Economic & Fiscal Outlook
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth
Senior Executive Fellows
March 6, 2012
GDP growth forecasts for 2012–13
IMF World Economic Outlook, Jan 2012
2010
2011 2012 2013
World Output
Advanced Economies
USA
European recession
Euro Area
5.2
3.2
3.0
1.9
3.8
1.6
1.8
1.6
3.3
1.2
1.8
–0.5
3.9
1.9
2.2
0.8
Germany
France
Italy
Spain
3.6
1.4
1.5
–0.1
3.0
1.6
0.4
0.7
0.3
0.2
–2.2
–1.7
1.5
1.0
–0.6
–0.3
Japan
UK
Newly Industrial Asian Economies
4.4
2.1
8.4
–0.9
0.9
4.2
1.7
0.6
3.3
1.6
2.0
4.1
Emerging & Developing Economies
7.3
6.2
5.4
5.9
Developing Asia
9.5
7.9
7.3
7.8
China
India
ASEAN-5
10.4
9.9
6.9
9.2
7.4
4.8
8.2
7.0
5.2
8.8
7.3
5.6
pulls down global growth
U.S. economic news so far in 2012
has been better
• Recent statistics:
– Unemployment has declined to 8.3%
– Growth in Q4 2011 revised up to 3.0%
(2/29/12)
• from 2.8 %
• Blue Chip Economic Indicators survey (February)
consensus forecast for 2012 GDP growth:
Q1 = 2.1 %, Q2 = 2.2 %, Q3 = 2.4 % , Q4 = 2.6 %.
3
After 3 years, the U.S. in 2011
finally achieved its pre-recession level of GDP
13,600
Real GDP
(billions of chain-type (2005) dollars seasonally
adjusted at annual rates)
13,400
Obama
Inauguration
13,200
End of
recession
13,000
12,800
12,600
12,400
12,200
2007
2008
2009
2010
2011
Jan. 2007 – Dec. 2011, monthly, estimated by Macroeconomic Advisers
Source: Macroeconomic Advisers
www.macroadvisers.comMon
Obama
Inauguration
End of
recession
Private
sector job
creation
(by quarter)
Average rate
of private job
creation
between the
two recessions
(Nov. 2001-Dec.2007)
Average rate
of private job
creation
throughout
8 Bush years
(Jan. 2001-Jan.2009)
Data Source: U.S. Bureau of Labor Statistics
Possible risks to the recovery in 2012
• Euroland: Worsening of sovereign debt crisis?
– and contagion to other high Debt/GDP countries.
• Political breakdown in Washington?
• like the debt ceiling standoff of August 2011
• which led S&P to downgrade US from AAA to AA
» for the 1st time in history.
• Emerging markets: hard landing?
– particularly in China.
• Major oil crisis?
– from military confrontation with Iran.
Sovereign debt worries
...
• Who is vulnerable to contagion?
• The emerging market countries are
in much better shape than past decades,
• in an amazing & historic role reversal.
7
A remarkable role-reversal:
• Debt/GDP of the top 20 rich countries
(> 80%) is already more than twice
that of the top 20 emerging markets;
• and rising rapidly.
• Nor are the Emerging Markets necessarily less
“debt tolerant” for a given debt/GDP
•
as Reinhart & Rogoff thought not long ago.
8
Country creditworthiness is now inter-shuffled
“Advanced” countries
AAA Germany, UK
AA+ US, France
AA
Belgium
AA- Japan
A+
A
Spain
ABBB+ Italy
BBB- Iceland, Ireland
BB+
BB
Portugal
B
CC
Greece
(Formerly) “Developing” countries
Singapore
Chile
China
Korea
Malaysia, South Africa
Brazil, Thailand, Botswana
Colombia
India
Indonesia, Philippines
Costa Rica, Jordan
Burkina Faso
S&P ratings, Feb.2012 domestic curren
What Determines Country Vulnerability?
• Fundamentally: Quality of institutions.
– This does not mean “tough” rules that lack enforceability
• like Stability & Growth Pact, debt ceiling or Balanced Budget Amendment.
– Better would be structural budget targets (Swiss)
with forecasts from independent experts (Chile).
• The smartest commodity producers in boom years
save export earnings in a Sovereign Wealth Fund (Botswana)
– One third of developing countries have graduated from procyclical spending to countercyclical since 2000.
– The US, UK & euro countries
could learn from them.
Correlations between Govt. Spending & GDP
1960-1999
Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours”
procyclical
Pro-cyclical spending
countercyclical
Countercyclical
spending
G always used to be pro-cyclical
for most developing countries.
Correlations between Govt. Spending & GDP
2000-2009
procyclical
Frankel, Vegh & Vuletin (2011)
countercyclical
In the last decade,
about 1/3 developing countries
switched to countercyclical fiscal policy:
Negative correlation of G & GDP.
