Edward M Gramlich: Reducing budget deficits
Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve
System, at the Concord Coalition Budget and Fiscal Policy Conference, Washington, DC, 24 June
2004.
* * *
Thank you for inviting me to speak today. Three years ago, at just about this time of year, I gave a talk
about the supposed large and growing federal budget surpluses that were then being projected. It then
appeared that the national debt could be paid off within the decade, and my remarks addressed the
economic and political implications of this declining national debt. Unfortunately, much has changed
for the worse since that time. Rather than expecting the stream of surpluses projected just three years
ago, budget analysts now expect sizable deficits for at least the remainder of the decade. The national
debt as a share of gross domestic product (GDP), which reached almost 50 percent in 1993 and
declined to 33 percent by 2001, is now rising again. Today, I am here to talk about how to deal with
our current worsening fiscal outlook.
Fiscal policy can have important long-run effects on the health of the economy, particularly through its
impact on national saving and the growth of productivity. National savings can be generated privately,
by households and business, or publicly, by government. Although fiscal policy can, in theory, help
boost private saving, this has proven difficult, in practice. Instead, the most important effect of fiscal
policy on national saving has been through the direct government budget. When the government runs
deficits, it siphons off private savings (reducing national saving), leaving less available for capital
investment. With less capital investment, less new equipment is provided to workers, and, all else
being equal, future productivity growth rates and levels are lower.
Productivity growth is the principal source of improvement in economic well-being. The faster
productivity increases over time, the more rapidly living standards increase. Maintaining a rapid rate of
trend productivity growth is particularly important in light of the coming budgetary pressures associated
with the retirement of the baby boom generation. A more productive economy will ease the financing
of Social Security and Medicare benefits for tomorrow's retirees without placing an undue burden on
tomorrow's workers. In contrast, if we allow debt to build now and in coming years, we will have both
lower output to meet future obligations as well as the added burden of financing a growing amount of
debt. Indeed, under numerous scenarios, our current debt path is unsustainable: without changes to
taxes or spending, we may reach a point where ever-larger amounts of debt must be issued to pay
ever-larger interest charges.
To be sure, budget deficits are not always inappropriate, and to a certain extent, the recent fiscal
deficits have helped limit the recent economic slowdown. But now that the recovery is well under way,
it is important to concentrate on longer-run fiscal policy. Specifically, it is time to bring the budget
deficits under control. Doing so will, of course, require action in the political arena. But the manner in
which the process of deficit reduction is framed can strongly influence the likelihood of success.
There are various ways to restore fiscal discipline. Today I will discuss some of these approaches,
focusing on their past performance and future potential.
Better information
One approach is to provide the Congress with better information about the fiscal situation and the
costs of legislation. The first milestone in that effort was the Congressional Budget and Impoundment
Control Act of 1974. This act established the Congressional Budget Office (CBO) to provide baseline
projections of current and future revenues and outlays and to estimate the budgetary effect of
spending proposals. The act named the Joint Committee on Taxation (JCT) as the official
"scorekeeper" for revenue legislation.
The CBO and the JCT provide credible estimates of taxes, spending, and deficits based on a common
set of assumptions. By establishing a sensible context in which the inevitable political struggles
associated with setting budgetary priorities can take place, this information significantly affects the
budget process and, ultimately, budget outcomes.
Many analysts have worried about deficiencies in the concepts underlying the official budget
estimates. Apart from a few exceptions, budget estimates are based on cash accounting. Thus, they
do not take into account the accrual of future obligations or revenues and do not offer an accurate
picture of the entire fiscal situation. For example, by today's cash-based yardstick, the federal budget
posted surpluses from 1998 to 2001; yet, if the budget definitions had included the costs of future
Medicare and Social Security benefits accrued over this period, the budget likely would have shown
substantial deficits. Similarly, if our measure of national debt had included the present value of our
already accrued future liabilities for Medicare and Social Security, the debt would never have been
close to being paid off. In short, although cash deficits have economic relevance, they can provide a
misleading picture of the nation's long-term budgetary situation.
