1. Jeff Frankel tops my National Journal post with nine more ways to trim the deficit.
2. EconomistMom Diane Lim Rogers scores the budget quote of the week: “‘Loosey-goosey’ out, loosey-goosey’ back at ya.”
3. Bruce Bartlett makes the case for a war tax: “wars financed heavily by higher taxes, such as the Korean War and the first Gulf War, end quickly, while those financed largely by deficits, such as the Vietnam War and current Middle East conflicts, tend to drag on indefinitely.”
A few weeks ago, the International Monetary Fund released a report analyzing the fiscal situation of the world’s largest economies. As I discuss at greater length in a piece over at e21, the IMF finds that the United States is not alone in facing daunting fiscal challenges. For example, the IMF predicts that the United States will have the fifth highest structural primary budget deficit in 2010:
Now you might be wondering what a structural primary budget deficit is. Good question. The “primary” part means that the IMF excludes from the calculation any interest that governments are paying on their outstanding debts. That’s a useful thing to do if you want to focus on the programmatic spending and revenue decisions that governments are currently making. The “structural” part means that the IMF has tried to strip out the effects of the business cycle to identify the underlying posture of government policy. (Because of the weak economy, the IMF estimates that the U.S. primary deficit will be 8.1% of GDP in 2010, much higher than the 3.7% of GDP structural primary deficit.) And just to round out the details, you should also be aware that to make things comparable across countries, the IMF combines all levels of government together, so the U.S. figures include not only the federal government, but also the state and local governments.
With that context, the basic message of my first chart is that the United States has a very large structural primary deficit, but a few countries are even worse off: Japan (which has been running large deficits for years) and Ireland, the United Kingdom, and Spain (which had more severe credit booms and busts than we did, suggesting that the crisis had some structural effects, not just cyclical ones). At the other extreme, Norway is sitting pretty with its oil revenues.
The IMF also estimated how large a fiscal adjustment (i.e., spending reductions and tax increases) each economy would have to undertake to get their government debts back to a reasonable level. The basic idea is that, at a minimum, nations should run small primary surpluses and, in addition, some (including the United States) may need to reduce the size of their debts relative to the economy. Using a quite ambitious debt target (60% of GDP for the gross government debt for most countries), the IMF projects the following adjustments would be necessary:
If you take these results at face value, they suggest that the United States will have to cut spending and increase revenues by a combined 8.8% of GDP between 2010 and 2020, a fiscal adjustment of around 0.9% per year. Imagine having to enact a permanent spending reduction or tax increase of $120 billion per year next year, and then do it again in each of the next nine years. Rather daunting.
One can, of course, quibble with the specific assumptions that IMF has used. For example, getting the gross government debt down to 60% of GDP (about where it was before the financial crisis) may be a bridge too far. But clearly the United States will have a lot of work to do. But hey, things could be worse. We could be Spain, Ireland, the UK, or Japan.
During the financial crisis, the best single piece of advice I received was: “Use Sweden’s playbook.” Sweden faced a severe financial crisis in the early 1990s and had managed it–through a combination of guarantees, capital injections, and good bank / bad bank separations–about as well as one could hope.
As our attention turns from the financial crisis to our looming fiscal crisis, that advice continues to be useful. When its financial crisis ended, Sweden found itself on an unsustainable fiscal trajectory, yet found a way to pull itself out. As Jens Henriksson wrote in a fascinating paper (“Ten Lessons about Budget Consolidation“) in 2007:
In its Economic Outlook of December 1994 the OECD projected that the Swedish public debt would explode. By the year 2000 the public debt was expected to hit a record 128 percent of GDP. Today we know that the gross debt for 2000 turned out to be less than half that figure at 53 percent. And within a few years the budget deficit, from a high of over 11 percent of GDP, turned into a large surplus.
How did Sweden do it? You should read Henriksson’s paper for all ten lessons, but two particularly important ones are:
These lessons are useful both for domestic politics and for world capital markets. Clear goals with shared sacrifice can, in the hands of strong political leaders, establish a commitment to budget consolidation, easing the path to success at home:
As a politician you can never explain why you need to cut pensions alone. But if, at the same time, you cut child benefits and unemployment insurance and raise income tax for the richest, you are on safe ground. The idea is to not single out the losers.
At the same time, clear, credible commitments will be rewarded by world capital markets through lower interest rates, which can help offset some of the contractionary effects of tightening the budget. (Henriksson’s description of Swedish politics at the time occasionally sounds like parts of the Clinton years, when the opinions of the bond market loomed large).
Earlier this week, the IMF released a key chapter from the upcoming World Economic Outlook: Chapter 4: What’s the Damage? Medium-Term Output Dynamics After Financial Crises. As noted in the much pithier summary, the report concludes that:
The global financial crisis is likely to leave long-lasting scars on the world economy, but governments can act to stimulate a quicker revival and counter output losses … . The study finds that banking crises typically have a long-lasting impact on the level of output, although growth eventually recovers. Lower employment, investment, and productivity all contribute to sustained output losses.
Those conclusions are based on their review of financial crises around the world since the early 1970s. As shown in the following graph, the key finding is that after a financial crisis economic output remains below trend for years:
The blue line shows, for example, that in the average country, output seven years after the crisis was about 10% below what would it would have been if the pre-crisis growth rate had continued.
The dotted red lines, however, highlight the enormous range of outcomes. At least one-quarter of the countries eventually had output that was above the level implied by the earlier trend; while another quarter eventually fell at least 25% below the prior trend.
The study slices and dices this result in numerous ways, trying to identify the factors that lead to better or worse outcomes. Some are bad news for the United States.
