October 12, 2008
The Budget Deficit...and Macro Policies Going Forward
Let's assume the Treasury, the Fed and the rest of the community of international financial policymakers are able to stabilize the financial system. What are the fiscal options available, given the borrowing and spending policies of the Bush Administration?
From Chowdhury and Huie, "Skyrocketing Issuance," US Economics/Strategy Weekly (Deutsche Bank, 10 Oct.) (not online):
Treasury issuance is likely to increase to extraordinary levels over the past year. There are 3 components to the issuance picture. The first is the traditional federal budget, which in fiscal year 2009 is likely to increase substantially from the 2008 deficit of around $440 bn. The second are the various Treasury rescue initiatives that involve buying assets or equities; only the expected net cost will be formally recorded on the budget, but the entire gross spending amount will be added to the issuance requirement. Finally, the Federal Reserve's liquidity facilities will also add to issuance, as the Fed no longer has capacity to sell or lend the Treasuries in its portfolio; instead, going forward it will rely on the Supplementary Financing Program, where the Treasury issues bills and deposits the proceeds at the Fed, to finance its lending facilities. In total, we expect net issuance to rise to $3.3 tn over the fiscal year.
For the on-budget contribution to issuance, we are expecting a $775 bn deficit in FY 2009. This is based on the CBO baseline, adjusted for increasing baseline expenses, falling revenue (particularly from corporate income taxes), potentially large fiscal initiatives, and a fiscal stimulus package from the new Administration that would all add up to a near doubling of the traditional measure of the budget deficit. For our estimate, we are assuming $100 bn outlays for FDIC rescues and as a fiscal stimulus, as well as $35 bn above the baseline for purchases of GSE preferred stock. The actual outcome relative to our budget deficit estimate is biased upward, since there could easily be a larger fiscal package, the FDIC outlays could move sharply higher if more banks fail, and tax revenues could fall if the economy enters into a deep recession.
I illustrate where that puts the budget deficit (not net debt issuance) for FY2009, in the context of the CBO's baseline, assuming the 2001 and 2003 tax cuts are made permanent (or alternatively if the cuts are re-arranged, but retain the same budget deficit implications -- see this post).
Figure 1: Budget balance to GDP ratio (blue), baseline (red), EGTRRA/JGTRRA extended (green), and Deutsche Bank estimate for FY 2009 (blue square). Source: Author's calculations based upon CBO, The Budget and Economic Outlook: An Update (September 2008)Table C-2 and Table 1-8 [xls], Deutsche Bank, "Skyrocketing Issuance," and author's calculations.
This means the Bush Administration will bequeath to the next Administration a budget deficit almost as large as that experienced under the Reagan Administration.
(Note: Net debt issuance differs from the budget deficit since the proceeds from debt issuance will be used to purchase assets. See the CBO director's discussion here.)
The report also notes that the maturity of the new issues will be skewed toward short end -- at least the portion not having to do with the budget deficit, largely because of the demands of foreign investors:
...A large proportion of the Treasury issuance will likely be bought by foreign investors, who prefer to buy short maturities. These investors are focused mainly on the currency exposure -- choosing dollar assets versus euro or other currencies -- and less on the yield of the asset. ...
So, the fear that we would be dependent upon foreign capital exactly at the time it was hardest to get capital has come to pass, although not exactly in way I expected. Here, it is likely that we can obtain the financing, but at shorter maturities than we would like otherwise. And excessive reliance on short term debt has, in other circumstances, led to vulnerabilities to capital reversals.
I am compelled to thinking about what could have been. As I wrote about two years ago:
...By virtue of the fiscal and monetary policies of the last five years, the U.S. is ever more dependent on foreign capital inflows to determine interest rates; and indeed the United States is as dependent as it has ever been (at least in the post-War era) on foreign official or quasi-state -- not private investor -- financing. How all the ties binding the world's single largest economy will be unwound is something nobody can be certain of. What we can be certain of is that the choices made by policy makers in the past five years have circumscribed our ability to manage a downturn.