The US budget
• What changes in American fiscal policy
would be desirable 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 is required:
– Current steps to extend the fiscal stimulus,
• designed to maximize bang for the buck.
– Simultaneous legislated measures to lock in future progress
back toward fiscal discipline in the long run.
• Not vague speeches, but specific & firm legislative commitments.
While fiscal stimulus should not be withdrawn
now, serious steps should be taken to lock in a
return to fiscal discipline in the long run.
• All politically very difficult, needless to say.
• Any solution must begin with:
– Honest budgeting (e.g., Afghan war on-budget, etc…)
– Regime of Shared Sacrifice
– Wise up to politicians who insist the budget can be
balanced entirely through cuts in domestic spending
(while cutting taxes),
• but who raise spending when they get the chance.
14
Short fiscal history: The 1980s
• In 1981, the newly elected Ronald Reagan complained
he had inherited (almost) $1 trillion of national debt:
– As $1,000 bills stacked up, the debt would reach 67 miles high.
• Reagan’s policy: sharp tax cuts (& rise in defense spending)
• The claim: budget surpluses would result.
• The reality: record deficits that added to the national debt
– a 2nd trillion in his 1st term
– a 3rd trillion in his 2nd term
– a 4th trillion when G.H.W. Bush initially continued the policies
(“Read my lips, no new taxes.”)
Fiscal history, continued: The 1990s
• The deficits were gradually cut, and then converted to
surpluses by the end of the 1990s.
• How was this accomplished?
– Regime of “Shared Sacrifice” --3 key policy steps.
• 1990: GHW Bush agreed spending caps, taxes, & PAYGO
• 1993: Clinton extended the policy.
• 1998: As surpluses emerged, “Save Social Security 1st.”
– Strong growth in late 1990s.
Fiscal history, continued: The 2000s
• The Shared Sacrifice regime ended
the day G. W. Bush took office in 2001.
• He returned to the Reagan policies:
– Large tax cuts
– together with rapid increase in spending (triple Clinton’s)
• Not just in military spending (e.g., Iraq & Afghanistan),
• but also domestic spending: discretionary + Medicare drugs benefit.
• Just like Reagan, he claimed budget surpluses would result.
• Just like Reagan, the result was record deficits:
– The national debt doubled.
• I.e., GWB left more debt than his father + Reagan + 39 predecessors
On what basis do some fiscal conservatives
claim that tax cuts lead to budget surpluses?
• (1) Tea Party logic:
– Claim: We can do it by cutting Head Start & foreign aid.
• I.e., repeal the Laws of Arithmetic.
• (2) The Laffer Hypothesis:
– Claim: Tax rate cuts raise income
so much that tax revenue goes up.
• (3) “Starve the Beast”
– Claim: Tax revenue decline will force spending cuts.
• “Congress can’t spend money that it doesn’t have.”
How far can we get by cutting spending?
• Total federal spending = $3 ½ trillion in round numbers.
• That spending minus tax revenue leaves
a budget deficit of $1.1 trillion in FY 2012
– down from $1.4 trillion in 2009.
• Most Republican congressmen want to exempt defense &
senior-related spending (Soc.Security & Medicare),
– to cut only non-defense discretionary spending.
– That was their official platform in 2010 election.
• How much would we have to trim non-defense
discretionary spending to balance the budget?
How far can we get by cutting spending? continued
• Start by eliminating all foreign aid.
• = 1 ½ % of total outlays, not 25% as Americans think.
• Next, veteran’s benefits.
• The same. We are now up to a total of 3 % of outlays.
• Next imagine zeroing out all federal spending on agr.,
science & environment, education & transportation,
• which includes programs so popular that congressmen voting for them would lose
re-election. But some of the freshmen say they are willing to pay that price.
• That is a total of $364 b = 1/3 of the 2012 deficit.
• Conclusion: Domestic discretionary spending
is not where the big bucks are.
• Would also need to eliminate either all of defense,
– or all of medicare or all of social security
– while still collecting the social security taxes that are supposed to pay for it!
3 biggest spending categories:
Health, Social security, & Defense
{ Medicare
& medicaid
Concord Coalition.
Data Source: CBO, Jan. 2012
Eliminating all non-defense discretionary spending
(including also parks, weather service, food safety, SEC, FBI, border patrol,
politicians’ salaries… everything !)
would not come close to eliminating the budget deficit
$92 b
$86 b
$61 b
$59 b
$56 b
$35 b
$30 b
$17 b
$6 b
Concord Coalition.
Data Source: CBO, Jan.2012
Breakdown of federal spending
Even if one could somehow eliminate all domestic spending,
it would not come close to eliminating the deficit
in FY 2012, from $1.4 trillion in FY 2009
Deficit
$1.1 tr.
Tax
revenue
$2.5 tr.
Concord Coalition.
Data Source: CBO, Jan. 2012
• Ten years ago, if the country thought it important enough to
protect any single category against belt-tightening in the
long run - say military or social security or taxes –
it would have been arithmetically possible, by making the
cuts elsewhere.
