In the Nation's Interest
By Joseph Minarik
The nation faces two seemingly contradictory economic and fiscal challenges. Different groups spout truisms as to why policy makers should address only one and ignore the other. The unfortunate reality is that we must face up to both.
In the near term, we have an economic growth challenge. It follows from the lingering damage from the financial crisis. It is exacerbated by cuts in federal appropriated spending. It is compounded by reduced business spending because of uncertainty and a lack of confidence that we inflicted upon ourselves through an ever-rising debt, a shutdown of the government, and a near-collision with our statutory debt limit.
But the nation also faces a long-term challenge from excessive public debt. Left unchecked, the debt will sooner or later exceed our perceived ability or willingness to service it. When that hour arrives, the cost for all Americans will be immense.
Without economic growth, we will not have the wherewithal to solve our budget problem. But so long as we ignore our budget problem, we will not have the policy certainty and stability needed to enable growth and reach our economy’s potential. A recent poll of Trustees of the Committee for Economic Development (CED) shows that 84% believe business investment would increase (with 36% citing a significant increase) if there were clarity that long-term federal tax and entitlement policies will be changed to avoid an unsustainable debt burden in the next decade (see the following chart).
The CED recommends a strategy to meet both challenges. This strategy begins to resolve the economic and financial uncertainty that lingers because of our unsustainable budget, and establishes a clear path toward fiscal responsibility and sound national priorities.
This approach is based on one fundamental premise that we believe should be self-evident to all parties in the fiscal debate: The nation’s public debt burden cannot grow without limit. There is a maximum safe level of debt (relative to the income – that is, the gross domestic product, or GDP – out of which that debt must be serviced) which the nation must not exceed, and prudentially should not even approach. If our elected policymakers in the Congress merely can reach a compromise on a limiting path for the size of the public debt burden, along with a framework for tackling the substance of budget reform in the coming months, it will provide a firm platform for economic growth.
This space has discussed CED’s “Savego” idea before (see here, here, and here). But our most recent detailed view of the actual numbers pre-dates the appropriations deal that was struck in the Congress at the turn of the year, and the economic outlook has changed; so the dimensions of the field have changed somewhat. Because of those developments, and because our CED Trustees have tried to reach out to the widest possible audience of policymakers, including through visits to Capitol Hill, the time may be right to go back to the very beginning of our thought process and explain just why we propose this approach to the nation’s budget problem, and more precisely how it would work.
Why the Problem Continues
First of all, despite some happy talk that you might hear, our nation’s long-run fiscal problem is far from solved. We are now enjoying a short period of grace, but renewed pressure is visible well short of the horizon.
The budget deficit has dropped sharply in the last few years, after shooting through the roof in the financial crisis. Denominated by the size of our economy (that is, as a percentage of the gross domestic product, or GDP), the deficit bottomed at 1.1 percent at the peak of the housing bubble in 2007, and then soared to a post-World War II record of 9.8 percent in 2009 (see the following chart).
Thereafter, just like every other time when the economy hit bottom and began to recover, the deficit improved. Unemployment compensation and other federal benefit payments fall in a recovering economy, while incomes increase and therefore income tax revenues increase as well. Furthermore, financial markets typically overshoot on the economy’s way down, but then recover sharply. The rising markets increase especially the incomes of wealth holders who tend to be in the highest income-tax-rate brackets. For these reasons, according to the Congressional Budget Office (CBO), if today budget policy is locked on autopilot, the deficit will fall to 2.6 percent of GDP by next year (fiscal year 2015). It seems like enormous progress.
But in fact, it is just enough progress to cause complacency, and far too little to get us out of the woods. The same CBO projections show the deficit rising to 4.2 percent of GDP by 2022, and still as high as 4.0 percent at the end of the measured budget window in 2024.
