US Fiscal Problems

APPENDICES

Jeffrey Frankel

Senior Executive Fellows, February 25, 2013

Appendices

• I: American “fiscal conservatives” are (mostly) not fiscal conservatives.

• II: Role reversal in Emerging Markets

• III: The long-term U.S. debt problem– (1) Where did today’s deficits come from?– (2) What will drive deficits in the future?

• IV: The medium-term outlook

Appendix I: 3 pieces of evidence to support the claim that US “fiscal conservatives” are not:

• (i) The voting pattern among the 258 Congressmen who signed an unconditional pledge not to raise taxes:– They had voted for more spending

than those who did not sign the pledge. [2]

• (ii) The pattern of spending under different presidents.[3]

• (iii) The pattern of states whose Senators win pork & other federal spending. [4]

• [2] William Gale & Brennan Kelly, 2004, “The ‘No New Taxes’ Pledge,” Tax Notes, July. • [3] JF “Snake-Oil Tax Cuts,”  EPI, Briefing Paper 221. 2008. • [4] JF Red States, Blue States and the Distribution of Federal Spending, 3/31/2010.

Vs. the 1990s: The Shared Sacrifice approach succeeded in eliminating budget deficits, importantly by slowing spending.

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Spending and Budget Balance(inverse) as % of GDP (Current US$)

Spending/GDP Budget Balance/GDP

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Source: OMB

ρ = 0.86

(ii) Spending & deficits both rose sharply when Presidents Reagan, Bush I, & Bush II took office.

Budget deficit

Spending

(iii) States ranked by federal spending receivedper tax dollar

versus party vote ratio in preceding election

Republican states take home significantly more federal $ (relative to taxes paid) than Democratic states.

“red”states

“blue”states

low inflow of US $

big inflow of US $

even while weakening in advanced economies.

World Economic Outlook, IMF, April 2012

Historic Role Reversal:Public finances in Emerging Markets

have become much stronger since 2000

Appendix II: Historic Role Reversal:Public finances in Emerging Markets

have become much stronger since 2000

Other advanced countries have the same long-term problem as the US: Rich countries’ Debt/GDP is the highest since the WWII spike.

US debt > big EMsbut < some other advanced countries

http://www.marketobservation.com/blogs/media/blogs/Statistics/DebtGDP.jpg

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Remarkable role-reversalin fiscal policy among Emerging Markets

• Debt/GDP of rich countries (> 90%) is nowthree times that of emerging markets;

=>• Some EMs Economies are now more creditworthy

than some Advanced Economies• as reflected in credit ratings or sovereign spreads.

Country creditworthiness is now inter-shuffled

“Advanced” countries (Formerly) “Developing” countries

AAA Germany, UK Singapore, Hong Kong

AA+ US, France

AA Belgium Chile

AA- Japan China

A+ Korea

A Malaysia, South Africa

A- Brazil, Thailand, Botswana

BBB+ Ireland, Italy, Spain

BBB- Iceland Colombia, India

BB+ Indonesia, Philippines

BB Portugal Costa Rica, Jordan

B Burkina Faso

SD GreeceS&P ratings, Feb.2012 updated 8/2012

World Economic Outlook, IMF, April 2012

Another indication of improved EM creditworthiness: EM sovereigns used to have to pay higher interest rates

than many US corporates (BB), but now pay less.

Copyright Jeffrey Frankel,

In the textbooks, benevolent governments are supposed to use discretionary policy to dampen cyclical fluctuations,

expanding at times of excess supply, andcontracting at times of excess demand.

But in practice, …Governments would raise spending in booms;and then be forced to cut back in downturns

Cyclicality of Fiscal Policy

• They took advantage of the 2002-07 boom

to strengthen their budget positions,• allowing them to run deficits

when the global recession hit in 2008-09.

• Some examples:– China was able to respond with big stimulus.– Chile, Korea, Malaysia, Botswana, Indonesia.

Another respect in which many EMs have improved their policies

since the crises of the late-1990s:A shift from pro-cyclical fiscal policy to counter-cyclical

pro

cyclic

al }

G always used to be pro-cyclical for most developing countries.

cou

nte

rcyclic

all

Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours”

Pro-cyclical spending

Counter-cyclical spending

Correlations between Gov.t Spending & GDP1960-1999

Correlations between Gov.t Spending & GDP 2000-2009

In the last decade, about 1/3 developing countries

switched to countercyclical fiscal policy:Negative correlation of G & GDP.

Frankel, Vegh & Vuletin (2011)

pro

cyclic

al

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To summarize the fiscal role reversal,

• Many Emerging Markets countries have, so far this century, achieved:– Lower debt levels than advanced economies;– improved credit ratings;– lower sovereign spreads; and– less pro-cyclical fiscal policies.

Most Emerging Market countries learned from the debt crises of the 1980s & 1990s.

