Linking the Debt Limit Hike To Spending Cuts Is Good Economics

Posted on May 18, 2011 by John Taylor

For months now top economic officials in Washington have been arguing that the Congress should vote to increase the debt limit without any reductions in the growth of spending—in other words a “clean debt limit hike.” Just last Thursday Ben Bernanke compared linking the debt limit and spending reductions to playing a game of chicken with U.S. credit worthiness, adding “I think using the debt limit as a bargaining chip is quite risky.” CEA Chairman Austan Goolsbee and Treasury Secretary Timothy Geithner have been saying much the same thing.

But these arguments do not take account of important economic advantages of linking the debt limit to spending reductions. Such a link is good economics in theory and in practice. It is essential to a credible return to sound fiscal policy and an end to the ongoing debt explosion.

Here’s why. In the current political and economic environment—where more people than ever in the United States and around the world are aware of, and paying attention to, the country’s debt problem—the decision about the debt limit will be precedent-setting. They also know that government spending has increased rapidly in recent years, rising from 18.2 percent of GDP in 2000 to over 24 percent now. If Washington does not change the budget game now, people will sensibly reason, it will never change the game. If politicians just increase the debt limit now when spending has been growing so rapidly compared to revenues without correcting that rapid growth of spending, then they will be expected to do so in the future. In contrast if they tie any increase in the debt limit to a halt in the explosion of spending, then people will be more likely to expect them to control spending in the future. Linking the debt limit vote with spending establishes a precedent and valuable credibility.

Another way to think about this approach is to contrast it with the debt failsafe mechanism that President Obama has proposed. Under the debt failsafe plan, if spending grows too rapidly in the future (after 2015) relative to forecast, and the debt thereby rises more than budgeted for, then there would be an automatic reduction in spending. In other words, debt increases and spending reductions are linked in future. But if there is no link in the present, as in a case of a clean debt limit increase, how can one expect one to be followed in the future? How can today’s politicians expect future politicians to adhere to such a policy if they can’t do so today? This is a common problem in economics, called the time inconsistency problem, covered from principles courses to Ph.D. courses.

The principle of linking the debt increase and spending reductions—put forth in a recent speech to the New York Economics Club by Speaker John Boehner—is therefore an important goal which is worth trying to achieve. True, it may run some risks as the deadline is approached, but those risks are far smaller than the risks caused by the debt explosion which is likely if the Boehner link is severed.

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More on Seniors, Guns And Money

Posted on May 14, 2011 by John Taylor

Paul Krugman returned to the debate with me about federal spending in his New York Times column yesterday. He says that federal spending cannot be brought back from its current high levels to the 19 to 20 percent range as a share of GDP, which we saw as recently as 2007. His argument consists of two points.

He declares that military spending as a share of GDP cannot go down. Why? Because, he says, “Republicans, needless to say, oppose.” But as I wrote when he first made this point, defense spending as a share of GDP can come down. And it could come down by an especially large amount as the size of GDP increases with higher economic growth. Krugman is taking defense off the table, not me, and not Republicans who are part of the budget debate in Washington. And he does not mention economic growth.

Krugman also points out that the number of retirees is projected to grow at a more rapid rate than the number of workers paying taxes. This point should not come as a surprise to anyone. But the implication is not that we should tax working people more. Rather the implication is that we should insist that programs like Medicare be reformed to improve their efficiency and deliver improved outcomes for future retirees for each tax dollar spent.

There is a good reform plan on the table which does just this. It would bring federal spending as a share of GDP to the 19-20 percent range and it would improve health care for Medicare recipients; it is none other than the House Budget Resolution of 2012; yes, the Ryan plan. Like the Obama Administration’s proposal, it aims to bring down the growth rate of future Medicare spending from the unsustainable levels under current law. Indeed, depending on economic projections, the Obama Administration’s new plan (presented by President Obama on April 13) proposes to bring the growth rate of future Medicare spending per beneficiary to about the same rate as the House budget plan, which has Medicare payments increasing faster than the CPI as people age.

