A FISCAL POLICY FIT FOR THE NEXT CRISIS / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

June 26, 2011 8:00 pm

A fiscal policy fit for the next crisis

By Clive Crook

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The debt-ceiling talks in Washington have stumbled again. The sticking point, as before, is taxes. Republicans refuse to raise them and Democrats are insisting on it. The drama and the walkouts are part of the show: in all likelihood a deal of some sort will still be struck before the August 2 deadline. Whether it is a good deal for the country is another question.
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A good deal means avoiding abrupt fiscal tightening in the short term – a point Federal Reserve chairman Ben Bernanke emphasised last week – while bringing long-term public borrowing under control. These arguments are well understood, even if the country’s politicians are ignoring them. Another topic, though, has received no attention at all. It is at least as important. This is the issue of fiscal capacity.

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By this I do not just mean getting public debt back under control. That matters, obviously. To retain counter-cyclical fiscal policy as an option in the next recession, the debt ratio will have to fall. The Congressional Budget Office just estimated that on unchanged policies, the ratio of public debt to gross domestic product would be 100 per cent by around 2020 and would then rise literally off the chart, making activist fiscal policy impossible. This is the argument for fiscal control that Democrats should have been making all along, and still are not.

But containing debt is only part of the problem. Important as it will be to get the debt ratio down, thus re-arming fiscal policy for future use, the question of fiscal capacity – the ability to respond to economic downturns with fiscal countermeasures – goes further.

The fiscal response to a recession is partly automatic (lower revenues and higher transfers as the economy shrinks) and partly discretionary (lower tax rates, infrastructure projects, extra help for states and so on). Two factors weaken automatic stabilisers in the US. First, the government is small, so economic fluctuations, other things being equal, move fiscal quantities less. Second, states are subject to balanced-budget rules. Much of the US government has to follow a pro-cyclical fiscal policy – cutting spending and raising taxes – during a recession.

This puts a great burden on discretionary policy. Extra federal stimulus, and plenty of it, is needed just to offset automatic tightening in the states. To supply net discretionary stimulus requires very aggressive action in Washington. It is much to Barack Obama’s credit that he pushed through a big federal stimulus for 2009.

Judged against the central government tax base – one way to measure fiscal effort – the difference he made was huge, and no other rich country comes close. Nonetheless, severe fiscal tightening in the states would have justified something even bigger.

Unfortunately Mr Obama lost the battle for public opinion. The country thinks the stimulus has failed – and this could be a lasting reversal for fiscal activism. Discussion now revolves around premature tightening and, equally disturbing, new budget rules to constrain fiscal discretion in future. The government of a country with weak automatic stabilisers is talking about ways to limit its own discretion – as though the current paralysis is not enough. This could be a new calamity in the making.

The debt-ceiling negotiators are looking at “targets and triggers” for taxes and spending. These can help in stabilising and reducing public debt – but only if care is taken to avoid pro-cyclical fiscal policy in the next downturn. Badly framed balanced-budget rules, making the federal government as helpless as the states, would be disastrous.

As well as steering clear of that, the US should embrace an explicit goal of strengthening its automatic stabilisers. The aim should be to boost stimulus in downturns and curb it in expansions, with a smaller need for intervention by Congress over the course of the cycle. The less one needs to ask of that broken institution, the better.

How to do it? Here are three thoughts – all of them desirable in their own right, not counting their fiscal-stabiliser advantages.

First, introduce a national sales tax. This could raise new revenue, which the US will need, but that is not the point. Consumption fluctuates more than income during the cycle, so shifting some of the tax base from income to spending would increase revenues in booms and reduce it in downturns. If Congress had the wit to alter the rate counter-cyclically, so much the better, but let us not make wild assumptions.

Second, lean hard against tax preferences for borrowing. In a credit-fuelled boom, tax reliefs for bigger mortgages and other kinds of debt reduce revenues. In a recession, as people pay down debt, their taxes rise. This is pro-bubble, then pro-slump. What could be more stupid?

Third, expand help for the unemployed by enlarging the Trade Adjustment Assistance programme. This offers retraining, relocation and other benefits to workers who have lost their jobs because of imports. The scheme is too narrow and too complicated. It should be simplified, merged with unemployment insurance and widened to cover everybody who loses a job.

I see the flaw in the logic, of course. Why should a Congress incapable of raising the debt ceiling without an operatic ideological battle be capable of changes such as this? Fair question. All I can say is that this approach requires responsible action on a one-time rather than an ongoing basis. Perhaps, if it only needs to do it once, Congress could get it right by accident.
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Copyright The Financial Times Limited 2011