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10112013 Crisis Driven Report Fullreport

10112013 Crisis Driven Report Fullreport

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Published by: caitlynharvey on Oct 16, 2013
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10/27/2013

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1
The Cost of Crisis-Driven Fiscal Policy
Prepared by 
Macroeconomic Advisers, LLC
For the
Peter G. Peterson FoundationOctober 2013
EXECUTIVE SUMMARYCurrent fiscal policy is unsustainable and large, prospective deficits and debt, driven by
mandatory
 spending on social benefits for the aging population and insufficient revenues, pose an eventual threatto the U.S. economy. Yet partisan divided government has failed to address this long-run problemsensibly, instead encouraging policy that is short-sighted, arbitrary, and driven by calendar-based crises.These policies have:
·
 
Saddled a still-struggling economy with the
fiscal drag
of a contraction in discretionaryspending.
·
 
Created general uncertainty about fiscal policy that, through its impact on financial markets, hasundermined economic growth.
·
 
Forced the first prolonged shutdown of the federal government since the first term of theClinton Administration.
·
 
Failed to raise the federal debt ceiling in a timely manner, conjuring the specter of a sovereigndefault, with all its financial and economic fallout.Results developed here suggest that the recent fiscal drag, in combination with heightened fiscaluncertainty, has slowed the annualized rate of growth in the nation
s Gross Domestic Product by asmuch as 1 percentage point since 2010. And while the government shutdown is, for now, moreeconomic inconvenience than catastrophe, the consequences stemming from the failure to increase thedebt ceiling could cause the next recession, even if the U.S. does not default on its debt.
 
2
Current Fiscal Policy is
 
Unsustainable
In its recent report on the long-term budget the Congressional Budget Office (CBO) projects that undercurrent law, the federal deficit, after dropping to 2.1% percent of the Gross Domestic Product (GDP) byfiscal year (FY) 2015, will climb steadily to 6.4% percent by FY 2038. In this scenario, the federal debtwill reach 100% of GDP within 25 years
a level not seen since World War II
and will continue to risethereafter.
1
Under less optimistic assumptions CBO projects that debt could climb to 190% of GDP overthe same period. Driving both projections is a mismatch between revenues and outlays. In comingdecades, outlays climb because of rapid increases in
mandatory spending
for Social Security andhealthcare, which reflect an aging population and the rising relative price of healthcare. In contrast,CBO projects that under current law
discretionary spending
”—
outlays budgeted through theappropriations process primarily to fund operations of the civilian government and the US military
willfall from 8% of GDP in FY 2012 to 5.3% by FY 2023, the lowest level in half a century. Hence, the nation
sfundamental fiscal problem is not the immediate size of government, but rather unfunded promises of future entitlements.
The Deleterious Effect of Deficits
Economists agree that failure to shrink prospective deficits and debt will bestow significant economicconsequences and risks on future generations. Federal deficits drive up interest rates,
crowding out
 private investment. If government borrowing supports consumption (e.g., through Social Security andmajor health programs) rather than public investment, the nation
s overall capital stock declines,undermining our standard of living. The process is slow but the eventual impact is large.
2
In addition,accumulating debt raises the risk of a fiscal crisis. No one can say when this might occur but, unlikecrowding out, a debt crisis could develop unexpectedly once debt reached high levels.High deficits and debt also undermine the efficacy of macroeconomic policies and reduce policymakers
 flexibility to respond to unexpected events. For example, in a recession, it would be harder to providefiscal stimulus if deficits and debt already were high. Furthermore, fiscal stimulus might be less effectivethen. Additional deficit spending could be seen as pushing the nation closer to crisis, thereby forcing upinterest rates and undercutting the effects of the stimulus. With fiscal policy hamstrung, the burden of counter-cyclical policy is thrust on the Federal Open Market Committee (FOMC) but, particularly in a lowinterest-rate environment, the FOMC may be unable (or unwilling) to provide additional monetarystimulus.
3
 
