all countries is an upward bias of:
• 0.4 % when looking 1 year ahead,
• 1.1 % at the 2-year horizon,
• and 1.8% at 3 years.
22
Official forecasts are overly optimistic, continued
• The bias appears in the US & other advanced countries,
– not particularly in emerging markets.
– Chile on average under-forecast its growth rate,
• by 0.8 % at the 1-year horizon.
• The sample of 33 countries:
–
–
–
–
26 from Europe (of which, 16 € members)
1 other major advanced country (US), and
3 advanced commodity-exporters (Australia, Canada, & NZ),
3 middle-sized emerging market commodity-exporters
(Chile, Mexico & South Africa).
– Getting data on official forecasts
• is very hard for others in this last category.
• Easy for Europe.
23
(3) Chile’s Official Budget Forecasts
Are Not Prone to the Optimism Bias of Others’
Figure 8a
24
Figure 8c: Budget Forecasts are more Biased
(4) in Booms & (5) at Longer Horizons
25
Official budget forecasts are biased
more if GDP is currently high & especially at longer horizons
Budget balance forecast error
as % of GDP, Full dataset
(1)
(2)
(3)
33 countries
One year ahead
Two years ahead
Three years
ahead
GDP relative
to trend
0.093***
0.258***
0.289***
(0.019)
(0.040)
(0.063)
0.201
0.649***
1.364***
(0.197)
(0.231)
(0.348)
Constant
Observations
398 up with the year 300
Variable is lagged so that it lines
in which the forecast 179
was made.
*** p<0.01, ** p<0.05, * p<0.1
Robust standard errors in parentheses, clustered by country. 26
(6) Official budget forecasts are more optimistically biased
in countries subject to a budget deficit rule (SGP)
Budget balance forecast error
33 countries
SGPdummy
as a % of GDP, Full Dataset
(1)
(2)
(3)
(4)
One year
ahead
Two years
ahead
One year
ahead
Two years
ahead
0.658
0.905**
0.407
0.276
(0.398)
(0.406)
(0.355)
(0.438)
0.189**
0.497***
(0.0828)
(0.107)
SGP dummy *
(GDP - trend)
Constant
Observations
0.033
0.466*
0.033
0.466*
(0.228)
(0.248)
(0.229)
(0.249)
399
300
398
300
*** p<0.01, ** p<0.05, * p<0.1
Robust standard errors in parentheses, clustered by country.
27
Budget forecasting is not easy
• (7) The key macroeconomic input for forecasting
budget balance in most countries: GDP.
•
In Chile: the copper price.
• (8)
Real copper prices mean-revert in the long run,
– but this is not always readily perceived.
– A mere 30 years of data cannot reject a random walk.
• (9) Uncertainty (option-implied volatility) is higher
when copper prices are toward the top of the cycle.
• (10) But forecasts do internalize reversion to trend.
28
Table 6b
GDP & inflation as determinants of budget balance
as a % of GDP, in 33 countries
(1)
(2)
(3)
VARIABLES
1 year ahead
2 years ahead
3 years ahead
GDP error
0.493***
0.450***
0.435***
(0.054)
(0.064)
(0.075)
0.148
0.248**
0.301***
(0.100)
(0.110)
(0.087)
0.359
0.675*
1.056**
(0.235)
(0.330)
(0.385)
Observations
214
185
159
R2
0.35
0.40
0.35
RMSE
1.892
2.438
2.664
Inflation error
Constant
29
Copper price as determinant of Chilean budget balance as % of GDP
1990-2009 (20 observations)
VARIABLES
Copper forecast error 1/
GDP growth error
Coefficient estimates
0.060**
0.056**
(0.021)
(0.021)
0.239
(0.187)
Constant
-0.023
-0.163
(0.754)
(0.683)
R2
0.299
0.251
RMSE
2.655
2.666
* p<0.05. Robust standard errors in parentheses
1.The copper forecast error is measured as:
30
[log (Aug. 15-month forward price) – log (average end-of-month price, Jan.–Dec., of the next year)]*100
(7) Figure 7b: Copper price movements dominate
budget forecasting in Chile in the short term
31
Do copper prices random-walk?
Or revert toward a long-run? trend
• 30 years of data cannot reject a random walk.
• But, then, a priori calculations suggest
there is not enough power in 30 years of data
to find mean-reversion even if it is there.
– One should need about 200 years of data.
