FROM THE OFFICE OF PUBLIC AFFAIRS

Two questions dominate our thoughts about the economy and fiscal policy.  First, what should we do to put the economy on a path of higher growth and more rapid job creation?  Second, how can we move toward the fiscal balance that we all agree we need to achieve in the long run?

 To return our economy to a path of higher growth and job creation, we must do more than overcome the regular ups and downs of the economic cycle.  We are recovering from the events in the 1990s, culminating in the stock market bubble and its aftermath, as well as the attacks of September 11th.  To sustain economic growth in this setting, we need to support consumption and promote investment on a balanced basis.  The President’s Jobs and Growth Plan, if enacted by Congress, will do this. 

 We must recognize that while budget deficits matter, total obligations for future spending matter much more.  To approach long-run fiscal balance, we first need to view the federal government’s financial position with a forward-looking measure that includes all of the government’s liabilities.  When we do focus on total liabilities, we will recognize the powerful truth behind the President’s insistence that only by growing the economy and controlling future outlays will we control future deficits.

Putting the economy on a path of higher growth and faster job creation

 The President’s Jobs and Growth Plan has been criticized for not being a pure short-term stimulus.  Its purpose, however, is not just to deliver a short-term boost to the economy but to raise the growth rate and boost job creation for the coming decade by enhancing confidence in our long-term prospects.

 We may hope that in a year or so, without any federal action, the economy will be growing rapidly.  It may be that, over the next few months, business investment and job creation will spontaneously surge.   But the President refuses to rest on that hope.  He wants us to act now to prevent the opposite outcome.  We need to prevent the risk that over the coming decade we slip toward sluggish growth more like that of Europe and Japan. 

 I fear that the challenge we face is not just one of overcoming another swing of the business cycle.  Our economy is still recovering from the extra-ordinary events of the 1990s.  First, the Federal Reserve wrung inflation expectations out of the American economy, lengthened investment horizons, and put us on a more rapid growth path.  Second, one quarter of the world’s humanity – China – entered the global economy.  Third, the communications revolution lowered transaction costs the world over.  These events contributed to our real prosperity but also fueled an historic stock market bubble.  We continue to live with both the dis-inflationary consequences and the destruction of wealth as the bubble burst.

Among the policy mistakes that Japan made in trying to recover from their own bubble in the early 1990s was to use fiscal policy as a tool only for “short-term stimulus.”  Each year brought forth another short-term stimulus package of more roads and bridges, and each year Japan’s output slipped further below its potential.  The error was in failing to deliver an enduring boost to demand, balanced between consumption and investment. 

An American version of Japanese-style fiscal policy might be reflected, I fear, in an excessive reliance on the short-term stimulus of rebate checks or the like as a substitute for promoting long-term economic growth.

The American people are smart enough to know the difference between a one-off check for $300 and an enduring improvement in their disposable income.  When consumers re-finance their mortgages at lower rates, they gain enduring improvements in household cash flow.  The same would be true of bringing forward to this year the tax rate reductions that Congress already approved, as the President has proposed.  This action would provide an enduring improvement to family income and help sustain consumer demand – policy for the long-term, beginning today. 

Eliminating the double taxation of corporate dividends can increase the efficiency of our entire capital investment process.  It would raise the burden of proof on corporate management either to have specific reinvestment plans for the cash they have retained or to pay it out to shareholders, who can then make their own reinvestment decisions.  As we speed up and re-target investment, we encourage capital formation, business formation and job creation.  As we sharpen the efficiency with which American business deploys over a trillion dollars of investment each year, we can enhance our productivity and raise both our actual and potential rates of growth.

Let’s not make the mistake of opting for unbalanced, short-term consumption stimulus.  We should choose policies that will promote consumer confidence and business confidence, sustained consumption and investment, real economic growth and job creation, both now and over the coming decade.

Getting on the path to long-run fiscal sustainability

How can we bridge the gap from the budget deficits that it is wise to incur now to the fiscal balance that we need to achieve in the long run?  Why does achieving fiscal balance – or even sensible political discussion of the topic – seem so hard?

We can bridge the gap to fiscal balance if we focus on the measures of fiscal sustainability that really matter.  Indeed, the intense political focus on deficits and debt, to the virtual exclusion of other concepts, diverts attention from the real driver of our fiscal imbalance, and impedes reforms that will move us toward real balance.