But by reforming Medicare and thereby avoiding the destructive price controls needed to limit spending in the Administration’s proposal without reform, the House plan would make Medicare recipients relatively better off. The Ryan and Obama plans both propose to reign in the explosive future growth of Medicare spending. The difference is that the Ryan plan does so in a way that is much more beneficial for seniors.

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The One Hundred Trillion Dollar Note and Other Visual Aids

Posted on May 11, 2011 by John Taylor

Patrick McGroarty and Farai Mutsaka have a great article in the Wall Street Journal about this famous one hundred trillion dollar note from Zimbabwe,including the fact that I carry one around in my wallet everywhere I go. Whenever someone says inflation is not caused by central banks printing too much money, I pull out this note and tell the story of Zimabwe’s hyperinflation. Although Paul Ryan and I collaborated on an oped on monetary policy recently, we did not coordinate on this use of the famous note.

If you are interested in relating this story to the Fed, I recommend adding a couple of other pictures including this photo of a QEIII license plate in Washington DC and the photo of $5 a gallon gasoline. I think these may have helped Fed rethink the idea of going beyond QEII.

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Bringing Gadhafi’s Money to Rebels Recalls Bringing Saddam’s Money to Iraqis

Posted on May 8, 2011 by John Taylor

The plan to use Moammar Gadhafi’s frozen assets to fund the Libyan rebels faces legal obstacles according to this weekend’s Wall Street Journal story “Obstacles Loom on Path To Funding Libyans.” This reminds me of the plan to use Saddam Hussein’s frozen assets to fund payments to the Iraqi people in 2003. The plan was developed before the military invasion and was part of an overall plan for financial stability. I was Under Secretary of Treasury with responsibility for the plan. Legal obstacles arose then too, and we had to develop legal procedures to deal with them.

Treasury lawyers determined early on that the President of the United States could legally issue an executive order calling on U.S. banks to vest Hussein’s frozen funds with the Treasury, which would then transfer them to the Iraqis. But an obstacle was the risk of law suits from Saddam’s victims, who could make claims on the funds, prevent their transfer, and thus threaten the financial stability plan. To deal with this risk, we recommended that the executive order contain an exception for such victims—but only if they had already made claims—and that the order state that using the frozen funds for the Iraqi people was in the interest of the United States.

So when the military operation began, President Bush issued Executive Order 13290, “Confiscating and Vesting Certain Iraqi Property,” saying that “All blocked funds held in the United States in accounts in the name of the Government of Iraq, the Central Bank of Iraq, Rafidain Bank, Rasheed Bank, or the State Organization for Marketing Oil are hereby confiscated and vested in the Department of the Treasury, except for the following….” The exception was for funds already claimed in a legal suit. The executive order also stated that “I [George W. Bush, the President of the United States of America] intend that such vested property should be used to assist the Iraqi people and to assist in the reconstruction of Iraq, and determine that such use would be in the interest of and for the benefit of the United States.”
Once the order was issued we opened an account at the New York Fed where Bank of America, JP Morgan Chase, and other banks transferred about $2 billion of Saddam’s previously frozen funds. The Treasury then withdrew the funds as needed. Cash was removed from the Fed’s warehouse in New Jersey, placed on armored trucks, shipped to Andrews Air Force Base, loaded on planes, flown to Iraq, and paid to Iraqis. I recall how Treasury staff went down to Andrews to inspect the first cash transfers. When they returned to report that the cash was airborne, they radiated well-deserved pride at their accomplishment. The picture shows David Nummy (blue shirt) of Treasury dispersing the cash (in the black box) to the Iraqis in Baghdad.

There are differences today—Saddam Hussein’s funds were frozen years before during the first Gulf war, but the legal procedures remain relevant. To overcome such obstacles, President Obama would have to say something like “I determine that using the funds to assist the Libyan rebels is in the interest of the United States.”

