A shorter runway
Fiscal sustainability is a situation in which the nation’s public debt is stable or declining as a share of gross domestic product (GDP). Today, no serious ob-server thinks U.S. fiscal policy could be considered sustainable under this definition. The Congressional Budget Office (CBO) estimates that if most current policies were kept in place, the debt-to-GDP ratio would rise from about 70% currently to 105% in 2022 and more than 200% by 2037. Markets will not continue to fund a government whose public debt is on an ever-rising path.
But exactly how urgent is achieving fiscal sustainability? It is important to keep in mind that the country’s fiscal policy challenges did not emerge overnight. Mostly they relate to the aging of the population and high healthcare cost inflation —trends that have been in place for a long time. Exhibit 1 shows longer-term projections of the debt-to-GDP ratio from the CBO, comparing this year’s forecast to 2007. Even before the recession and financial crisis, budget projections from the CBO and others anticipated that the public debt would spiral higher without policy action. The recession had the effect of shortening the runway, but the basic problem of unsustainable entitlement spending is not new.
In addition, high private sector savings reduce the urgency of fiscal consolidation to a degree. During the recession, federal deficits jumped from a modest 1.2% of GDP in 2007 to a peak of 10.1% of GDP in 20091. If the economy were running at full capacity, an increase in government borrowing of this scale would normally put upward pressure on interest rates. However, because of the severe downturn, the surge in government spending coincided with an even larger surge in U.S. private sector savings.
We can see this clearly by looking at the country’s “macro balance” — the differences between saving and borrowing across sectors in the economy. During the recession, the public sector moved into deep deficit and financed increased spending through debt issuance. At the same time, the domestic private sector —including households and businesses — sharply increased its savings (Exhibit 2). The amount of foreign capital inflows actually slowed moderately during the recession and the share of Treasury securities held by overseas investors declined2. As a result of the rise in private savings, the government has had relatively little trouble issuing large amounts of debt recently — the extra borrowing has been absorbed by U.S. households and firms, either directly or indirectly through financial intermediaries3.
For these reasons, the U.S. likely still has some time left before markets demand fiscal consolidation. However, the window may be as short as the next presidential term and the candidates are rightly focused on longerterm fiscal sustainability. The challenge will be to make progress toward this goal without damaging the recovery along the way.
Politics aside, as investors we need to decide what constitutes a good fiscal plan and what does not. Which steps would contribute to confidence and growth and which would damage the recovery. We would put forth the following five principles for a growth-friendly path to fiscal sustainability:
1. Get started. U.S. policymakers should begin taking steps toward fiscal sustainability in the not-too-distant future. Today’s low interest rate environment depends importantly on investor expectations that the U.S. will ultimately move the budget balance on to a sustainable path. But that credibility cannot be taken for granted and eventually expectations need to be reinforced by tangible actions. Getting started on a path toward fiscal sustainability could also have positive effects through business and consumer sentiment. Although the evidence is somewhat mixed, last year’s debt ceiling debacle and rating agency downgrades did seem to weigh on confidence for a time. Business leaders often cite uncertainty about fiscal policy as a factor holding back hiring and investment. Delaying longer-term budget plans could risk further downgrades and possibly negative effects on business and consumer confidence and spending.
2. Go slow. Although we think it will be important for next administration to get started on the needed fiscal adjustment, it will be even more important to get the pace right. There is a healthy debate among economists about the effects of fiscal policy on the economy, but we think a balanced reading of the research makes two broad points:
a. Fiscal tightening will slow growth. The most recent comprehensive look at the effects of fiscal tightening on economic activity comes from the International Monetary Fund’s (IMF) October 2010 World Economic Outlook4. Using an innovative dataset, the IMF finds that a 1% of GDP tightening of fiscal policy lowers real GDP by about 0.5% after two years (meaning that it lowers the rate of growth of GDP by about 0.25% for each of the next two years). This fiscal “multiplier” is actually at the low end of the typical range, which survey papers usually put at 0.52.05.
b. Fiscal tightening is likely to be more painful, and more risky, in today’s economy. The U.S. economy is currently operating wellbelow potential and growth remains subpar. Traditional monetary policy is constrained by the zero lower bound on nominal interest rates. In this environment, fiscal multipliers may be larger than in normal times and the costs of overshooting could be high6. If fiscal tightening were to tip the economy back into recession, deflation would be a meaningful risk. Deflation and its impact on tax revenue has been a major contributor to Japan’s public debt overhang — a scenario U.S. officials should be careful to avoid.