 The popular understanding of our national fiscal position revolves around two concepts, the annual budget deficit (or surplus) and total debt held by the public.  The Congressional Budget Office now forecasts a deficit of $246 billion for this fiscal year; our debt held by the public is about $3.6 trillion.  As shares of our total economy – our gross domestic product of $10.6 trillion a year – our expected deficit is about two and a half percent of GDP and our debt is around 34 percent of GDP.

 These figures understate our fiscal challenge and point us in the wrong direction: the past.  They reflect the government’s continued reliance on cash accounting, recording transactions only when cash changes hands.  They ignore the commitments we have yet to fund: our future obligations. 

A more accurate and complete measure of the government’s fiscal position would take account of all future obligations, calculating costs and revenues as they accrue regardless of when they must be paid.  Chairman Greenspan dedicated more than half of his recent monetary policy testimony arguing this precise point. 

 The concept of “net present value,” or NPV, is used everywhere in finance except the federal government.  Similar in concept to accrual accounting, it sums the current value of all expected revenues and costs, and denominates that total in today’s dollars. The federal government does not yet – but should – calculate its overall financial position based on a net present value calculation.  But the rough measures we do have present an alarming picture. 

 Later this month, the Treasury will publish the Financial Report of the United States Government.  This annual report provides an assessment of the government’s net liability for Social Security, for Medicare, and for government worker and military retirement benefits.  The government has assumed these obligations, and has designated taxes and revenues to pay for them.  Last year’s report concluded that, looking forward over 75 years, these programs collectively have a current negative net present value of $26 trillion.  This figure drops slightly if we look at the whole federal fisc.  Projecting total federal revenues as a share of the economy for the next 75 years at the past 40-year’s average rate, the government’s current net financial position is “only” negative $23 trillion.

 So on a backward looking basis, only counting the amounts that we have borrowed, our debt-to-GDP ratio is 34 percent.  But on a forward-looking basis, our total liabilities-to-GDP ratio is well over 200 percent.

  Our problem, however, is not just one of scale but of perverse incentives and crossed signals.  If we keep looking backwards rather than forwards, we are not likely to find our way. 

 Relying only on current deficits and debt to guide our way to fiscal balance is like trying to drive a car safely while peering only at the rear-view mirror.  Even forecasts of future annual budgets, whether for five or ten years, are highly imperfect measures of our fiscal position.  Forecasts of future deficits are just an artist’s rendering of what we may see out the rear window once we get a little further down the road.

 Our misdirected attention creates perverse incentives that weaken our real fiscal position.  Budget scoring understates the cost of future promises, providing an incentive for making more of them through the creation and extension of benefit and guarantee programs.  These promises do not add appreciably to current year outlays, and thus “score” well for deficits, but do add to total liabilities.  Today’s liabilities will be tomorrow’s outlays, ultimately contributing to deficits, just not in the year of enactment.  This creates a powerful bias against reforms that could move us toward real balance. 

Take an example on the outlay side.  Imagine a reform proposal that promises to improve overall fiscal balance: reducing the negative net present value of all future outlays and revenues.  If the proposal accomplishes this by increasing today’s deficits while cutting tomorrow’s outlays by a larger amount, under current budget rules, we would reject it as “too expensive.”  The numbers that we focus on (deficits) distract us from the numbers that merit our attention (total liabilities).

 And on the revenue side, with static budgetary modeling, we fail to prize ideas that will boost economic growth and, thereby, our ability to pay for future obligations.

 There is only one path to fiscal discipline: to focus on total liabilities – to count them properly and to constrain their growth.   In Washington budget jargon, we need a “total liability pay-go” much more than we need a “budget pay-go.” 

Once we have the government’s total financial position in mind, and only then, can we start real discussion about closing the gap between future revenues and outlays. 

From 1961 to 2001, through five Democratic and five Republican administrations, as tax debates have come and gone, total federal revenues have ranged from 17 to 21 percent of GDP.  The average has been 18.6 percent.  We are now operating a bit below this long-run average, as we would both hope and expect given the state of our economy.   The prudent way to plan for the government’s finances over the coming decades is to project that federal revenues remain around the average of the last forty years.  When we plan in this cautious way, we will of course realize that federal revenues can only grow with growth in the economy.

 Real fiscal discipline will only come about if we consider a forward-looking measure of the federal government’s fiscal position.  When we grapple with the fiscal gap that matters – between the current value of future outlays and future revenues – we will recognize the force of the President’s insistence that only by growing the economy and controlling future spending will we control future deficits.