CBO’s New Way to Evaluate Fiscal Consolidation Plans

In its recently released budget outlook, the Congressional Budget Office projects that this year’s federal deficit will increase by 35% from last year to $590 billion, and that the debt will rise from $14 trillion to $23 trillion by 2026, or from 77% to 86% of GDP. Clearly it’s time for a fiscal consolidation plan.

Yet we’re not hearing about any such a plan on the campaign trail. If anything candidates are proposing more, not less, federal government spending because many people think reducing the deficit is bad for the economy, even though modern economic models show this need not be the case. It would help the political debate if CBO would employ such state-of-the-art models, as I recommended here based on research with John Cogan, Volker Wieland and Maik Wolters.

Actually the CBO might be getting closer to such a recommendation. This year the CBO estimated the impact of a fiscal consolidation plan proposed by the House Budget Committee. The plan, which was used in developing a budget resolution, would reduce the deficit mainly by reducing non-interest spending as a share of GDP compared to the baseline (from 22% to 17% by the year 2040), while increasing revenues as a share of GDP by a much smaller amount (.2%).  Here is a graph showing the multi-year plan for non-interest spending (labeled Budget Resolution); it is unclear how much is discretionary versus mandatory spending, but based on the 2016 budget resolution (see summary here) it is mainly mandatory.


The CBO estimated the impact of this multi-year fiscal consolidation plan by combining a short-run Keynesian modeling approach with a long-run growth modeling approach.  The Keynesian approach captures demand-side effects while the growth model captures supply-side effects due to changes in the capital stock and labor supply.  As far as I can tell neither model is forward looking, but at least CBO’s approach to combining the models is clearly specified: Estimated output effects for the 1st, 2nd, 3rd, and 4th years of the consolidation plan have weights of 1.00, 0.75, 0.50, and 0.25, respectively, on the short-run model with the remaining weight on the long-run model. Estimates for the fifth year and beyond are based entirely on the long run model. (See the CBO report for more information). Obviously the weights are rather arbitrary, and I would prefer a single model which combines these effects in a consistent way and takes account of incentive effects. But at least it is a step in the right direction.

The results in terms of real GNP per person are shown here:


and percentage change from the baseline is shown here:


According to the CBO estimates, there is a negative demand-side effect in the short-run, but it is quite small especially compared with the larger and continuing longer-run supply side effects. Recall that in the Cogan, Taylor, Wieland, Wolters model, the short-run effects are all positive due largely to expectation effects.  In any case, even the CBO finds the overall impact of fiscal consolidation to be, on balance, very positive for economic growth.


Posted in Budget & Debt, Fiscal Policy and Reforms

The Staying Power of Staggered Wage & Price Setting in Macro

The new Handbook of Macroeconomics is now in production as all 34 chapters have been submitted (by 74 different authors).  It will be out later this year. Harald Uhlig and I edited the book, and we each contributed a chapter. My chapter (a draft appears as an NBER Working Paper) is on the staggered price and wage setting model.

The staggered wage and price setting model has had remarkable staying power.  Originating in the 1970s before the advent of real business cycle models, it has been the theory of choice in generation after generation of monetary business cycle models used for policy analysis as Volker Wieland, Elena Afanasyeva, Meguy Kuete, and Jinhyuk Yoo show in their review of over sixty macroeconomic models in their chapter for the Handbook.

But in recent years “Big Data” style research projects have radically expanded knowledge of the microeconomics of wage and price setting behavior from a few salient facts about magazine prices or personal salary experiences into complex data sets with millions of observations. These data sets provide new evidence to test and discriminate between different types of models.

There is new evidence that prices are set at a fixed level for six months or more, especially if sales and reference prices are accounted for properly. There is new evidence that wages are set a fixed level for longer periods and that there is a peak in the estimated hazard function at one year that precludes certain popular simplifications. There is new evidence that both wage and price decisions are staggered or unsynchronized over time, and that this staggering creates a contract multiplier which converts short spells of rigidity at the micro level into longer persistence at the macro level.  There is more evidence of time-dependence than state-dependence. But in each of these dimensions—length, degree of staggering, shape of the hazard function, degree of state-dependence—there is a great deal of heterogeneity across countries, types of product, types of employment, and types of industry structure.

