US Fiscal Problems APPENDICES Jeffrey Frankel Senior Executive Fellows, February 25, 2013

Appendices I: American “fiscal conservatives” are (mostly) not fiscal conservatives. II: Role reversal in Emerging Markets III: The long-term U.S. debt problem – (1) Where did today’s deficits come from? – (2) What will drive deficits in the future? IV: The medium-term outlook

Appendix I: 3 pieces of evidence to support the claim that US “fiscal conservatives” are not: (i ) The voting pattern among the 258 Congressmen who signed an unconditional pledge not to raise taxes: –They had voted for more spending than those who did not sign the pledge. [2] (ii) The pattern of spending under different presidents. [3] (iii) The pattern of states whose Senators win pork & other federal spending. [4] [2] William Gale & Brennan Kelly, 2004, “The ‘No New Taxes’ Pledge,” Tax Notes, July.The ‘No New Taxes’ Pledge [3] JF “Snake-Oil Tax Cuts,” EPI, Briefing Paper “Snake-Oil Tax Cuts,EPIBriefing Paper 221 [4] JF Red States, Blue States and the Distribution of Federal Spending, 3/31/2010.Red States, Blue States and the Distribution of Federal Spending

Vs. the 1990s: The Shared Sacrifice approach succeeded in eliminating budget deficits, importantly by slowing spending. (ii) Spending & deficits both rose sharply when Presidents Reagan, Bush I, & Bush II took office. Budget deficit Spending

(iii) States ranked by federal spending received per tax dollar versus party vote ratio in preceding election Republican states take home significantly more federal $ (relative to taxes paid) than Democratic states. “red” states “blue” states low inflow of US $ big inflow of US $

even while weakening in advanced economies. World Economic Outlook, IMF, April 2012 Historic Role Reversal: Public finances in Emerging Markets have become much stronger since 2000 Appendix II: Historic Role Reversal: Public finances in Emerging Markets have become much stronger since 2000

Other advanced countries have the same long-term problem as the US : Rich countries’ Debt/GDP is the highest since the WWII spike.

US debt > big EMs but < some other advanced countries

9 Remarkable role-reversal in fiscal policy among Emerging Markets Debt/GDP of rich countries (> 90%) is now three times that of emerging markets; => Some EMs Economies are now more creditworthy than some Advanced Economies as reflected in credit ratings or sovereign spreads.

Country creditworthiness is now inter-shuffled “Advanced” countries (Formerly) “Developing” countries AAA Germany, UKSingapore, Hong Kong AA+ US, France AA BelgiumChile AA-JapanChina A+Korea AMalaysia, South Africa A-Brazil, Thailand, Botswana BBB+Ireland, Italy, Spain BBB-IcelandColombia, India BB+Indonesia, Philippines BBPortugalCosta Rica, Jordan BBurkina Faso SD Greece S&P ratings, Feb.2012 updated 8/2012

World Economic Outlook, IMF, April 2012 Another indication of improved EM creditworthiness: EM sovereigns used to have to pay higher interest rates than many US corporates (BB), but now pay less.

Copyright Jeffrey Frankel, In the textbooks, benevolent governments are supposed to use discretionary policy to dampen cyclical fluctuations, expanding at times of excess supply, and contracting at times of excess demand. But in practice, … Governments would raise spending in booms; and then be forced to cut back in downturns Cyclicality of Fiscal Policy

They took advantage of the boom to strengthen their budget positions, allowing them to run deficits when the global recession hit in Some examples: –China was able to respond with big stimulus. –Chile, Korea, Malaysia, Botswana, Indonesia. Another respect in which many EMs have improved their policies since the crises of the late-1990s: A shift from pro-cyclical fiscal policy to counter-cyclical

procyclical } G always used to be pro-cyclical for most developing countries. countercyclical l Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours” Pro-cyclical spending Counter- cyclical spending Correlations between Gov.t Spending & GDP

Correlations between Gov.t Spending & GDP In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy: Negative correlation of G & GDP. Frankel, Vegh & Vuletin (2011) procyclical countercyclical

To summarize the fiscal role reversal, Many Emerging Markets countries have, so far this century, achieved: –Lower debt levels than advanced economies; –improved credit ratings; –lower sovereign spreads; and –less pro-cyclical fiscal policies.