Should the Congress try to target a better measure of the fiscal situation than the deficit as it is
currently defined? Would providing the Congress with this better measure affect budget outcomes and
help improve the fiscal outlook? Some have suggested moving to an accrual-based accounting
system, where the deficit would better account for future obligations and revenues. Others suggest
adopting the generational accounts framework. Rather than focusing on a particular year's imbalance
between revenues and spending, this framework recognizes that, ultimately, we must pay for all
government spending, and instead calculates the net burden of government taxes and spending on
each generation.
Calculating generational accounts and other long-term budget measures requires many assumptions
that are not as critical under today's rules. For example, to calculate generational accounts, one must
specify the future path of numerous economic and demographic variables like wages, capital income,
immigration, longevity, health costs, and inflation.1 One must also specify a discount rate in order to
calculate present values - a choice that would likely be controversial and that could greatly affect the
results. Finally, one must assume something about future policy variables. Typically, generational
accounts assume the continuation of current policy. Thus, they measure the fiscal burden under the
assumption that current tax policy is continued, Social Security benefits are not curtailed, and
Medicare spending continues to rise with health costs.2
The information provided by generational accounts and other similar methods would definitely be
valuable, but their computational methods seem too complicated and rely too much on assumptions
about future variables to make them a viable alternative to the current deficit as the main benchmark
of fiscal policy. Moreover, much useful information about the future implications of current policy is
already provided by the Office of Management and Budget and the CBO, both in their official five- and
ten-year budget projections and in their longer-run projections. Targeting longer-term measures like
generational accounts is further complicated by the fact that the estimates would be affected by
promises to raise taxes or cut spending far off in the future. These very long-term calculations may be
subject to a great deal of budgetary sleight of hand. Indeed, even the five- and ten-year targets
currently used in the budget process have already been subject to considerable budget sleight of
hand.
Most important, I am skeptical of the view that more information, as desirable as it is, would alone lead
to greater budget discipline. The major differences between the various measures of the current fiscal
situation stem from differences in their accounting for Medicare and Social Security. It is no secret to
the public or to members of the Congress that these programs face long-term imbalances. This
information has been widely known and studied in depth for many years. And yet, despite that fact, we
still find ourselves on a fiscal trajectory that is probably unsustainable. Better information alone does
not seem to be the answer to our fiscal difficulties.
Overall deficit targets
A second approach to controlling budget deficits is for the Congress to establish budget targets. This
approach was the centerpiece of the Balanced Budget and Emergency Deficit Control Act of 1985 -
commonly known as the Gramm-Rudman-Hollings (GRH) Act. That act aimed to wipe out the deficit in
five years. It did so by establishing annual targets - declining to zero - for the budget deficit. The
process worked as follows: if projected deficits in the next fiscal year exceeded the targets by
$10 billion or more, the legislation mandated that unprotected programs be cut, across-the-board, and
by enough to reach the legislated targets. This process of across-the-board cuts was known as
"sequestration". The law did not specify how the targets were to be reached; instead, the assumption
was that the existence of those targets and the threat of sequestration would be enough to get the
Congress and the Administration to agree on a package of spending cuts and tax increases.
GRH did not allow changes in external circumstances to affect the budget deficit targets. Spending
cuts were to be enforced regardless of whether the deficit picture had deteriorated because of
worsening economic circumstances or because of congressional action. The result of this legislation
was quite different than originally envisioned. A sequestration was enforced only once, in the first year.
In other years, the Congress used various gimmicks to avoid sequestration, or it simply raised the
targets. The actual deficit did not meet the target in any of the years GRH was law, in part because,
during this period, external events, such as the savings and loan crisis, tended to overtake the policies
that the Congress had enacted to try to close the budget gaps.
Other countries have also used budget targets as a means of enforcing fiscal discipline. For example,
the Stability and Growth Pact of the European Monetary Union specifies that the budget deficits of
member countries are not to exceed 3 percent of GDP except under some special circumstances. If
they do, sanctions are to be imposed. But the Stability and Growth Pact has been as ineffective as
GRH has, and for the same reasons: countries have resorted to budgetary gimmicks to meet the
criteria, and the sanctions have not been imposed on countries that have not met their targets.
