During much of the last decade, U.S. fiscal policy has been procyclical, that is, destabilizing. We wasted the opportunity of the 2003-07 expansion by running large budget deficits. As a result, in 2010, Washington now feels constrained by inherited debts to withdraw fiscal stimulus at a time when unemployment is still high. Fiscal policy in the UK and other European countries has been even more destabilizing over the last decade. Governments decide to expand when the economy is strong and then contract when it is weak, thereby exacerbating the business cycle.
Meanwhile, some emerging market and developing countries have learned how to run countercyclical fiscal policy – saving in the boom and easing in the recession – during the same decade that we advanced countries have forgotten how to.
The frenetic debate at any moment for or against “fiscal conservatism” is artificial. It is not the right answer always to shrink any more than it is the right answer always to expand. Americans should take a perspective longer than the annual budget cycle or the bi-annual electoral cycle, let alone the daily news cycle. When the United States was able to take advantage of the long 1992-2000 boom to eliminate its budget deficit, the key legislation had been enacted in 1990 and 1993. Similarly, the big deficits of the last ten years were created by the legislation of 2001 and 2003. Bringing back far-sighted fiscal policy would mean taking steps today to lock in long-term progress toward fiscal responsibility (such as enacting social security reform) but at the same time extending last year’s short-term fiscal stimulus so long as the economy is still weak.
It might help to have ways to insulate fiscal policy from some of the wilder vagaries of politics. I came away from a conference in Chile recently, impressed anew by that country’s accomplishments. It has achieved countercyclical fiscal policy over the last ten years by means of some innovative institutions. Chile has a rule that targets the structural budget balance. In other words, it can only run a deficit to the extent that GDP and the price of copper are below their long-run trends. But a structural budget rule is not enough in itself. Who is to say which deficits are structural and which are temporary? Chile’s key innovation ten years ago was to vest responsibility for determining the long-run trends in GDP and copper prices in two panels of independent experts. Why does this matter? One reason that politicians spend too much in booms is that they convince themselves that deficits are temporary even when they are really structural. Officials in the US and Europe made overly-optimistic forecasts of future growth rates and tax revenues during the 2001-07 expansion. Research shows that this is a systematic pattern. The biased forecasts contributed to unaffordable tax cuts and accelerated spending, which in turn spelled excessive deficits and debts. Today we are living with the consequences of this procyclicality.
[For comments, go to SeekingAlpha.]