And those numbers are troubling because they are large enough to drive up our nation’s accumulated debt, as distinguished from our annual deficit, relative to the size of our GDP. It is the size of our accumulated debt stacked against our GDP that is the best indicator of whether our finances are sound. The ultimate question is whether we can service that debt, and that is best measured relative to the collective income (our GDP) out of which we must pay that debt service. If our debt continually grows faster than the income out of which we must service it, eventually the debt and debt-service costs will grow out of control.
And weighed in that balance, our fiscal outlook is found wanting. With budget deficits greater than about 3 percent of the GDP later in this decade, the debt indeed grows faster than that GDP. So CBO projects that our debt would bottom out at 72.3 percent of the GDP in 2017, and then rise continuously to 79.2 percent in 2024 (see the following chart). Absent some change in policy, there is no reason to expect that debt growth would slow in later years; indeed, it should accelerate. Betting on pure chance – such as hoping that continuously more-rapid economic growth, or lower-than-forecast interest rates, or slower increases in healthcare costs will bail us out – would be irresponsible. The costs if we are wrong would be far too great. And if outcomes should shade in the other direction, our fiscal state could go downhill fast.
And that is why the budget situation is so perilous. It is all well and good that a crisis has not yet broken, but debt – for the federal government or for any other entity – can become an exponentially compounding problem. If creditors become distrustful, they can demand higher interest rates, which makes the debtor’s position even more precarious, which raises interest rates even further, and so on and on. Market sentiment can shift in a heartbeat, and by the time you recognize that you are behind the curve, it already is too late.
Beyond that extreme threat, the nation’s fiscal aimlessness reduces our prosperity every day. As was noted at the outset, CED has polled its membership and found that they predict reduced or cancelled investment projects and lower economic growth and job creation because of the continued uncertain condition of our nation’s fiscal health. Business confidence has been eroded further by last year’s government shutdown and the flirtations with government default both last year and in 2011.
Breaking the Deadlock
So what is Washington going to do about this problem? According to virtually every knowledgeable Washington watcher, nothing. Government is divided, and each side wants to wait until a future election when it runs the table and can solve the problem all its own way. Of course, financial markets that observe such implacable attitudes, and foresee that future elections might yield continued divided government, may very well bolt at the most difficult moment – such as just after an election yields two or four more years of divided power, and therefore presumed deadlock.
But although Washington’s policymaking apparatus is stuck in park, CED’s Trustees believe that this is no time to be idle. Although at a slower rate, the public debt continues to pile up. And on the shiny side of the coin, this quiet period could be a window of opportunity for people with foresight.
The Washington pundits say that nothing is going to happen – and by past patterns of behavior in this town, they are absolutely right. In today’s Washington, every approach that a budget wonk could put forward would be dismissed as politically impossible. We do not claim to have cut that Gordian knot. But what we did try to do was to find the least impossible approach. Or to put it another way: Imagine yourself five years in the future, looking back to see that the budget problem had been solved – not in the heat of a crisis, but through leadership. How did it happen? We tried to find the most credible answer to that hypothetical question.
And to find that answer, we tried to pose the question differently. We know the long list of issues on which the two parties in Washington cannot agree: taxes versus spending; Medicare; defense; and on and on. But is there some significant issue on which they can agree? We concluded that there was. If there could be a serious negotiation among those Washington policymakers who are within an arm’s reach of the political center – and we believe that, confronted with a real opportunity, they would constitute a majority – we believe that they could come to agreement on the maximum prudent debt burden (certainly less than the current historically high level) expressed as a percentage of the GDP, and a path on which the debt should be brought down from that level over the next 10 years.
Think of it this way: What Member of Congress or Executive Branch official would dare to say that, unless I get everything my way, I would prefer to let the nation’s debt grow without limit? Confronted with that very real choice, we believe that every responsible elected official would have to acknowledge the need to negotiate, and ultimately to compromise, in the nation’s interest.
So that is the minimum condition on which elected policymakers would have to agree to get the process out of deadlock. And so that is where we started.