Another example of deficit targets comes from the balanced-budget requirements of the states, which
can be viewed as deficit targets with the target set at zero. Most states have some form of
balancedbudget requirement, although the form and stringency of the requirement varies considerably across
states. In the most stringent cases, states are required to pass balanced budgets, and no borrowing is
allowed to finance the operating budget. The states can use rainy day funds built up from previous
years' surpluses to finance current operations. The states keep capital budgets separate, and states
are permitted to finance capital expenditures with borrowing.
The available academic literature suggests that these balanced-budget requirements do work, at least
in part. Although states have a wide array of budgetary tricks they can and do employ to hit their deficit
targets, research evidence suggests that the balanced-budget requirements do limit borrowing and
that, as a result, states with more stringent requirements face somewhat lower borrowing costs.
Furthermore, there seems to be a deeply held consensus that state budgets should be balanced, and
this consensus undoubtedly helps legislators make the difficult choices sometimes necessary to
balance state budgets.3
Hence, it may seem attractive just to limit overall deficits, but such limits have had only mixed success.
They have typically worked, at least to a small degree, for U.S. states. For national governments,
however, they typically generated more budgetary gimmicks than real cutbacks because the limits
have not adjusted to the sources of fiscal shock. In a political setting, inflexible deficit limits are likely to
lead more to avoidance than to real changes.
Controls on legislative action
A third approach involves tighter controls on legislative action. Even though GRH did not produce the
budget balance it sought, the determination to improve the fiscal outlook remained. In response to the
perceived failures of GRH, the Congress passed the Budget Enforcement Act (BEA) of 1990. This
legislation replaced the system of deficit targets with two types of restraints on legislative actions. First,
a cap was imposed on discretionary spending - spending that the Congress appropriates each year -
and was to be enforced with a sequestration process. The cap declined slightly over time, in real
terms. Second, for revenues and entitlement programs, the BEA established a system called PAYGO
(pay as you go) that required all revenue and mandatory spending legislation to be deficit-neutral over
a five-year period. For example, an expansion in a program like Medicare would be allowed only if it
were accompanied by a reduction in other entitlement spending or an increase in revenues. In other
words, the PAYGO restraint didn't require the Congress to climb out of the deficit hole by any
particular date, but it did prohibit the Congress from digging the hole any deeper.
The largest difference between the BEA and GRH was that the BEA attempted to restrain legislative
action alone. Changes in the deficit resulting from changes in economic conditions, health prices,
demographics, and other technical or economic factors were allowed to show through to the deficit
without sanction. Only those parts of the budget that the Congress could control directly - discretionary
spending and programmatic changes to entitlement and revenue programs - were subject to the new
requirements.
The BEA's budget rules - which were extended twice before they were allowed to expire in 2002 -
appear to have been more successful than previous attempts at budget control. Budget deficits
declined sharply from 1992 to 1997 and then turned to surpluses from 1998 through 2001. To a
significant extent, of course, the decline in the deficit and the emergence of surpluses were attributable
to circumstances external to the budget process, including the stellar performance of the economy; the
increase in equity prices, which raised tax revenues to historic highs; and the end of the Cold War,
which allowed for a decrease in defense spending.
But without a broad consensus to reduce the deficit, and without a mechanism to enforce that
consensus, the Congress might have responded to these positive developments by increasing
spending or cutting taxes. Instead, the federal deficit was allowed to decline. As a result, national
saving increased, providing further impetus to economic growth. Most economists view these rates of
national saving as an important factor in the strong economic performance of the late 1990s.