• (8) Sure enough, copper prices revert to trend
– with statistical significance,
– when tested on 217 years of data (1784-2009);
– at an estimated speed of 0.13 per year
32
10 or 30 years of data are not enough to discern
reversion of real price of copper to long-run trend
Appendix Figure 1:
33
226 years of data are enough to discern reversion
of real price of copper to long-run trend
Appendix Figure 2:
34
(9) Uncertainty is genuinely higher
when the spot price is high
35
Table 4: Uncertainty Is Greater When the Copper Price
is Above its Long-run Trend
Regression of option-implied copper price volatility
on log (real spot price) – linear trend (log real spot price, using data for 230 years)
(1)
(2)
(3)
(4)
(5)
VARIABLES
12 month
15 month
24 month
27 month
39 month
Real copper
price (vs. LR trend)
7.34**
8.38***
9.90*** 10.04*** 9.516***
(3.19)
(3.02)
Constant
Observations
(2.82)
(2.77)
(2.68)
29.19*** 27.74*** 24.88*** 24.32*** 23.42***
(2.624)
(2.489)
(2.381)
(2.353)
(2.276)
60
60
60
60
59
*** p<0.01, ** p<0.05
Robust standard errors in parentheses
36
(10) Forecasts do internalize the tendency
for copper prices to revert toward long-run equilibrium
Figure 4: Copper prices spot, forward, & forecast
2001-2010
37
Table 3: Do private forecasters recognize
mean reversion in copper prices? Yes
(1)
(2)
(3)
logrealdiff15
logrealdiff27
logrealdiff63
-0.00291***
-0.00468***
(0.00018)
(0.00031)
(0.00092)
0.0232***
0.0405***
-0.0119
(0.00697)
(0.0116)
(0.0466)
258
204
93
R2
0.147
0.232
0.186
RMSE
0.0631
0.0980
0.201
VARIABLES
Spot price real -0.00167***
Constant
Observations
*** p<0.01
Robust standard errors in parentheses
LHS [ln(real forward price)-ln(real spot price)]*100
Real price ≡ nominal price divided by US CPI.
15-month forward is Jan.1989 – July 2010. 27-month is July 1993- July 2010. 63-month is Oct.2002.
Data source: LME via Bloomberg for copper prices. IMF IFS for US CPI.
38
Conclusions
• Official growth & budget forecasts tend toward wishful thinking:
– unrealistic extrapolation of booms three years into the future.
• The bias is worse among the European countries
supposedly subject to the budget rules of the SGP,
– presumably because government forecasters feel pressured to be able to
announce they are on track to meet the budget targets even if they are not.
• Chile is not subject to the same bias toward over-optimism in
forecasts of the budget, growth, or the all-important copper price.
• The key innovation that has allowed Chile
to achieve countercyclical fiscal policy:
– not just a structural budget rule in itself,
– but rather the regime that entrusts to two panels of independent experts
estimation of the extent to which copper prices & GDP depart from their
long-run averages.
39
Application to other countries
• Any country could adopt the Chilean mechanism,
– not just commodity-exporters.
• Suggestion: give the panels more institutional independence
– as is familiar from central banking:
• requirements for professional qualifications of the members
• and laws protecting them from being fired.
• Two open questions:
– Are the budget rules to be interpreted as ex ante or ex post?
– How much of the structural budget calculations are
to be delegated to the independent panels of experts?
• The minimalist approach:
they are mandated solely to compute 10-year moving averages.
40
41
Appendices
1. The political success of the Chilean
government’s fiscal strategy, 2008-09
2. The Greek sovereign debt problem
3. Three big themes of the last decade
4. What should US fiscal policy be now?
42
Appendix 1: Chilean politics
Poll ratings of Chile’s
President over time
In 2009, the popularity of the Socialist President of Chile Michelle Bachelet
rose sharply (both with respect to handling of the economy and overall),
to the highest levels since the restoration of democracy 20 years earlier.
More remarkable: the rise in the polls, from very low to very high, came just as the
economy moved from rapid growth to slow growth -- not the usual pattern. Why?
43
Chart source: Eduardo Engel, Christopher Neilson & Rodrigo Valdés, “Fiscal Rules as Social Policy,” Commodities Workshop, World Bank, Sept. 17, 2009
Poll ratings
of Chile’s
Presidents
and Finance
Ministers
And the
Finance
Minister?:
August 2009
In August 2009, the
popularity of the
Finance Minister,
Andres Velasco,
ranked behind only
President Bachelet,
despite also having
been low two years
before. Why?
Chart source: Eduardo Engel, Christopher Neilson & Rodrigo Valdés, “Fiscal Rules as Social Policy,” Commodities Workshop, World Bank, Sept. 17, 2009
44
2. The Greek sovereign debt problem
Frankfurt & Brussels
made 3 mistakes
• 2002-09: Did not allow spreads to open up
between sovereign debt of Greece & Germany.
• Winter 2010: Did not tell Greece to go to the IMF.