Most Emerging Market countries learned from the debt crises of the 1980s & 1990s. But many leaders in advanced economies failed to do so. They thought it could never happen to them -- most notably, leaders of euroland, –even after the periphery countries violated the deficit & debt ceilings of Maastricht and the SGP; –And even after the Greek crisis hit in late 2009.

But Reinhart & Rogoff remind us: sovereign default is an old story, including among advanced countries – This Time is Different, updated in “From Financial Crash to Debt Crisis,” 2010 Sovereign External Debt: Percent of Countries in Default or Restructuring 50%- Sources: Lindert & Morton (1989), Macdonald (2003), Purcell & Kaufman (1993), Reinhart, Rogoff & Savastano (2003), Suter (1992), and Standard & Poor’s (various years). Notes: Sample size includes all countries, out of a total of sixty six listed in Table 1, that were independent states in the given year 1980 s 1930 s 1870 s 1830 s

Carmen Reinhart & Kenneth Rogoff found a growth threshold in Debt/GDP of 90%. MoneyHoney blog, Feb.20, 2010 ‘Growth in a Time of Debt’ GDP growth Debt/GDP < 90%

20 The historic role reversal Debt levels among rich countries (debt/GDP ratios > 80%) by 2008 reached twice those of emerging markets. Some emerging markets have earned credit ratings higher than some so-called advanced countries. Over the last decade some emerging market countries finally developed countercyclical fiscal policies: They took advantage of the boom years –to run primary budget surpluses and cumulate reserves. By 2007, Latin America had reduced its debt to 33% of GDP, –vs. 63 % in the US. –And so were able to respond to global recession of

The Greek budget deficit never got below the 3% of GDP limit, nor did the debt ever decline toward the 60% limit 21

Appendix III: The Long-term US debt problem (1) From where did today’s debt come? (2) What will drive debt in the future? –The problem is not budget deficits in the next few years. –The problem is the far larger increases in entitlement programs based on current promises.

As of 2000, Debt/GDP had been on a declining path. What changed?

(1) From where did today’s debt come? $13 trillion in 2011 debt, relative to 2001 official projection Over-optimistic economic assumptions in 2001, e.g., growth rate Bush tax cuts (which were supposed to expire in 2011) Wars in Iraq &Afghanistan (so far) } } } Source: The Great Debt Shift: Drivers of Federal Debt Since 2001, Pew Charitable Trust.

Fiscal stimulus { in response to the recession accounts for < 1/3 of deficits and has virtually disappeared by now. CBPP, May 2011 { Obama stimulus

Budget deficits have declined since 2009.

Jan fiscal cliff: Letting the Bush tax cuts expire on schedule would have stabilized debt/GDP CBPP, May 2011

(2) The long-term problem

World Economic Outlook, IMF, April 2012 Euro-recession is pulling down growth. The US is doing better. GDP growth forecasts (percent) Emerging Market growth is slowing too, but solidly >0. Appendix IV: The medium-term outlook.

Source: Macroeconomic Advisers Obama Inauguration End of recession Jan – Dec. 2011, monthly, estimated by Macroeconomic Advisers

After 3 years, the U.S. in 2011 finally achieved its pre-recession level of GDP Jan – Feb. 2012, monthly, estimated by Macroeconomic Advisers Obama Inauguration End of recession

Data Source: U.S. Bureau of Labor Statistics Obama Inauguration End of recession Private sector job creation (by quarter) Average rate of private job creation between the two recessions (Nov Dec.2007) Average rate of private job creation throughout 8 Bush years (Jan Jan.2009)

Possible risks to the recovery in 2013 Euroland: Return of sovereign debt crisis?Euroland: Return of sovereign debt crisis? –and contagion to other high Debt/GDP countries. Political breakdown in Washington?Political breakdown in Washington? like the debt ceiling standoff of August 2011like the debt ceiling standoff of August 2011 which led S&P to downgrade US from AAA to AAwhich led S&P to downgrade US from AAA to AA »for the 1 st time in history. Major oil crisis?Major oil crisis? –from military confrontation with Iran.

If we opt for short-term fiscal stimulus, –or at least on counteracting the current fiscal contraction, what form should it take? U.S. fiscal policy in 2013 Renew some elements of the Obama stimulus – such as infrastructure investment (roads & bridges ) – & giving money to the states so that they can re-hire laid-off teachers, policemen, firemen, subway drivers & construction workers – as in the Jobs Bill that the Congress voted down.

US Fiscal Problems Jeffrey Frankel Harpel Professor of Capital Formation and Growth Harvard Kennedy School