1
The Congressional Budget Office,
The 2013 Long-Term Budget Outlook 
(September 2013).
2
Eventually, when yields on Treasury debt rise persistently above the economy
s underlying growth, the processcan become explosive.
3
The FOMC has a
dual mandate
of sustaining
maximum
employment while maintaining
price stability
. Attimes, the near-term inconsistency of these sometimes-competing objectives can be addressed throughcoordination with fiscal policy
provided fiscal policy is not rendered inoperative by high deficits and debt. Inaddition, the FOMC cannot reduce the short-term interest rate below the
zero bound
. Hence, in a low-rateenvironment, the Fed must turn to unconventional policies to provide monetary stimulus. One such policy is
forward guidance,
essentially a promise to keep short-term interest rates lower for longer. The other is
 
3
Principles of Sensible Policy
In addressing our fiscal imbalance policymakers should be guided by a few sensible principles thattranscend the details of any particular solution. First, policy should address the real problem
themismatch between revenues and the promises made through our entitlement programs
in a crediblemanner. To be credible, a proposed solution must seem realistic, entail shared sacrifice, and include anenforcement mechanism not easily overturned by future political regimes. Second, fiscal adjustmentshould begin early enough to avoid a crises-driven response later on. It will be less painful to disciplineourselves politically today than be disciplined by global financial markets tomorrow. Third, while deficit-reduction eventually raises living standards, initially it can reduce economic growth and raiseunemployment. Only later does the resulting decline in interest rates, perhaps accelerated by easiermonetary policy, stimulate interest-sensitive spending enough to restore the economy to fullemployment at a higher standard of living.
4
Fourth, given the trade-off between short and long-runeffects, fiscal adjustment should be gradual and predictable in order to reduce near-term
fiscal drag
 while minimizing the adverse impact of policy uncertainty on near-term economic growth. Fifth, inprinciple, the FOMC can mitigate or even offset entirely the effect of any fiscal drag. However,monetary policy affects the economy with a lag. Hence, to offset near-term fiscal drag, not only mustthe FOMC be able to cut interest rates, it must do so in advance of the fiscal contraction. Sixth, the fiscaladjustment should be
back-loaded
to occur when the economy is closer to full employment andinterest rates closer to normal. At that point, the economy can more easily absorb fiscal drag and theFOMC can more effectively respond by lowering interest rates in advance of the fiscal adjustment.
Recent Insensible Policy
Unfortunately, polarized government has fostered a systemic refusal
or inability
to legislate sensiblelong-run policies to address U.S. fiscal imbalances. While there is disagreement over the terms of theinter-temporal trade-off implied by the requisite fiscal contraction, the political battle centers on thedistributive role of government in society. Intransigence over that issue, combined with the annualneed to appropriate funding for defense and other discretionary federal programs while avoidingsovereign default, has driven Congress and the Administration to adopt short-sighted, sometimesseemingly arbitrary policies. The number of temporary tax provision set to expire at the end of eachyear has risen dramatically over the past two decades. Too frequently Congress has failed to passannual budget resolutions on time that set overall levels of spending within which priorities are thennegotiated; and too often lawmakers rely on a series of 
continuing resolutions
(CRs) to fund parts of 
quantitative easing
, the purchase of long-dated Treasury and mortgage-backed securities in an effort to reducelong-term interest rates directly. While these unconventional policies can be effective, they also carry risks thatmay discourage their further use, even in the face of a large fiscal contraction. For example, the recent back-up inlong-term yields shows how difficult it might be to
exit
smoothly from the current state of monetaryaccommodation. In addition, despite today
s low inflation rate, some economists remain concerned about thepotential inflationary consequences of quantitative easing.
4
To be sure, this view is not universally held. Some economists build models that show an immediateimprovement in GDP following a sharp fiscal contraction usually because the models assume
unrealistically, inour judgment
that households and business quickly expect lower future taxes and so feel free to spend enoughextra to offset any fiscal drag. Furthermore, often these models assume no unemployment, or treat it as a choice.

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