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New Study Questions Justification For Quantitative Easing

Posted on May 7, 2011 by John Taylor

Proponents of Quantitative Easing frequently cite—inappropriately in my view—the Taylor Rule as support, saying that the rule calls for a federal funds rate as low as minus 6 percent, well below the zero bound. But in various pieces over the past year, such as Taylor Rule Does Not Say Minus 6 Percent, I have argued the contrary. If you simply plug in current inflation and output (gap) you will find that the interest rate is above zero with the policy rule coefficients I originally derived. But QE II proponents change the coefficients. Frequently they use a higher coefficient on output (around 1.0) rather than the lower coefficient (0.5) which I originally recommended. The higher coefficient on output gives a much lower interest rate now and is thus used by proponents of quantitative easing.

A new paper by Alex Nikolsko-Rzhevskyy and David Papell provides important evidence relevant to this debate. They show that, if history is any guide, the higher coefficient would lead to inferior economic performance compared with the original coefficient I recommended.

First, they look at the 1970s when monetary policy was too easy: in much of this period the interest rate was too low creating high inflation and eventually high unemployment. They show that the higher coefficient on output would have perpetuated the bad policy while the lower coefficient would have prevented it.

Second, they look at years in the 1990s when monetary policy is widely viewed as good, helping to create a long expansion. Here they show that the higher coefficient would have prevented this good policy. Actual policy was more consistent with the lower coefficient which I had proposed.

In sum, they find no reason to use a higher coefficient, and that the lower coefficient works better. David Papell’s guest blog yesterday on Econbrowser nicely puts these new results into the context of today’s policy debate and provides more details. He emphasizes that his paper with Nikolsko-Rzhevskyy does not endeavor to estimate the impact of QEII, but rather shows that the typical policy rule rationale for this discretionary action is flawed. In my view it is an example of “discretion in policy rule’s clothing.”

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How to Avoid the New Bailout Authority

Posted on May 6, 2011 by John Taylor

Title II of the Dodd-Frank bill, which creates a new orderly liquidation authority for financial institutions, has recently come under fierce attacks from a variety of perspectives. Paul Ryan writing in the Wall Street Journal on April 5 argues that we should get “rid of the permanent Wall Street bailout authority that Congress created last year.” Then, after reading an FDIC report on how Title II would have worked in the case of Lehman, Simon Johnson in effect agrees with Ryan arguing that any Treasury Secretary, at least one in the Paulson-Geithner mold, would go right around Title II and simply bail out the creditors of large financial firms as in 2008. Recently Stephen Lubben has piled on in The FDIC’s Lehman Fantasy and Michael Krimminger (FDIC General Council) finally replied.

Missing from the recent debate is the role of a possible amendment to the bankruptcy code to deal with large financial firms. An amendment could supplement—or even replace—the orderly liquidation authority of Dodd–Frank and deal with the problems raised by Paul Ryan and Simon Johnson. One such amendment has been proposed by a group of lawyers, economists and financial institution experts sponsored by Stanford University’s Hoover Institution. The amendment is called “Chapter 14,” because this is currently an unused chapter number in the U.S. Code on Bankruptcy. Last week we (I’m a member of the group) presented the idea to Michael Krimminger at the FDIC and to the legal staff at the Fed which is responsible for a mandated study of the bankruptcy code. The idea is explained here.

In brief, the problems with the new orderly liquidation authority, at least in the absence of a new bankruptcy process, is that it increases uncertainty, raises constitutional due process issues, increases the probability of bailouts, and creates moral hazard. Chapter 14 would give the government a viable alternative to Title II and thereby avoid these problems. We argue that government officials would likely find Chapter 14 more attractive than Title II, or a more direct bailout, and thereby choose this option. So with such an alternative, bailouts would be less likely. As George P. Shultz puts it, “Let’s write Chapter 14 into the law so that we have a credible alternative to bailouts in practice.” Compared with Title II, Chapter 14 would more predictable and rules-based and it would minimize spillovers to the economy. It would also permit people to continue to use the company’s financial services—just as people continue to fly when an airline company is in bankruptcy.