Our Proposal In a Nutshell
So how can we force Washington to face up to that choice, and where do we go once we do? In outline form, here is how we would proceed. A more-detailed discussion follows.
1. Choose a maximum acceptable path for the debt burden (debt held by the public, as a percentage of the GDP) over the 10-year budget-forecast horizon, assuming that the deficit reduction to comply with that path begins two years from now (in fiscal year 2016).
2. Compute the total dollar amounts of deficit reduction that will be needed, year by year, to comply with that maximum debt path, based on the current CBO budget projections. Write those dollar budget-savings requirements into law.
3. Lock the appropriate negotiators from the Congress (Republicans and Democrats, House and Senate) and the White House into a room. Supply pizza as required. Don’t let the negotiators out until they reach an agreement on the policy changes needed to comply with the budget savings targets to which they already have agreed. If the negotiators hit the target for the first year but fall short for any subsequent years, reconvene the negotiations next year to finish the job (but supply fresh pizza at that time). Repeat reconvening year by year as necessary.
Why This Proposal? How Would It Work?
The maximum debt-burden path. It would be up to the Congress and the President to negotiate just how much of a debt burden would exceed prudential limits, given the current shaky state of the economy. Our elected policymakers would have to weigh the need for a sustainable budget policy versus the risk to the economic recovery from the purchasing power removed from consumption and investment as a result of the budget cuts, and the cost to the citizenry of reduced spending and increased taxes. Just about any bipartisan agreement on this front would be better than no agreement at all. However, given the current state of the budget, the debt and the economy, we at CED would suggest that an achievable but aggressive limit would be a downward path of the debt burden reaching 65 percent of GDP by the end of the 10-year budget horizon (fiscal year 2024) (see the following chart).
Given the state of the economy, we would recommend that the first deficit-reduction steps be postponed for two years – until fiscal year 2016. There already is immediate and ongoing deficit reduction in the current appropriations caps (including the “sequester”). Further deficit reduction now might cut the legs out from under the economic recovery. But the Congressional Budget Office currently projects that by 2016 the economy will have grown sufficiently for the Federal Reserve to begin to increase its policy interest rate (the Federal Funds rate). Not only is it reasonable to expect that the recovery would be stronger by 2016, it also would allow the Fed to fine-tune the timing of its interest rate increases to compensate for the restrictive fiscal-policy effects of our recommended deficit reduction.
It turns out that, based on the current CBO budget outlook, turning the current debt-burden path down to 65 percent of the GDP in 2024 will be no mean feat. As of today, the debt burden is projected to bottom out at well over 70 percent of the GDP in 2017, and then to begin to rise significantly late in this decade. The path that we contemplate would diverge significantly from that baseline within the next 10 years (as was shown in the preceding chart). Assuming that year-by-year savings follow proportionately the past major deficit reduction laws, bending the debt path as much as we contemplate would require deficit reduction very much on the order of the budget law that was enacted in 1993 – in the face of considerable political resistance (see the following chart and table). Thus, while we believe that the debt reduction path that we suggest would be achievable, there is no question that it also is ambitious.
This unusual approach would surely raise some questions.
Why would Congress agree to this idea? There is no approach to the current budget problem that can guarantee political success. But with no guarantee, this framework at least has the advantage of being built on a step that we believe would have majority support: limit the debt burden to a maximum downward path. What Member of Congress would argue that the debt burden, relative to the size of the economy, should not be on a downward path from its current near-record levels? And who could justify allowing the debt burden to explode if he or she could not have precisely his or her first choice of a deficit-reduction program?
Why schedule budget savings now to occur two years from now? Why not just wait to reduce the deficit until the economy already has improved? Because then the actual deficit reduction would be too late. It will take Congress a significant period of time to negotiate actual deficit reduction; two years is not too long before a deadline. Once the economy has begun to strengthen, interest rates will begin to rise, perhaps quickly. If the Congress only begins to act at that point, it will most likely be behind the curve. Furthermore, business decision-makers need the assurance soon that the nation’s fiscal affairs are under control so that they can begin to make the investments that will yield economic growth.