This heterogeneity is not simply a nuisance; it has major implications for aggregate dynamics, and it has been offered as a response to criticism of the models, much of which came after the financial crisis.  Often that criticism applied to a particular simple staggered contract model that does not capture the regularities mentioned above, and the criticism isn’t valid when heterogeneity is taken into account.

In this sense, the implication of this chapter is similar to what Tom Sargent has said about the entire Handbook “This remarkable collection belies uninformed critics who assert that modern macroeconomics was wrong footed by the 2007-2009 financial crisis.”


Posted in Teaching Economics

Desperately Needed:  Reforms to Raise Productivity Growth

The data released this week on labor productivity growth are really terrible. The growth rate has been negative now for three quarters in a row, and it was – .4 percent over the past year. Unfortunately, these data are reinforcing a pronounced negative trend in recent years which implies declining income growth and lower standards of living.

Sadly, there is little public discussion of what to do about it.  Many say that policy reforms—whether tax reform, regulatory reform, budget reform, or monetary reform—will not work because the stagnation is “secular,” and we are in a new era of permanently lower growth. Others say that productivity data are not reliable and should not influence public policy.  Still others say that supply-side reforms will not work because we have a demand-side problem; rather we need another short-term economic stimulus.

The chart suggests otherwise. It shows productivity growth since the 1960s smoothed in two different ways—a five-year moving average and a Hodrick-Prescott trend. Both show major swings in productivity over this period. I have highlighted the swings with the green arrows.

Productivity Growth

Clearly there is nothing permanent or secular here.  Productivity growth fell in the 1970s and then picked up in the 1980s and 1990s.  Clearly it is not demand related: Virtually all schools of macroeconomics argue that demand deficiency periods are the length of the business cycle not decades or more.

In my view, as explained here, it is a policy-performance cycle because one can see changes in economic policy that are closely associated with the changes in growth.  So what we need is a public discussion—inside and outside of the political campaigns—on practical policy reforms to turn productivity growth around, including a clear explanation of why any proposed reform will, in fact, raise productivity growth.

Posted in Fiscal Policy and Reforms, Regulatory Policy, Slow Recovery

Economic Exasperation Continues

With today’s disappointing GDP release for the second quarter and downward revisions for the previous two quarters, the U.S. economy completes 7 years of economic expansion with a whimper. And with an average annual growth rate of only 2.1 percent over the 28 quarters from 2009Q3 to 2016Q2, the economic expansion is more aptly called economic exasperation.  I have been pointing to poor government economic policy as the main reason for this poor performance from the start, explaining the defects with each alternative explanation as it has arisen over time, including “it’s not so weak” and then “weak recoveries just happen after deep recessions” and then “it’s just secular stagnation.”  People’s exasperation about the economy and Washington policy is seen in this presidential election season.  The slow economic recovery is a tragedy for many people, especially when you combine it with the great recession that went before it. Policy must change. You would think that reports of three more quarters of disappointing growth would spur people into action.

Here is an update of a graph I have been using to compare the exasperation period with the much stronger expansion period of the 1980s:


and an updated list of links to posts on this subject on EconomicsOne.com which also include pro-growth policy reforms.

Posted in Slow Recovery

An Economic and Security Policy Blueprint for America

A timely new policy book, Blueprint for America, edited by George P. Shultz, is being released today online for the first time. The release coincides with the start of platform writing by Republicans this week and Democrats the following week, and then by national political conventions and the general Presidential campaign.  But the book is purposely meant to be non-partisan as ten contributors with experience in economics, national security, finance, health care, energy, and education join Shultz in laying out novel and practical reforms for governing as well as for campaigning during the election.Shultz_Blueprint_cover

In my view, the book is worth a serious look because it endeavors to bring a greater focus to economic and security policies than we have seen in the campaign. It candidly describes and diagnoses the serious economic and security problems America now faces, and it offers solutions to those problems.  Importantly it combines practical ideas on economics and national security, stressing the importance of getting back to long-term strategic thinking with the goal of improving people’s lives.