Chapter 14 would differ from current bankruptcy law in Chapter 7 and Chapter 11. It would create a group of “special masters” knowledgeable about financial markets and institutions; a common perception is that bankruptcy is too slow to deal with systemic risk situations in large complex institutions, but under the proposal there would be capacity to proceed immediately. In addition to the typical bankruptcy commencement by creditors, an involuntary proceeding could be initiated by a government regulatory agency, and the government could propose a reorganization plan—not simply a liquidation. An advantage of this approach is that debtors and creditors negotiate with clear rules and judicial review throughout the process. In contrast, the orderly liquidation authority is less transparent with more discretion by government officials and few opportunities for review.

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A Morale Booster for the Financial Front Too

Posted on May 3, 2011 by John Taylor

Anyone who has served in the military during the nearly ten years since 9/11 must feel a sense of closure with Bin Laden’s death. As Lindsay Wise writes in the Houston Chronicle “Bin Laden’s death is a dramatic morale booster for those who served in the war on terror, now aptly dubbed The Long War.” The demise of Bin Laden marks an important victory to which all who served contributed in one way or another. A Marine who signed up just after 9/11 said this to me just after President Obama’s announcement: “It feels kind of like I can come home again,” but then, after a pause, “I guess we have a few more things to do.” An email was circulating around Stanford yesterday saying: “Congratulations to all Stanford veterans who laid the groundwork for this momentous occasion. Thank you for your service and your sacrifice.”

I think thanks are also due to the people who served in the financial front of the war on terror during these ten years—many in the United States Treasury. President Bush announced the terrorist asset freezing operation in the Rose Garden on September 24, 2001. It was before military actions in Afghanistan. It was the first shot in the war on terror. The announcement sent an important message to the terrorists and to the people at Treasury who were just entering to the fight. He said,

“Today, we have launched a strike on the financial foundation of the global terror network. Make no mistake about it, I’ve asked our military to be ready for a reason. But the American people must understand this war on terrorism will be fought on a variety of fronts, in different ways. The front lines will look different from the wars of the past….It is a war that is going to take a while. It is a war that will have many fronts. It is a war that will require the United States to use our influence in a variety of areas in order to win it. And one area is financial.”

Soon thereafter the G7 finance ministers released a statement pledging to work together to “freeze the funds and financial assets not only of the terrorist Usama bin Laden and his associates, but terrorists all over the world” setting off what turned out to be the most impressive effort in international coordination in the finance area in history. Soon financial intelligence networks were set up to get information about the terrorists, and new financial tools began to be used as a weapon against proliferation. To solidify these efforts a new position of Under Secretary of the Treasury for Terrorism and Financial Intelligence was created in 2004, and Stuart Levey was appointed to the position by President Bush. Stuart was asked to continue by President Obama, and only recently stepped down. Senator Kaufman’s praise on the Senate floor for Stuart and others in the Treasury shows why thanks are in order.

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YouTube Assignment for Macroeconomics Students

Posted on April 28, 2011 by John Taylor

As a respite from comparing the “Keynesian cross” versus the “dynamic stochastic general equilibrium” model, watch this “Keynes” versus “Hayek” video with lyrics written by John Papola and my colleague Russ Roberts. But my favorite lines are more micro than macro:
Keynes: “Even you must admit that the lesson we’ve learned is that more oversight’s needed or else we’ll get burned”
Hayek: “Oversight? The government ‘s long been in bed with those Wall Street execs and the firms that they’ve bled.”

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Spending Rise Has Much To Do With Policy