Preferred instead to “handle it internally.”
• Still today: No “Plan B” to restructure Greek debt
(and save the bailout fund for more deserving banks & PIIGs).
45
Judging from spreads, 2001-07,
investors put zero odds on a default by Greece
or other Mediterranean countries
Council on Foreign Relations
46
• Suddenly, in 2010, the Greek sovereign spread
shot up, exceeding 800% by June.
• Even when the Greek crisis erupted,
leaders in Brussels & Frankfurt
seemed to view it as a black swan,
– instead of recognizing it as a close cousin
of the Argentine crisis of ten years earlier,
• and many others in history,
– including among European countries.
47
Predictions
• Greece will have re-structure its debt.
• The euro-zone will not break up.
– There is no legal provision for members to leave.
48
Sovereign debt worries
...
• The next big asset market to fall
• after the stock market in 2000
• the housing market in 2006
• and banking in 2008
• will be sovereign debt
• among the advanced economies.
• The big emerging market countries
are in much better shape,
• in an amazing & historic role reversal.
49
A remarkable role-reversal:
• Debt/GDP of the top 20 rich countries
(≈ 80%) is already twice that
of the top 20 emerging markets;
• and rising rapidly.
• By 2014 (at ≈ 120%), it could be triple.
50
Appendix 3:
Three big themes of the last decade
1. The importance of volatile-priced minerals
–
and other commodities.
2. The importance of institutions
–
including for setting fiscal policy.
3. The importance of emerging market countries
–
–
–
as a possible new source of lessons,
reversing the historic roles
in which advanced countries had been the models
•
•
e.g., Japan in the 1980s
And the US in the 1990s.
51
Where to look for lessons?
• Two decades ago, many had drawn a lesson from the
1980’s: Japan’s variant of capitalism was the best model,
– that other countries around the world should and would follow it.
– But the Japanese model quickly lost its luster in the 1990’s.
• A decade ago, many thought that the lesson of the 1990’s
was that the US variant of capitalism was the best model,
– that other countries should and would follow.
– The American model lost its attractiveness in the 2000’s.
• So, where should countries look now, in 2010,
for models of economic success to emulate?
• Perhaps to the periphery of the world economy.
52
Big lessons from small countries
• Some smaller and less-rich countries have experimented
with policies & institutions that could usefully be adopted
by some of the “advanced countries.”
• Two illustrations from microeconomics.
– 1st, Singapore pioneered the use of the price mechanism
to reduce traffic congestion in its urban center.
• London emulated Singapore, successfully adopting congestion
pricing in 2003; other big cities should do the same.
– 2nd, Mexico pioneered Conditional Cash Transfer programs,
• making poverty benefits contingent on children’s school attendance.
• They have been emulated widely, embraced even in NYC.
53
On the larger theme that advanced economies
could learn some things from developing countries
• This line of argument is not meant as an attack
on Western values or modes of thought.
• It is not a celebration of Confucian values
or native folk remedies in the Andes or Africa.
• In my view, when Americans lectured others on the virtues
of fiscal discipline, market-based economics, the rule of
law, and electoral democracy, they were mostly right.
• Where they were wrong:
– the failure to see that their own country needed to be
on the receiving end just as much as developing countries.
54
Advanced economies could learn some things
from developing countries, continued
• Countries that are small, or newly independent,
or far-away, or emerging from a devastating war,
are often more free to experiment,
– than is the US or other large established countries.
• Not all the experiments will succeed.
• But some will.
• The results may include useful lessons.
55
Advanced economies could learn some things
from developing countries, continued
• In some cases, Western institutions were successfully
transplanted to other countries in the past,
and now needed to be re-imported.
• An analogy.
– In the latter part of the 19th century
the vineyards of France were destroyed by
Phylloxera vastatrix, a microscopic aphid.
– Eventually a desperate last resort was tried:
grafting susceptible European vines
onto resistant American root stock.
– It saved the European vineyards.
– The New World had come to the rescue of the Old.
56
The last decade has seen a historic reversal
in roles between advanced countries
and emerging/developing countries
regarding fiscal policy.
• Some of the latter took advantage of the 2002-08 expansion
• to run surpluses, pay down debt,
• and provide for future pension costs;
• allowing budget deficits in the 2008-09 recession.
• = A counter-cyclical fiscal policy
• The US, UK & some other advanced countries
have forgotten how.
57
Appendix 4:
What should be
the overall stance of US fiscal policy?
• Moving toward discipline in up-times
– 1993-2000. It did.
– 2003-2007, It didn’t.
• Expansionary during down-times
– 2010. It isn’t.