And that was, of course, before the $240-300 odd billions spent in Iraq over the last two fiscal years alone . That being said, there are now many calls for fiscal stimulus in the face of the possibility of a deep and prolonged recession, despite the yawning deficit (contingent liabilities strike!). One particularly persuasive argument is made by Barry Eichengreen; given his knowledge of history, I think his recommendations should be given close attention (although I'm not certain I'd go with 5 ppts. of GDP stimulus, given portfolio balance effects). But the situation does look pretty dire -- as indicated by the WSJ survey of forecasters.
Figure 2: Output gap, calculated as log deviation from potential GDP, from 26 Sep release (blue line), and implied GDP gaps from WSJ survey (October survey, red line) and highest for 2008-09 from MacroEcon Global Advisers (teal), and lowest from MFR (green). Source: BEA, CBO [xls], WSJ [xls], and author's calculations.
(Note that this figure differs from Figure 2 in this post in that the "low" forecast was for the 2008Q3-09Q2 period, while this "low" forecast is for the 2008Q4-09Q4 period; the "hi" forecast is MacroEcon Global Advisers in both instances, though).
The mean forecast is for output gap in excess of 4% (log terms) by 2009Q4. While not unheard of, there remains considerable downside risk. The low-growth forecast implies a substantial 6% gap (albeit one less than the 8% gap in 1982Q4). The high estimate by MacroEcon Global Advisers indicates only about a 1% negative output gap, but as one can see from the relation of this forecast to the mean forecast, it's an outlier. This forecaster's forecast for the 2008Q3-09Q4 period is about 4 standard deviations (!) from the mean.
Figure 3: Histogram for 2008Q3-2009Q2 growth rates. Source: WSJ [xls].
If we were to undertake further fiscal stimulus, how should we structure it? I would say the way not to proceed is by enhanced tax cuts to the highest income quintiles. The marginal propensity to consume is highest for the liquidity constrained invidividuals, so that would argue for skewing any additional tax cuts to lower income households, if tax cuts are to be pursued at all.
We really need the biggest bang for the buck, given that we have borrowed so much already. That should be an organizing principle for any fiscal policy initiative, and I think is congruent with EconomistMom's admonition to not abandon fiscal responsibility even in these dire straits. In a macro context, transfers (such as unemployment insurance) will also have a greater impact for the same reasons as why tax cuts aimed at lower income groups have biggest multiplier effects. Counterarguments that extended unemployment insurance payments will only be saved make sense in a permanent income context; but if liquidity constraints are binding, recipients are more likely to spend a higher proportion.
As anybody who's taken intermediate macro knows, in a Keynesian framework (arguably the relevant one when there are underutilized resources in the economy, i.e., when the aggregate supply curve is pretty flat), a dollar's worth of expenditures on goods and services yields a larger multiplier than that on transfers or tax cuts. This suggests that supporting already planned investment in infrastructure -- by states and municipalities that are currently liquidity constrained , and squeezed by declining tax revenues -- would be a more effective way of supporting aggregate demand than tax cuts (state and local balance on a NIPA basis has decreased by about 1 ppt of GDP since 2006Q1, suggesting that there will be further compression in state and local spending as the balanced budget requirements, credit constraints, and declining tax receipts collide). That suggests aid to states as a means of fast spending (the argument against discretionary countercyclical fiscal policy is usually that the outside lag is too long).
Still, too bad we didn't get to a zero structural budget balance (last seen in 2000)  when we had the chance.
Figure 1 from CBO, The Cyclically Adjusted and Standardized Budget Measures, October 2008. "The cyclically adjusted deficit or surplus attempts to filter out the effects of the business cycle. The standardized budget measure removes the effects of other factors in addition to those of the business cycle. Potential gross domestic product is the level of output that corresponds to a high level of resource—labor and capital-use. The shaded vertical bars indicate periods of recession. (A recession extends from the peak of a business cycle to its trough.) The dashed vertical line separates actual from projected data."
Note: The CBO projections assume the EGTRRA/JGTRRA provisions expire, as established in the original legislation.
A comprehensive survey of the effectiveness of discretionary, counter-cyclical fiscal policy is in Chapter 5 of the IMF's World Economic Outlook. [pdf]
Posted by Menzie Chinn at October 12, 2008 11:28 PMdigg this | reddit
Your website has been a great source the last few weeks! I look forward to reading more.
