James R. and Helen D. Russell Professor of Finance; Faculty Director, Kellogg Public-Private Initiative (KPPI)
Jan Eberly served as Assistant Secretary for Economic Policy at the Treasury Department from 2011–2013, for a Democratic administration. Her collaborator on a recent article, Phillip Swagel, held the same position in the previous Republican administration. The pair recently generated a series of fiscal policy recommendations in a recent article for the Peter G. Peterson Foundation. Eberly was kind enough to speak to us about those recommendations.
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Kellogg Insight: What made the two of you sit down together to do this?
Eberly: There’s a perception, as people watch policy being made in the political arena, that there’s a broad gap between different points of view—especially on fiscal issues, where controversy has resulted in the government shutdown and the debt-ceiling debate.
But among economists who work on fiscal policy, there’s actually quite a lot of consensus on big issues. Of course, there’s disagreement on exactly what should be done and how, but Phill and I actually have very similar points of view on what the broad strokes of fiscal policy need to be going forward.
KI: Thanks to sequestration cuts and other policy changes, low borrowing rates, and our emerging recovery, the budget is actually in a pretty okay place right now. Is that right?
There’s a lot of controversy about whether there’s some threshold number after which the debt-to-GDP ratio really becomes a problem.
Eberly: It has improved substantially. In the depths of the financial crisis and the recession, the budget deficit was around 10% of GDP. As the economy has recovered, revenue has gotten stronger. Support for recession-driven programs has been pulled back, and so the budget deficit has naturally tended to close. Then on top of that, explicit policy measures have been put in place and have also helped.
The budget deficit in the most recent data is running a little under 3% of GDP—below the long-run average. That takes off the immediate pressure. But we have long-term challenges, and these will be easier to address if we do so at a time like now, when we’re not in a reactive situation, and can make deliberate and thoughtful policy decisions.
KI: So we have about a decade, you estimate, before our debt will start to become unmanageable?
Eberly: There’s a lot of controversy about whether there’s some threshold number after which the debt-to-GDP ratio really becomes a problem. I think the consensus among economists is that the debt-to-GDP ratio can’t be looked at in isolation. There’s also a country’s ability to collect taxes, its credit policy, whether credit is growing quickly, and the strength of its political institutions. So it’s not as if there’s a moment we can point to in the future and say, “That&rsqursquo;s the deadline.”
We do know that, with current policies in place, the debt-to-GDP ratio is projected to eventually grow unsustainably. We know that action needs to be taken, and the sooner we do it, the less dramatic it will have to be.
At the same time, the economy is still getting back on its feet. The data last week showed that GDP shrank in the first quarter. There were some one-off factors, like the weather, that help explain why the numbers look so grim, but it’s a reminder that the economy is still recovering. On the other hand, employment has been improving. So, we want to be cautious about what additional shocks we interject into the economy.
KI: You recommend two fronts for long-term fiscal action. What are these?
Eberly: The first is to expand the focus of our budget deliberations. Fiscal adjustment, largely through the sequester, has thus far focused on the discretionary spending part of the budget. But this is just one part of the budget, and a narrow one at that. Even within spending, it excludes all of the “mandatory programs” funded by the government and Congress: legislation sets the retirement age for Medicare, or the eligibility and benefit levels for Social Security, for example. As people apply for and qualify for those programs, their participation determines the level of spending.
Evidence shows that fiscal measures can have a significant impact both in raising incomes and in reducing unemployment.
So the discretionary side—which includes things like education and research that generally promote economic growth—has been squeezed much more than the mandatory side. In fact we might think about expansions in this area to promote growth and economic mobility. But if you look at where the spending growth comes from in the long run, it’s from the health and age-related programs on the mandatory side. And, the revenue side can also be made more efficient. I don’t think anyone is satisfied with the current tax code.
KI: The elephant in the room being the fact that we as a nation are aging?
Eberly: Exactly. With no changes to Social Security and Medicare, spending goes up, because the number of people who qualify for those programs goes up over time, and so does the cost of health care.
KI: And what’s the second front for fiscal action?
Eberly: There are always unexpected things happening in the economy. You want to make sure that you have some arrows in your quiver to be able to respond.
Right now monetary policy—implemented by the Federal Reserve—is still expansionary. Basically, the policy interest rate is already as low as it can go. If fiscal policy—which is decided by Congress and the executive branch—were to pull back, and there was an unexpected shock to the economy (from Europe, say, or the Middle East, or energy prices) there is very little additional room for monetary policy to support the economy.
While fiscal adjustment is needed to stabilize the debt-to-GDP ratio, the adjustments should not start while monetary policy is still accommodative. You want the economy to gain sufficient strength for monetary policy to pull back and renormalize. Then fiscal policy can pull back. That also leaves policy makers room to move in response to a shock to the global economy. Eventually, we will want to rebuild fiscal capacity, so that fiscal policy can also respond to future economic downturns, just as we had to do during the financial crisis.
KI: So what can policy makers do to build in more flexibility for dealing with economic shocks?
Eberly: Evidence shows that fiscal measures, such as those in the American Recovery and Reinvestment Act (also known as the stimulus program) can have a significant impact both in raising incomes and in reducing unemployment. The lesson here is that fiscal policy can be powerful, especially in a severe downturn where there’s underutilized resources in the economy.
But in order to be able to use it when the economy is weak—in order to have the capacity to increase spending and decrease taxes and run a budget deficit—you have to know when to pull back. People remember the expansion when the economy is weak; they forget about the adjustment when it is strong.
KI: That’s why you argue that policy makers should consider more automatic stabilizers.
Eberly: Right. A big part of fiscal policy is automatic stabilizers, which include things like unemployment benefits, or Supplemental Nutrition and Assistance Program (SNAP) benefits. When the economy weakens and unemployment rises, more people qualify. So spending goes up in a recession: a naturally countercyclical fiscal measure.
Those things tend to stimulate the economy without any legislation being passed. They’re just automatically in place. They’re predictable, they’re expected and that also makes them more effective because people know that, for example, if they become unemployed during a recession, they can claim unemployment benefits and that provides them some insurance.
We propose expanding the use of automatic stabilizers both for economic reasons and also for practical reasons. For economic reasons, you’d like to see fiscal policy be countercyclical so that fiscal policy comes in when the private economy is suffering a downturn and rolls off when the economy strengthens. The practical value is that it can be very hard to get policies passed and implemented in a timely way. And then, once programs are in place, it can be hard to pull them back.
KI: Are you optimistic that we will make the changes we need to for improved fiscal health over the next few years, or the next decade?
Eberly: We’ve seen movement already. We know that policy is difficult. There are many pressures, in addition to good economic judgment, on the policy process. I think there’s a lot of awareness of what needs to be done. The most optimistic path forward is for the economy to strengthen, and immediate pressures to abate, leaving space for longer-term decision making.
But we need to preserve programs–like early childhood education and research–that promote growth. If there’s any single thing that will help the long run budget situation, it’s strong growth. That goes a lot further than even the hardest fought budget deals.
Eberly, Janice and Phillip Swagel. Fiscal Balancing Act. June 2014. (Prepared for the Peter G. Peterson Foundation.)
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