Why not trigger deficit reduction based on some index of actual economic indicators? Because the world always is more complicated than a single economic indicator, or even a combination of indicators. For example, most economists agree today that the unemployment rate is misleading because the weak labor market has discouraged job seekers to the point where they have stopped looking for work, and therefore are not counted as unemployed. In this extraordinary economy, there is no substitute for real-time judgment.
But what if the economy does not improve on your schedule? Then the Congress will have to act accordingly, and alter policy. Surprises always can occur in the economy. But failing to act now will not lead to predictability. In fact, given the wide agreement that the federal budget is not sustainable, acting to put it back on track would be an important source of stability for the economy.
Why do you recommend the precise debt goal that you chose? We present an example of a debt path (and the budget savings goals that follow from it) that we believe would be prudent – aggressive, but achievable. As noted above, we can comply with our debt goal by replicating approximately the amounts of the 1993 deficit reduction legislation (relative to the size of the economy), which was politically difficult but was enacted into law. But we by no means insist that ours is the only choice. It is more important that the Congress act than that it choose any particular goal.
Dollar amounts of required budget savings. If our policymakers could achieve just that bipartisan agreement on a limit to the acceptable debt burden, then important further steps could follow directly. The Budget Control Act of 2011, plus the budget compromises reached for fiscal years 2014 and 2015, establish ceilings for annual appropriations through fiscal year 2021. If the Congress were to assume that the growth of appropriations in subsequent years would be constrained to the rate of inflation, then the amounts of annual appropriations for the entire budget window would be determined.
The next fundamental step would be for the Congress to write into law long-term savings targets – dollar amounts of savings in the parts of the budget other than the annual appropriations that would need to be obtained starting in fiscal year 2016. These savings, achieved through entitlement and tax reform, would be set at year-by-year amounts sufficient to turn around the projected public debt (relative to the gross domestic product) to the agreed-upon sustainable downward path.
We call this framework “Savego” because it is modeled on the successful “Paygo” system that was created on a bipartisan basis by Republican President George H.W. Bush and the Democratic congressional leadership in 1990, and then re-enacted in 1993 and 1997. Under Paygo, the budget moved from the then-worst deficits in history to the largest budget surpluses in history – the first budget surpluses in almost 30 years. Paygo required that the Congress “pay for” all budget changes in entitlement programs and taxes – that is, that any budget changes add up to a net zero for the bottom line. Because the budget situation today is far worse, however, Savego must go farther. So Savego requires that budget changes in entitlement programs and taxes achieve a net savings, not just a net zero effect on the deficit.
We recommend that the Congress write a total amount of budget savings in the law. However, we do not recommend that the Congress attempt at this time to divide those savings between entitlement spending cuts and tax revenue increases; to do so would merely prevent agreement. Better to make that decision in the course of the negotiations to write the actual deficit-reduction law, so that it can be based on specific choices rather than on purely abstract “principle.” We do not recommend that the Congress require any “failsafe” device (such as the current spending sequester) to achieve the target savings in the event of failure by the policymakers to achieve agreement.
Again, we expect that our recommendations would raise questions.