The book consists of 12 chapters (all online here)

  • The Domestic Landscape by Michael J. Boskin
  • Entitlements and the Budget by John F. Cogan
  • A Blueprint for Tax Reform by Michael J. Boskin
  • Transformational Health Care Reform by Scott W. Atlas
  • Reforming Regulation by Michael J. Boskin
  • National and International Monetary Reform by John B. Taylor
  • A Blueprint for Effective Financial Reform by John H. Cochrane
  • Education and the Nation’s Future by Eric A. Hanushek
  • Trade and Immigration by John H. Cochrane
  • Restoring Our National Security by James O. Ellis Jr., James N. Mattis, and Kori Schake
  • Redefining Energy Security by James O. Ellis Jr.
  • Diplomacy in a Time of Transition by James E. Goodby

cleverly interspersed with four insightful essays by George Shultz on why out-of-control entitlement spending is a problem, on human resources, on a world awash in change, and on the art and practice of governance. Shultz reflects on his time as secretary of state in these essays, writing that “I worry about the sorry state of the world and my instinct is to say something constructive about the problems.”  A good way to get into the book is to read Shultz’s poignant essays first, and then go on to study the reform proposals in individual pieces.  Here is a quick overview of some of those proposals.

Michael Boskin starts off by documenting the need for general government reform asking, for example, why we have “forty-six job-training programs, sprawling over nine government agencies.” He also considers the need for tax reform, demonstrating why lowering rates and broadening the base will raise growth and create simplicity, and for regulatory reform, proposing an overall regulatory budget cap and a requirement stating that an old regulation of comparable cost must be removed for every new regulation imposed, as a means of balancing of benefits and costs.

John Cogan offers proposals to reform social security and other entitlements arguing that “returning the welfare system to the states is long overdue.” Addressing impediments to reform he notes that “discussions about welfare are too often ideological.” He shows that “reformers are incorrectly cast as heartless people who are unwilling to help the less fortunate. State governments are erroneously cast as uncaring entities…. An effective welfare reform… improves the actual outcomes for the targeted citizens. Welfare reform should be judged on such results.”

Scott Atlas proposes a novel six-part health care reform plan that “restores the original purpose of health insurance: to protect against the risk of significant and unexpected health care costs.” He shows how the Affordable Care Act “has made private insurance less affordable and pushed health insurance reform in the wrong direction. It has furthered the erroneous view that insurance should subsidize the entire gamut of medical services, including routine medical care.” In contrast he shows that his plan “enhances the availability and affordability of twenty-first century medical care for all Americans, ensures continued innovation, and reduces health care costs by trillions of dollars over the decade.”

Rick Hanushek gives a comprehensive overview of the problems in K-12 education and then delves into the role of the federal government versus state and local governments. He puts forth the important principle that “The federal government is in the best position to specify what needs to be produced, but it is quite unprepared to direct what 100,000 schools should do to accomplish this. The states should be given the ‘how’ role.”

John Cochrane offers reforms to deal with financial crises and the too-big-to-fail problem including a novel proposal for equity-financed run-free banks. He also makes a refreshingly unabashed case for free trade backed up by history and basic economics, and he shows the rule of law and immigration benefit America.

In an essay on monetary policy I make the case for a proposal for domestic monetary reform that has already been written into legislation passed by the House of Representatives, and I show how this reform can be extended to create a rules-based international monetary system.

The book then shifts to national security policy with a thoughtful chapter by James Ellis, James Mattis and Kori Shacke that proposes several key strategic reforms. They argue that the current approach to developing a National Security Strategy is too unfocused: “Rather than cataloguing every interest, strategy should consist of decision rules that allow for application to events as they unfold,” a statement that would equally apply to economic policy proposals in the book.  They also emphasize that America needs a “strategy of security and solvency, showing that “economics are integral to military power. In fact, they are dispositive: no country has ever long retained its military power when its economic foundation faltered.” This is also theme that is echoed through the book.  Stressing the need for alliances they argue that a strategy which America adopts “must, foremost, be ally-friendly,” suggesting a simple guide that “those countries that are not against us are for us.”