Continue reading “IMF: The Lasting Effects of Financial Crises”
The fiscal outlook for the United States is grim. This year’s deficit will be around $1.4 trillion, about 10% of GDP, and the Obama Administration projects that deficits in the next ten years will total about $9 billion. Under those projections, the ratio of publicly held debt to GDP will be approaching 77% by the end of 2019, up from 41% just a year ago.
Those figures are daunting. We are in a deep fiscal hole. But we shouldn’t give up hope just yet.
As the Committee for a Responsible Federal Budget notes in a new report, numerous countries have faced gigantic deficits and found the political will to change course. A few examples:
Finland (1992–2000): Following a major banking crisis, Finland faced large deficits (around 8 percent of GDP) and a rapidly rising debt (58 percent of GDP). Prior to the crisis, Finland was running surpluses of around 6 percent of GDP. Motivated by strong political support to get its house in order to qualify for eurozone participation and by the need to address external financing concerns, the government pursued a fiscal consolidation program. A medium-term budget framework, entitlement reforms, spending cuts and tax reform were part of the program. By 2000, the debt/GDP ratio was under 45 percent. The cyclically adjusted primary fiscal balance improved cumulatively by 10 percent of GDP from 1992.
Spain (1993–97): Spain’s fiscal position had been deteriorating since the late 1980s. By 1995, its fiscal deficit exceeded 7 percent of GDP. Its public debt exceeded 70 percent of GDP. Facing external financing concerns and strong public support to adopt fiscal disciplinary measures to prepare for euro area membership, the government adopted a fiscal consolidation plan that emphasized spending (including cuts in social transfers, government wages and health care spending) but also included tax reform. Fiscal balances improved, cumulatively by around 4 percent of GDP since 1993.
Sweden (1994–2000): Sweden’s fiscal situation deteriorated severely in the early 1990s as a result of a banking and economic crisis. In the midst of a recession, the government adopted a fiscal consolidation program to achieve fiscal balance through a tightening up on household transfer payments and an increase in various taxes. As a result of its fiscal consolidation efforts, the fiscal position shifted from a deficit of over 11 percent of GDP to a surplus of 5 percent of GDP and the debt/GDP ratio was reduced from 72 percent to 55 percent in 2000.
The CRFB report draws some interesting lessons from these episodes (e.g., Lesson 6: “It is preferable to make fiscal adjustments on your own terms before they are forced upon you by creditors.”)
But my point today is much simpler: Just as we were hardly the first developed economy to face a major financial crisis, we also are not the first to face a looming fiscal crisis. Indeed, as the examples of Finland and Sweden show, we aren’t even the first developed economy to face a potential fiscal crisis in the aftermath of a financial crisis.
As we prepare (I hope) to address our looming deficits, we can take heart from the fact that some other nations have successfully faced similar challenges.
At the TED conference in Oxford last month, Paul Romer put forward a big idea: charter cities. His basic vision is that the best way to promote growth in developing countries may be to start over. Of course, you can’t just sweep away the existing system of economic and political institutions; they may be killing growth, but they are well-entrenched. So do the next best thing: clear some ground and build new charter cities.
Those cities will have rules — indeed, economic history teaches that they must have rules — but they will be focused on providing an environment that promotes economic growth. In short, property rights and the rule of law are in, corruption and political patronage are out.
His provocative example: If the U.S. gives up on Guantanamo, Raul Castro should invite the Canadians to help manage the area as a charter city. Over time, perhaps Guantanamo could become the Hong Kong of the Caribbean.
To illustrate how prosperity varies around the globe, Romer uses the increasingly popular approach of showing night time satellite photos. North Korea is a sea of darkness next to South Korea, illustrating the perils of too much government control. The darkness of Haiti, as compared to its neighbor the Dominican Republic, similarly illustrates the perils of too little government or, at least, too little governance.
As Romer frames it, development is a classic Goldilocks problem of finding the right set of rules — not too hot, not too cold — and then allowing people to make the choices that eventually lead to prosperity.
I was flipping through a report from the Bank for International Settlements (BIS) recently (ht Torsten Slok) and came across this fascinating six-pack of charts:
The charts show how much banks have had to pay in interest on their senior, subordinated, and guaranteed debt, relative to the interest rates of comparable government bonds. For example, the chart shows that banks in the United Kingdom have recently had to pay about 250 basis points (i.e., 2.5 percentage points) more on their senior debt than the UK government pays on its debt.
There are many interesting stories spread across these charts. For example, the red lines suggest that the first wave of investors in guaranteed bank debt in the United States and France did well for themselves (since the decline in yields implies an increase in bond prices).
But the thing that really caught my eye was the behavior of the senior debt (green) and sub-debt (blue) lines. In the five European countries, you see what you might expect: the sub-debt trades at a higher spread than the senior debt. That makes sense, since the sub-debt faces greater risk of losses. Investors demand compensation — a higher yield — for bearing that risk.
And then there’s the United States.
This morning, the Wall Street Journal editorial page questioned the oft-alleged link between health care costs and the competitiveness of American business. Echoing Council of Economic Advisers Chair Christina Romer, it referred to that argument as “schlock.” At the same time, everyone interested in health policy is still absorbing the trillion-dollar price tag that the Congressional Budget Office (CBO) put on the Kennedy health bill.
I’d like to point out that these two issues – any link between health care and competitiveness and the estimated cost of health reform – are closely related. The way that CBO estimated the budget impacts of the Kennedy bill implies that health care has little effect on competitiveness. If you take the contrary view, that health care is a big deal for American competitiveness, then you should also believe that CBO has underestimated the difficulty of paying for health reform.
Government deficits have skyrocketed in the past year, yet the U.S. as a whole is borrowing much less from the rest of the world. What’s going on?
As shown in the following chart, the answer is simple: Americans are saving more and investing less.
You must be logged in to post a comment.