It is difficult to know exactly what the deficit path would have been in the absence of the BEA. But
budget experts generally believe that the BEA did help to reduce deficits. How? A likely possibility is
that the rules helped solve the prisoner's dilemma problem inherent in the legislative process. When
representatives choose between seeking funding for local projects and exercising fiscal discipline (by
not requesting funding for local projects), they will naturally consider the payoff of each choice. Without
a set of credible budget rules, the narrow local interest is usually the more attractive option for two
reasons. First, any individual representative knows that bringing home the pork is not likely to have
much of an effect on the deficit. Therefore, there really is no measurable payoff in greater national
fiscal virtue from an individual representative curtailing efforts to win special benefits for the home
district. Second, in the absence of a credible set of budget rules, representatives have no assurance
that others in the Congress will not be doing everything in their power to work the system to their
benefit, and an individual representative would not want to appear to be relatively lax in his or her
pork-procuring efforts. Budget rules help alleviate this problem. Under discretionary caps and PAYGO,
individual representatives could choose to forgo their special projects, secure in the knowledge that
others would not gain an advantage as a result.
As already noted, an advantage of the budget rules was that they aimed at constraining the things that
the Congress could control directly rather than targeting the overall level of the deficit. But these rules
also had a fatal flaw, which was that they had no sensible stopping point. Over the course of the
1990s, the economic news got better and better. The federal budget was borne along on the tide, and
eventually moved into surplus, even excluding the Social Security cash surplus. At that point, a
welldesigned set of rules probably would have said "enough". But unfortunately, even when surpluses
emerged, the PAYGO rules continued to require deficit neutrality in mandatory spending and revenue
programs and adherence to the discretionary caps. Unfortunately, because such strict fiscal discipline
was no longer viewed as necessary, the budget rules ceased to be effective: Congress enacted
measures that reduced or eliminated their bite until they were finally allowed to expire in 2002. As a
consequence of this aftertaste, it may be harder to bring back PAYGO rules now, when they are really
needed.
A sensible strategy for the future
The main lesson to be learned from this examination of past budget rules is that, within limits, budget
institutions do matter. A good budget process can help the Congress enforce fiscal discipline if the
political consensus to do so exists. In order to be effective, the process must be based on reliable
information about current and future baseline budget deficits and about the effects of legislation on the
budget. It must produce results that are reasonable and valued by the Congress and the public. The
process must be flexible enough to adjust in a reasonable way to changing economic and technical
factors that affect the budget. Of course, no single set of rules can be flexible enough to address all
possible circumstances, and over time, any set of budget rules likely will have to be revised.
Although the budget rules of the BEA did not prove flexible enough to endure in the face of budget
surpluses, that is no longer an important problem. Reinstating both the discretionary caps as well as
the PAYGO rules for revenue and mandatory spending programs - perhaps with some adjustments -
would be useful initial steps in restoring fiscal discipline. Once some success has been achieved with
these measures, it may be easier to tackle the more ambitious step of instituting overall deficit limits.
Two further issues are worth considering. First, what is the appropriate time horizon for budget rules?
We have seen problems in the past with periods that were too short - for example, under GRH, the
annual budget targets could be met by simply pushing costs into the next year. But there are also
problems with periods that are too long - for example, when budget rules are satisfied by specifying
painful measures that occur ten years in the future. The current focus on five years may be a
reasonable compromise, or it might be worth considering some more-complicated rules that might limit
annual deficits as well as five- or ten-year totals.
A second question concerns the ultimate target of budget rules. Should we, as a nation, aim to build
up surpluses to fully fund all of our future Medicare and Social Security liabilities as they would exist
under current law? Would that commit the government to maintain those programs as they are under
current law rather than allowing the government to adapt them to future circumstances? Can the
government reasonably accumulate the large stock of assets that full funding would require?
These are all difficult questions on which there is no political consensus. In the past, a reasonable goal
might have been to maintain a zero deficit in our on-budget accounts - those accounts that exclude the
Social Security and Medicare surplus - and to begin a serious discussion of reforms to Social Security
and Medicare to bring them closer into actuarial balance. In the future, as the cash surplus for these
retirement programs winds down, a proximate budget goal might be just a balanced overall budget
(including the retirement programs), though we will still need to confront Social Security and Medicare
issues.
As I have stressed, rules alone cannot create fiscal discipline where none exists. So, in conclusion, let
me reiterate the most important point: restoring fiscal discipline should be one of our nation's most
important priorities. While the current deficits may not be terribly harmful in the short run, a failure to
confront them now will steadily detract from the growth of the economy and will require even more
wrenching changes in the future.