Posted on April 28, 2011 by John Taylor
  • The running debate between Paul Krugman and me is bringing more facts to bear on important budget and policy issues. Since I wrote my reply yesterday to Krugman’s criticism of my Wall Street Journal article, he has responded three times, with Taylor Digs Deeper, 2021 and All That, and One More Point about 2021.
  • Krugman now admits that spending as a share of GDP would rise from 19.6 percent of GDP in 2007 to around 24 percent in 2021 under the budget proposed by the Administration on February 14, which is what I showed in my original graph.
  • And since spending averages around 24 percent of GDP in 2009-2011, this confirms my point that “Mr. Obama, in his budget submitted in February, proposed to make that spending binge permanent.” Krugman also reports some of the components of the rise in entitlement spending, showing that Social Security, Medicare, and Medicaid spending rise as a share of GDP under Obama’s proposal.
  • But Krugman now argues that “the great bulk of this projected rise has nothing whatsoever to do with Obama’s policies.” This is wrong on two accounts.
  • First, in proposing his February 14 budget, Obama chose policies that did not control the growth of spending by enough to prevent an increase in spending as a share of GDP, even though he could have chosen such policies. In fact, the policies he chose for his second budget on April 13 did impose such controls including “setting a more ambitious target of holding Medicare cost growth per beneficiary to GDP per capita plus 0.5 percent beginning in 2018” (White House Fact Sheet April 13). These recent spending controls were proposed after the House budget proposal was put forth, and they take spending in the direction proposed by the House. That Obama’s second budget has lower spending than the first demonstrates that the rate of spending increase has very much to do with Obama’s policies.
  • Second, the Obama budget does propose new spending programs, including the new health care law. And there is a step increase in entitlement spending as a share of GDP in 2009-2011 which goes beyond what would be expected from the recession, and spending remains at the higher level through 2021. If demographic changes were the only reason for the increase in spending as a share of GDP, then you would not see such a step increase.
  • In the latest post on this subject, Krugman expands his criticism to include Senators Corker and McCaskill. Here Krugman admits that the rate of increase in government spending is affected by Obama’s policies, but he now gives reasons “why federal spending shouldn’t stay at or near the share of GDP it was at in 2007” arguing that Obama should not choose such policies. I disagree. Even with current demographic projections it is possible to institute good reforms which keep Medicare and Medicaid from rising so rapidly as a share of GDP and also deliver better health care services. And of course it is possible also to reduce other types of spending as a share of GDP, including national defense.
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Paul Krugman Versus Budget Facts

Posted on April 26, 2011 by John Taylor
  • Yesterday Paul Krugman, citing Brad DeLong’s post earlier in the day, joined the commentary on my Wall Street Journal article of Friday which I further discussed in my blog of Sunday. Krugman takes issue with my statement that “Mr. Obama, in his budget submitted in February, proposed to make that spending binge permanent” and instead claims to see no “huge expansion of the federal government” once one takes account of the slowdown in nominal GDP growth due to the recession.
  • Krugman is wrong. The Administration’s budget did propose spending levels which make the recently increased rate of government spending as a share of GDP permanent, regardless of the reason for the recent increase. If you want to see this in a way that takes account of changes in nominal GDP growth related to the recession, then you can compare actual spending before the effects of the recession began with proposed spending after the effects of the recession are over. For all of 2007, spending was 19.6 percent of GDP. For all of 2021—after the impacts of the recession and the final year of the budget window—the budget submitted in February proposed spending equal to 24.2 percent of GDP. These two budget facts are part of the data presented in my Wall Street Journal chart and are taken directly from CBO tables. The 4.6 percentage point increase represents $1 trillion more federal spending per year at 2021 levels of GDP.
  • Much of the increase comes in the form of mandatory spending. Using the CBO baseline of January 2011 (which is below the February budget), mandatory spending would increase from 10.4 percent of GDP in 2007 to 14.0 percent of GDP in 2021.
  • DeLong mainly quotes from another post which focuses on the increase in spending during the Bush Administration. But in the Wall Street Journal I said explicitly that spending increased from 18.2 percent of GDP in 2000 (at the end of the Clinton Administration) to 19.6 percent in 2007, and my chart shows that spending started increasing more rapidly in 2008. The increase in 2008 was in part due to the stimulus package passed in February of that year; I have been critical of that stimulus package as I have been of the discretionary fiscal actions taken in 2009. My critique of policies leading up to the financial crisis Getting Off Track: How Government Actions and Interventions Caused, Prolonged and Worsened the Financial Crisis was written before any policies were enacted by the Obama Administration.
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