58
The US public discussion is framed like a battle between
conservatives who philosophically believe in strong
budgets & small government, and liberals who do not.
Not the right way to characterize the debate. [1]
• (1) The right goal should be budgets that allow
surpluses in booms and deficits in recession.
• (2) The correlation between how loudly an American
politician proclaims a belief in fiscal conservatism
and how likely he is to take corresponding policy steps < 0.
[1] Forget that small government is classically supposed to be
the aim of “liberals,” in the 19th century definition, not “conservatives.”
My point is different: those who call themselves conservatives in practice tend to
adopt policies that are the opposite of fiscal conservatism. I call them “illiberal.”
“Republican & Democratic Presidents Have Switched Economic Policies” Milken Inst.Rev.592003.
Three pieces of evidence to support the claim
that “fiscal conservatives” are not:
• (i) The voting pattern among the 258 Congressmen
who signed an unconditional pledge not to raise taxes:
– As of 2004, they had voted for more spending
than those who did not sign the pledge. [2]
• (ii) The pattern of spending
under Republican presidents.[3]
• (iii) The pattern of states whose Senators win pork
& other federal spending. [4]
•
•
•
[2] William Gale & Brennan Kelly, 2004, “The ‘No New Taxes’ Pledge,” Tax Notes, July.
[3] JF “Snake-Oil Tax Cuts,” EPI, Briefing Paper 221. 2008.
[4] JF Red States, Blue States and the Distribution of Federal Spending, 3/31/2010.
60
(ii) Spending & deficts both rose sharply when
Presidents Reagan, Bush I, & Bush II took office.
Vs. the 1990s: The Shared Sacrifice approach succeeded in
eliminating budget deficits, importantly by slowing spending.
Spending and Budget Balance(inverse) as % of GDP (Current US$)
15
24
13
22
11
20
9
18
7
ρ = 0.86
5
16
G.W. Bush
R. Reagan
G.H.W. Bush
10
1
-1
-3
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008 Est
2009 Est
2010 Est
12
J. Carter
14
W.J. Clinton
3
Spending/GDP
Budget Balance/GDP
Source:
61
OMB
(iii) States ranked by federal spending received
per tax dollar paid in 2005
versus party vote ratio in preceding election
“red”
states
“blue”
states
big inflow of US $
Republican states take home
significantly more federal $
(relative to taxes paid)
than Democratic states
low inflow of US $
62
U.S. fiscal policy in 2010-2011?
• What changes in American fiscal policy
would be desirable at the current juncture,
– if politics were not an obstacle?
• On the one hand, the economy is still weak.
• On the other hand, the U.S. can’t wait until the recovery
is complete to tackle the long run fiscal problem.
• A two-part strategy:
• Current steps to extend the fiscal stimulus,
– designed to maximize bang for the buck.
• Current steps to lock in future progress
back toward fiscal discipline in the long run.
63
U.S. fiscal policy in 2010-2011, continued
• Maximizing bang for the buck ≡ fiscal stimulus that
gives the most demand per $ added to long-term debt.
• Example that would minimize bang for the buck:
– proposal to make permanent the 2010 estate tax abolition .
– Almost as poorly targeted: proposal to prevent the Bush tax
cuts from expiring in 2011 for those households > $250,000.
• If the stimulus has to take the form of tax cuts,
then the best options are:
–
–
–
–
extending President Obama’s “Make Work Pay” tax cuts,
fixing the Alternative Minimum Tax, and
extending the Bush tax cuts for those households < $250,000.
Some business tax cuts could also give high bang for the buck.
• such as temporary credits for investment or hiring.
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U.S. fiscal policy in 2010-2011, continued
• But spending boosts demand more than tax cuts do,
– because the latter are partly saved.
• Extend elements of the Obama stimulus
– such as infrastructure investment and
– giving money to the states
• so that they don’t have to lay off teachers, policemen,
firemen, subway drivers & construction workers.
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U.S. fiscal policy in 2010-2011, continued
• How does one take steps today
to lock in future fiscal consolidation?
– Not by raising taxes or cutting spending today (see above);
– nor by promising to do so in a year or two (not credible).
– There are lots of economically sensible proposals
• for spending to eliminate,
• more efficient taxes to switch to,
• and “tax expenditures” to cut.
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U.S. fiscal policy in 2010-2011, continued
• One big reform might work best:
pass legislation today to put Social Security
on a sound financial footing in the long term.
• It would consist of a combination
– of raising the retirement age
• just a little (in proportion to lengthening life spans)
– and slowing the growth of benefits for future retirees
• just a little (perhaps by “progressive indexation).
• If Washington could fix Social Security,
– it would address the long-term fiscal outlook,
– yet would create no drag for the current fragile recovery.
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