Friday, July 06, 2007

How To Advise on Fiscal Policy

There has been some chatter among Jared Bernstein, Greg Mankiw, and Brad DeLong about whether it was appropriate for Greg to have advised President Bush in 2003 in support of the second round of major tax cuts. (See here, here, and here.) You can read everything I've blogged about budget policy, but here's a summary as it pertains to giving advice.

The overriding problem in conducting fiscal policy is that politicians, in both the executive and legislative branches, face electoral pressure to please their current constituencies. It is extremely tempting for them to boost spending or lower taxes today, handing out windfalls to today's voters and leaving an unrepresented constituency--future taxpayers--to foot the bill.

It takes an enormous amount of energy to resist that temptation. That energy has to come from the politician's advisers. In the White House, the most senior of them carry the titles Assistant to the President, in most cases preceded by the word "Deputy" or "Special" to connote their place in the hierarchy. During the year I spent at CEA, I worked with a number of them who were excellent. But if you ask them what their objectives are, or if you listen to their arguments during policy meetings, what you find is that they are working extremely hard to advance the President's policies (which they have often had a central role in shaping and hopefully improving). They may have very good intentions at heart, but in my experience they were not usually the ones looking at the larger picture who might help resist the temptation to act in a politically opportunistic manner. There were exceptions, and I'm not looking to impugn anyone here.

There are other advisers with a central role to play in fiscal policy, however, who are Presidential nominees who undergo Senate confirmation and who can be called to testify to Congress on the President's policies. We should expect them to be the ones who look at the larger picture, who take a longer horizon into their policy discussions, and who do the heavy lifting to help the politician resist the temptation to use future generations' resources to buy votes today. On fiscal policy, the three main advisers are the Secretary of the Treasury, the Director of the Office of Management and Budget, and the Chairman of the Council of Economic Advisers.

To address the overriding problem, these three advisers must insist on an explicit budget target. The weakest one that I would accept is that the debt-to-GDP ratio (including debt held by government trust funds) must show no upward trend. (A stronger one would be that the on-budget deficit should be in balance over a full business cycle.) Long-term entitlement programs should be in projected actuarial balance to the extent it is possible to make a projection. (You can see here what happened to one adviser who made reasonable arguments without first getting agreement on a standard.)

The standard can be that simple, and it isn't as austere as I'm trying to make it sound. It doesn't rule out cutting taxes during the weak part of a business cycle, for example, but it does rule out cutting taxes to run a deficit that the Administration has no intention of paying back during the strong part of a business cycle. As a corollary, it does rule out passing tax cuts with explicit sunset provisions and then arguing to extend them with the budget not in balance. There can be occasional exceptions, but their presumed infrequency should immediately cause them to be fully explained. (Think of the President addressing a joint session of Congress.)

Twice a year, the Administration makes an economic forecast to underlie the budget or its mid-session review. I'd be surprised if you ever see such a forecast that predicts an upcoming recession. That means that every budget or mid-session review should be projecting on-budget surpluses or their quick resumption if we are just coming out of a recession. As I've discussed elsewhere, the "cut the deficit in half in five years" policy was at variance with this standard.

I acknowledge that my views on this don't match the usual discussions of the impact of deficits. I think too much of those discussions are about their impact on interest rates and thus the incentive for private investment. This is where economists spend a lot of their time, but that doesn't make it the most relevant question. Suppose for the sake of argument that deficits don't put much upward pressure on interest rates. Even in that case, they still have to be financed at the existing interest rate, and the burden of financing them has to be borne by someone in the future. Taxing someone in 2020 to pay for our spending binge in 2003 violates my notions of fairness, and that is a substantially more salient issue here than any additional concerns about efficiency.


Matt Lewis said...

it violates my notion of fairness that we have to pay off previous generation's debts but can't pass any of ours off to the next one. why should this generation be the one left holding the bag?

plus, deficit spending could be on things that provide benefits far down the road. for instance, in education, where the next generation will be the primary beneficiaries of our investment. it seems fair that they might have to shoulder part of that burden.

clearly the line needs to be drawn somewhere. not all deficit spending is justified. i don't know exactly where to draw the line, but upcycle deficit spending that promotes long-term growth seems pretty reasonable to me. a place to start, at least.

Ken Houghton said...

The issue isn't the appropriateness of advising; it's the subsequent dissembling about the effect of the policy enacted.

If NGM were to say, "This is what I said they should do. They didn't" (in a more sensible manner than Paul ["Alan played politics and I didn't"] O'Neill did, of course, but we would expect that naturally), no one would be berating him. It's "I recommended this, and it has (against all evidence, as Max, Jared, and Brad have noted) worked" that has caused the fooforah.

(Well, that and the ad hominem attack on Bernstein with which he began.)

Anonymous said...

When considering ingenerational fairness, remember that deferring payment has a progressive bias: future generations will be richer than current ones. Of course, this should be balanced by your view of the proper discount rate for utility. If you think it is zero - as I do - then that progressive bias would be outweighted by the extra interest costs, and the conclusion is the same.

PGL said...

So excellent that I had to take the liberty of posting this over at Angrybear. One recommendation - fix the links.

Tom said...

State and local governments have capital budgets that are often financed, either by sinking funds or explicitly with bonds. GAAP is quite clear what is capital and what isn't with regard to governments. I would recommend changing Andrew's "rule" to allow for capital projects in any part of the business cycle.

That nit aside, I'd sure be impressed by any candidate who made a promise to use a rule like this (and stuck to it), even when his/her party controls Congress. Of course, in today's world, such a promise usually comes along with a boatload of hideous republican-statist social is so hard sometimes :)