Why do you recommend that the budget savings targets be set in dollar terms? Why not target the deficit itself, which is what we care about? What if the economy does not match your forecast, and so the dollar targets prove wrong? Experience has shown that the Congress needs a target that is both fixed and under its control (such as the fixed budget savings targets in the 1990 “pay-as-you-go” rules, which yielded the balanced budgets at the end of that decade). The Congress needs to know with certainty what it will be required to achieve, and then to set about achieving it. Moving targets – like the deficit or the debt at any particular moment – can lead to frustration or complacency. For example, consider the failed 1985 Gramm-Rudman deficit-reduction law which preceded the “Paygo” system. The Congress simply could not comply when the Gramm-Rudman deficit goalposts kept moving further away. Nor did Gramm-Rudman’s deficit targets prove any more successful at reducing the deficit; in fact, quite the contrary. Reading Gramm-Rudman today, with its re-estimates and failsafe procedures, one would conclude that there was absolutely no way that it possibly could fail to produce a balanced budget in 1990. Except that it did. Experience demonstrates that a better approach – like the one we propose here – is to require the Congress to control the controllable. And what is controllable is the amount of budget savings that the Congress should produce. Finally, fixed-dollar savings targets would provide a more stable understanding of what the fiscal authorities are trying to do, which would help the Federal Reserve in making its monetary policy decisions.
What if the Congress falls short of its target savings? We propose multi-year targets. If the Congress fails to achieve all of the later-year target savings in its first year, it will be able to come back and finish the job in subsequent years. It is perfectly satisfactory to achieve the savings over several years and several pieces of legislation, rather than all at once and up front.
Won’t the budget savings actually turn out to be all tax increases or all entitlement spending cuts? The budget savings will be what the Congress can enact. Right now, we have a divided Congress. A law that passes will be acceptable to both sides, and therefore, it will be a compromise, and both sides will get something they want, as well as giving something up. The alternative is to fail to act, and to allow the debt burden to continue to grow. Each party could wait in the hope that it will take over all branches of government, but that might never happen; alternatively, the other party might take total control. It makes sense to try to solve the problem sooner rather than later, and on a bipartisan basis.
Why do you propose no failsafe device to reduce the deficit if the Congress does not? Some people might think that they can guarantee hitting a deficit target with a failsafe device, like the sequester. The reality is that there can be no guarantee. The economy will drive the deficit in real time, much faster than any change in law possibly could influence it. Gramm-Rudman demonstrated that in the 1980s. We believe that the best outcome would be if the Congress and the President would do everything they could to re-establish the past atmosphere of honor and trust, where commitments could be based on a word and a handshake. The alternatives are of limited value. But if the Congress were to insist on a failsafe, then we would recommend one with no exclusions whatever. We would include across-the-board cuts of Social Security benefits, Medicare reimbursements, unemployment compensation benefits, and an equal percentage across-the-board increase in all tax rates, excluding only those few spending items (like the government’s existing contractual commitments) that absolutely could not be cut. However, based on the difficulties of the sequester and the already unacceptable level of the public debt burden, we believe that the Congress and the President should commit to budget savings targets written into law that achieve a maximum path for the debt burden.
It is essential that our nation’s businesses and consumers know that our long-term fiscal challenges finally are being resolutely and adequately addressed. The straightforward measures that we suggest here would end today’s persistent and debilitating economic uncertainty. It would codify the fundamental long-term point on which all parties to this debate should be able to agree: that whatever the means chosen to assure it, the public debt must be limited relative to the size of the economy, and now, for a significant period of time, must grow more slowly than the collective income that is available to service it.
The nation needs a budget. It needs a budget because it needs economic growth. It needs economic growth because, beyond our fundamental goal of prosperity for the American people, we will not solve our potentially disastrous long-term public debt problem without growth.
The federal government is the largest single economic actor in the United States. As long as the basic economic policy of the federal government is unpredictable and subject to lurching change in frequent periodic crises, the U.S. private sector cannot plan, and cannot make long-term commitments to invest and hire. The business community faces enough instability from the legacy damage of the financial crisis. Our elected policymakers should not create further instability by creating new potential crises over budgetary decisions that are totally subject to their control.
It is time to address the problem, but we already are far behind the curve. Accordingly, CED proposes a framework that is built on the decisions that can and must be made now, but that sets aside the challenging compromises that best can be made later. Crucially, however, this framework both supports near-term economic growth and provides the certainty needed to support economic growth continuing into the coming years.