James Ellis then reviews energy policy. He describes how dramatically circumstances have changed for US energy policy, noting that “The US energy situation today is by almost all accounts better than it has been for decades.” He documents that in 2014, “just 16 percent of our country’s net petroleum use was imported from OPEC. That is now less than 6 percent of our total energy consumption, putting OPEC behind the total energy supplied by, for example, the state of Pennsylvania (7 percent) and just ahead of Colorado (4 percent).” Nevertheless, he argues that energy policy still has problems to deal with including the need to reduce carbon emissions and maintain a diversified portfolio of energy supply.

In the chapter on diplomacy, James Goodby summarizes an interview with George Shultz on governance of foreign policy in the state department, and offers proposals for a range of reforms, including better training and a greater focus on improving the foreign services.

In the concluding essay of the book, George Shultz puts these proposals into perspective observing that the American people have dealt with similar problems in the past and arguing that they can deal with today’s problems if they work at it, reminding us that “democracy is not a spectator sport.”

Posted in Budget & Debt, Financial Crisis, Fiscal Policy and Reforms, International Economics, Monetary Policy, Regulatory Policy

Now is the Time for “Chapter 14” Bankruptcy Reform

Yesterday a “Chapter 14” bankruptcy reform passed the House of Representatives as Title XI (The Financial Institution Bankruptcy Act) of the Appropriations Bill on Financial Services and General Government.  This is a very promising development. The reform would largely end the problem of too-big-to-fail by making it feasible for a large failing financial firm to actually fail and go through bankruptcy under clear rules without systemic spillovers, thereby greatly reducing the likelihood of government bailouts.  The fact that this reform is largely nonpartisan and is part of a passed appropriations bill greatly increases the chance of it becoming law soon, maybe even before the election or at least in this congress. That is the conclusion on the Wall Street Journal in this report.

Much of the research and legal work on this proposal has been conducted by the Resolution Project at Stanford’s Hoover Institution under the direction of Ken Scott, who unfortunately passed away last month. Ken founded and was the driving force behind the Resolution Project which consisted of legal scholars, economists and market practitioners from around the US and the UK. The goal of the Resolution Project was to design legal and economic reforms to prevent bailouts and spillovers of failed financial institutions. Under Ken’s leadership, the Resolution Project—it began work in 2009—developed the “Chapter 14” bankruptcy reform. In a short span of time he edited three books on this subject, Ending Government Bailouts as We Know Them (2010), with me and George Shultz; Bankruptcy Not Bailouts: A Special Chapter 14 (2012) with me, and Making Failure Feasible: How Bankruptcy Reform Can End Too Big To Fail (2015) with Tom Jackson and me.   Without Ken’s dedication, rigorous thinking, insistence on excellence and genuine good-nature, these scholarly and practical contributions would have been impossible. The research has been bolstered by many opeds, blogs and congressional testimony.  The idea has been out there, debated and written into law. It is time to make it the law of the land.

Posted in Financial Crisis, Regulatory Policy

Debt Explosion Still Looks Like July 4th Fireworks

Six years ago, on July 4, 2010, in a post on this blog, I plotted the CBO’s projection of the ratio of federal debt to GDP because it reminded me so much of the Fourth of July fireworks. What does it look like now?

The most recent CBO long term projection was made in June of last year (CBO is later than normal this year).  For some reason, however, the CBO no longer reports debt levels higher than 250% of GDP, as it did in the past, though it does publish estimates of the primary deficit (the difference between revenues and non-interest spending) under its alternative fiscal scenario through 2089. So I use those estimates and calculate the debt levels assuming that the interest rate remains at the levels forecast by CBO.  test


As you can see from the figure, the fireworks explosion is still there, and it looks just the same! Clearly this future debt picture is not sustainable.  A fiscal consolidation—a reduction in the primary deficit—is needed if the debt explosion is to be avoided. That the debt is projected to grow relatively slowly as a share of GDP for the next 5 or 6 years has led to complacency, but the longer the fiscal consolidation is postponed the harder it will be to carry out without disruptions.

The decrease in the debt to GDP ratio in the late 1990s was largely due to a decline in defense spending as a share of GDP coupled with strong economic growth. The increase in recent years is due to the weak economy—the recession of 2007-2009 and the slow recovery.  The projected increase in future years is mainly due to the rapid growth of entitlement spending compared to GDP

Posted in Budget & Debt