3. Focus on the long term. The current federal budget deficit is quite large, but mostly this reflects the policy response to the 20082009 recession. The more serious fiscal issues are longer term in nature and relate to excessive growth in healthcare and other entitlement spending. Focusing on these issues would more directly tackle the real fiscal sustainability problem. Moreover, reforms aimed at longer-term budget questions would be more likely to boost confidence, and less likely to weaken current growth. Credible long-run budgets plans should therefore be a top priority.
4. Favor spending cuts. Speaking strictly from an economic perspective, spending-based fiscal reform would be preferable to revenue-based reform7. This is not to say that revenue increases could not be part of a broader fiscal package. But there are a couple specific reasons why economists tend to prefer spending cuts:
a. History suggests that spending-focused fiscal consolidations tend to stick. This is because they often involve reform of government programs, which have broad buy-in from the public and which are quite difficult to reverse. Revenue-oriented fiscal consolidation, in contrast, has succeeded less frequently in the past because subsequent governments can easily reverse tax increases.
b. Central banks have tended to respond to spending-based fiscal tightening with easier monetary policy, helping cushion the impact on growth. In contrast, central banks have historically been less likely to ease policy in response to tax-based consolidation. The reason is probably related to the indirect effect of tax increases on measures of consumer prices: value added tax (VAT) increases, for example, boost measured inflation and therefore might make central banks less likely to ease.
5. Hope for help from the Fed. This gets to the last principle, which will largely be out of the hands of the next president: hope for help from the Federal Reserve. Past experience shows that fiscal tightening will slow the economy, but that the hit to growth is much smaller if the central bank eases monetary policy. Because conventional policy tools are constrained and its willingness to use unconventional tools is uncertain, the Fed’s likely response to fiscal tightening remains an open question.
Where they stand
At present both candidates get a mixed scorecard (Exhibit 3). Governor Romney — assuming he takes Congressman Ryan’s proposals on board — gets credit for a serious plan to deal with entitlement spending. The Ryan budget overhauls both Medicare and Medicaid and brings the debt-to-GDP ratio back to 53% by 2030. Congressman Ryan’s proposal also focuses on spending reform, which history suggests would be more likely to stick if enacted.
At the same time, the Congressman’s budget
resolution rapidly cuts the budget balance over the next two years: under his plan, the primary (ex-interest) budget deficit shrinks by 2.6% of GDP in 2013 and 2.1% in 2014. Tightening fiscal policy by roughly 4.5% of GDP over two years would be risky given the fragile recovery.
President Obama’s latest budget, in contrast, trims the primary balance by a more modest 1.4% in 2013 and 1.9% 2014.
This would also affect growth, but would be less damaging over the near-term than Congressman Ryan’s plan. However, the president gets demerits for an insufficient focus on longer-term spending reform. His Affordable Care Act (ACA) — the healthcare law passed in 2010 — includes the creation of an independent advisory board tasked with uncovering savings in the Medicare program. But the ACA was relatively light on specific ideas to rein in health care costs.
Ultimately, what we are looking for is a balanced approach to achieving fiscal sustainability. We would like to see the next administration start the process of fiscal consolidation, but to proceed cautiously at first. Plans also must address the core fiscal sustainability issue — longer-term entitlement spending trends — not just tax reform. At this point neither campaign’s proposals meet all the criteria. We hope they get closer before the next presidential term begins.
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
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1 All budget figures expressed in fiscal year terms.
2 From a peak of 51% to 44%, according to the Federal Reserve’s Flow of Funds Accounts.
3 This is the same dynamic that allows the Japanese government to finance gross debt of more than 200% of GDP.
4 Chapter 3, “Will it Hurt? Macroeconomic Effects of Fiscal Consolidation”.
5 See, for example, Valerie Ramey, “Can Government Purchases Stimulate the Economy?” Journal of Economic Literature, 2011.
6 See, for example, J. Bradford Delong and Lawrence Summers, “Fiscal Policy in a Depressed Economy.” Brookings Papers on Economic Activity, 2012; Michael Woodford, “Simple Analytics of the Government Expenditure Multiplier.” NBER Working Paper, 2010.
7 For background see, “The Speed Limit of Fiscal Consolidation.” Goldman Sachs Global Economics Paper¸ 2011; “Limiting the Fallout from Fiscal Adjustment.” Goldman Sachs Global Economics Paper, 2010.