• But we no longer have the luxury of such choices after the
legacy of the last decade —
–
–
–
–
after the effects of mammoth tax cuts (2001 & 2003),
two wars (2001, 2003),
the Medicare prescription drug benefit (2003),
and the severe financial crisis & recession (2008).
• Starting from our current position, each of the 5
components must play a role, along with taxes.
The US public discussion is framed as a battle between
conservatives who philosophically believe in strong budgets
& small government, and liberals who do not.
Democrats, Republicans,” & the media all use this language.
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 genuine policy steps < 0.
[1] Never mind 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. 2003.
U.S. fiscal policy in 2012-2013, continued
• How does one take steps today
to lock in future fiscal consolidation?
– Not by raising taxes or cutting spending today (new recession);
– 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.
How to reduce the budget deficit
The only way to do this is both reduce spending
& raise tax revenue, as we did in the 1990s.
• Spending.
Examples:
– Cuts in farm subsidies for agribusiness & farmers
– Cut unwanted weapons systems
• a rare success: the F22 fighter
– Cut manned space program
How to reduce the budget deficit
The only way is both reduce spending & raise tax revenue, continued.
• Tax revenue options
– Let President Bush’s tax cuts for the rich expire in 2013
– Curtail expensive and distorting tax expenditures
• E.g., Tax-deductibility of mortgage interest,
• & health insurance
• Subsidies to oil industry…
– Or more ambitious tax reform
• Introduce a VAT or consumption tax
• Or phase in auctioning of tradable emission permits
Doing nothing is an option
CBPP, May 2011
Distortionary subsidies hiding as tax expenditures
$128 b
$305 billion
$93 b
$84 b
Joint Committee of Taxation, Jan. 2012
The long-term problem is entitlements
Concord Coalition.
Data Source: CBO, Jan. 2012
• Social security
– Raise retirement age – just a little
– Progressively index future benefit growth to inflation
– Optional options:
• To please Democrats: Raise the cap on social security taxes.
• To please Republicans: encourage private accounts
– though that contributes nothing to closing the gap.
32
• Health care
– Encourage hospitals to standardize
around best-practice medicine.
• Standardize around best-practice treatment
– e.g., to pursue the checklist that minimizes patient infections,
– and avoid unnecessary medical tests & procedures.
– That is not “death panels.”
• Lever: make Medicare payments
conditional on these best practices
– To please Republicans: rein in malpractice litigation.
– Curtail corporate tax-deductibility of health insurance,
• especially gold-plated.
33
For background writings,
you can Google “Jeffrey Frankel Harvard”
.
Or go to my webpage: http://www.hks.harvard.edu/fs/jfrankel/index.htm
Or my blog:
http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/
Including
“Did Obama Turn Around the Economy?” Project Syndicate, Feb. 17, 2012.
"Small Countries, Big Ideas," forthcoming, Business Economics (National
Association of Business Economists), April 2012.
“A Lesson From the South for Fiscal Policy in the US and Other Advanced
Countries,” Comparative Economic Studies, 2011.
“Snake-Oil Tax Cuts,” Economic Policy Institute, Briefing Paper 221, 2008.
Appendix I: 3 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 different 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.
(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:
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 $
Appendix II:
The Long-term debt problem
• (1) From where did the debt come?
• (2) What will drive debt in the future?
– The problem is not budget deficits in the next few
years, which are coming down.
– The problem is the far larger increases in
entitlement programs based on current promises
• Social security
• Medicare and other health programs
(1) How did we
get here?
$13 trillion in 2011 debt,
relative to 2001 official projection
}
Wars in Iraq &Afghanistan (so far)
}
Bush tax cuts (which were
supposed to expire in 2011)
}
Over-optimistic economic
assumptions in 2001, e.g., growth rate
Source: The Great Debt Shift:
Drivers of Federal Debt Since 2001,
Pew Charitable Trust,
2009-11 fiscal
stimulus in response
to the recession
accounts for less
than 1/3 of recent
deficits
and is rapidly
disappearing.
CBPP, May 2011
(2) The long-term problem
Appendix III
U.S. fiscal policy in 2012-2013
• If we opt for short-term fiscal stimulus
– or at least on counteracting the current fiscal contraction,
• what form should it take?
U.S. fiscal policy in 2012-2013, cont.
• 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 2013 for those
households > $250,000.
• .
U.S. fiscal policy in 2012-2013, cont.
• If the stimulus has to take the form of tax
cuts, then the best options are:
– extending President Obama’s payroll tax cuts,
– fixing the Alternative Minimum Tax, and
– extending the Bush tax cuts for those
households < $250,000.
– Some business tax cuts can also give bang
for the buck.
• such as temporary credits for investment or hiring
U.S. fiscal policy in 2012-2013, cont.
• 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.