But many leaders in advanced economies failed to do so.

• They thought it could never happen to them --

• most notably, leaders of euroland,– even after the periphery countries

violated the deficit & debt ceilings of Maastricht and the SGP;

– And even after the Greek crisis hit in late 2009 .

But Reinhart & Rogoff remind us: sovereign default is an old story, including among advanced countries –This Time is Different, updated in “From Financial Crash to Debt Crisis,” 2010

Sovereign External Debt: 1800-2009 Percent of Countries in Default or

Restructuring50%-

Sources:Lindert & Morton (1989), Macdonald (2003), Purcell & Kaufman (1993), Reinhart, Rogoff & Savastano (2003), Suter (1992), and Standard & Poor’s (various years). Notes: Sample size includes all countries, out of a total of sixty six listed in Table 1, that were independent states in the given year

1980s1930s1870

s1830s

Carmen Reinhart & Kenneth Rogoff found a growth threshold in Debt/GDP of 90%.

MoneyHoney blog, Feb.20, 2010 ‘Growth in a Time of Debt’

GDP growth

Debt/GDP < 90%

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The historic role reversal• Debt levels among rich countries (debt/GDP ratios > 80%)

by 2008 reached twice those of emerging markets.

• Some emerging markets have earned credit ratings higher than some so-called advanced countries.

• Over the last decade some emerging market countries finally developed countercyclical fiscal policies:

• They took advantage of the boom years 2003-2007 – to run primary budget surpluses and cumulate reserves.

• By 2007, Latin America had reduced its debt to 33% of GDP, – vs. 63 % in the US.

– And so were able to respond to global recession of 2008-09 .

The Greek budget deficitnever got below the 3% of GDP limit,

nor did the debt ever decline toward the 60% limit

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Appendix III: The Long-term US debt problem

• (1) From where did today’s debt come?

• (2) What will drive debt in the future?– The problem is not budget deficits

in the next few years.– The problem is the far larger increases in

entitlement programs based on current promises.

As of 2000, Debt/GDP had been on a declining path. What changed?

(1) From where did today’s debt come?$13 trillion in 2011 debt,relative to 2001 official projection

Over-optimistic economic assumptions in 2001, e.g., growth rate

Bush tax cuts (which were supposed to expire in 2011)

Wars in Iraq &Afghanistan (so far)}

}

}

Source: The Great Debt Shift: Drivers of Federal Debt Since 2001,Pew Charitable Trust.

Fiscal stimulus {in response to the recession accounts for < 1/3 of 2009-11 deficits

and has virtually disappeared by now.

CBPP, May 2011

{Obamastimulus

Budget deficits have declined since 2009.

Jan. 2013 fiscal cliff:Letting the Bush tax cuts expire

on schedule would have stabilized debt/GDP

CBPP, May 2011

(2) The long-term problem

World Economic Outlook, IMF, April 2012

Euro-recession is pulling down growth.

The US is doing better.

GDP growth forecasts (percent)

Emerging Market growth is slowing too, but solidly >0.

Appendix IV: The medium-term outlook.

2007 2008 2009 2010 201112,200

12,400

12,600

12,800

13,000

13,200

13,400

13,600

After 3 years, the U.S. in 2011 finally achieved its pre-recession level of GDP

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Source: Macroeconomic Advisers www.macroadvisers.comMon

Obama Inauguration

End of recession

Jan. 2007 – Dec. 2011, monthly, estimated by Macroeconomic Advisers

After 3 years, the U.S. in 2011 finally achieved its pre-recession level of GDP

Jan. 2007 – Feb. 2012, monthly, estimated by Macroeconomic Advisers

Obama Inauguration

End of recession

Data Source: U.S. Bureau of Labor Statistics

Obama Inauguration

End of recession Private

sector job creation (by quarter)

Average rate of private job creation between the two recessions (Nov. 2001-Dec.2007)

Average rate of private job creation throughout 8 Bush years(Jan. 2001-Jan.2009)

Possible risks to the recovery in 2013

• Euroland: Return of sovereign debt crisis?– and contagion to other high Debt/GDP countries.

• Political breakdown in Washington?• like the debt ceiling standoff of August 2011• which led S&P to downgrade US from AAA to AA

» for the 1st time in history.

• Major oil crisis?– from military confrontation with Iran.

• If we opt for short-term fiscal stimulus,– or at least on counteracting the current fiscal contraction,

• what form should it take?

U.S. fiscal policy in 2013

• Renew some elements of the Obama stimulus – such as infrastructure investment (roads & bridges) – & giving money to the states

• so that they can re-hire laid-off teachers, policemen, firemen, subway drivers & construction workers

– as in the Jobs Bill that the Congress voted down.

US Fiscal Problems

Jeffrey FrankelHarpel Professor of Capital Formation and Growth

Harvard Kennedy School