Posted by: Jeremy at October 13, 2008 12:56 AM
"This suggests that supporting already planned investment in infrastructure -- by states and municipalities that are currently liquidity constrained , and squeezed by declining tax revenues -- would be a more effective way of supporting aggregate demand than tax cuts (state and local balance on a NIPA basis has decreased by about 1 ppt of GDP since 2006Q1, suggesting that there will be further compression in state and local spending as the balanced budget requirements, credit constraints, and declining tax receipts collide). That suggests aid to states as a means of fast spending (the argument against discretionary countercyclical fiscal policy is usually that the outside lag is too long)."
Where do the funds come from that give states and municipalities this largess?
Posted by: Babinich at October 13, 2008 02:47 AM
any thoughts on the impact at the long end from all this issuance ?
Posted by: joe at October 13, 2008 08:16 AM
It appears that this issue has moved far beyond only domestic policy. http://www.thetrumpet.com/index.php?q=5593.3907.0.0
Hopefully Berlusconi is correct. We may be at a point in history where leadership in the world economic community will consider another Bretton Woods Agreement and I do not mean President Bush. If such an agreement actually includes a return to stable linked currencies, preferably by returning to a gold standard, we could see a very quick world recovery.
But that would just be a start. The world economic system must reverse its trend toward central planning and return to free markets.
Another serious condition is an international block to world trade could be developing. Materials will not be loaded onto ships unless letters of credit are in hand indicating that the receiver can pay, so goods are beginning to pile up on docks including incoming and outgoing. In our comparisons to the Great Depression this could be a 21 Century version of Smoot-Hawley.
Posted by: DickF at October 13, 2008 08:22 AM
"If such an agreement actually includes a return to stable linked currencies, preferably by returning to a gold standard, we could see a very quick world recovery."
It's damned near impossible to spend like a drunken sailor (thought they'll give it a shot) when your currency is tied to a hard commodity.
Posted by: Anonymous at October 13, 2008 09:08 AM
Bottom line, a house isn't worth 50 times what a car sells for, and a car isn't worth 10,000 times what a decent loaf of bread sells for. Propping up cars and houses (via "demand management") is a mistake, because then bread gets way way (way) more expensive ... and people need food much more than houses or cars. Misdirected demand is what got us into this mess.
The government should not address solvency until it has a firm policy of triage in place and should first keep it's finances solid so that the dollar doesn't crash later. Despite having blown 2.5 trillion (and partly because of it), the U.S. consumer will be badly hurt by this as the losses are transferred from the population to non-viable institutions. So far it's been very much the Japan solution.
The government could unlock liquidity by guaranteeing interbank settlements
The market will convert the excesses back to sustainable consumer demand. But it takes time. Houses production doesn't change into food production very easily. So it will take time.
Posted by: JIMB at October 13, 2008 09:14 AM
Professor, while being a partisan hack can get you a Nobel Prize in an election year, that slot has already been filled for '08.
Are you going to ignore Speaker Pelosi's call for a return of Congress to pass a $150 billion stimulus bill?
Without a doubt, the Bush presidency has clealy degenerated into financial farce, now. But, early signs are, and past actions show, that the Dems will not be any better. And, I fear as shown by FDR's actions during '33-'39 -- confiscation of gold, burning of crops, maintenance of high real wages -- that they will be worse.
Posted by: jg at October 13, 2008 09:21 AM
Make that third paragraph: the authorities could have guaranteed interbank settlements of paper less-than 91 days to prevent implosion (if that's what we're really facing. With the ability to borrow directly from the Fed, I am not so sure that interbank market is the problem).
Posted by: JIMB at October 13, 2008 09:22 AM
jg: Thank you for your kind and insightful remarks.
Posted by: Menzie Chinn at October 13, 2008 10:39 AM
As for tax cuts on the low end, it is just poltics. The problem is, any cuts won't make much difference as the low end doesn't pay many taxes. So while the multiplier effects may be large, the initial stimulus is low.
Given our current progressive system of taxes where the wealthy pay by far the the most (top 1% pay 37% a share while the bottom half of the income bear only 3.5% of the tax burden), tax cuts for the poor may be fair, but they have little real effect.
Tax cuts for the rich matter since the wealthy have great discretion in how they earn and pay taxes. This is a separate process than a multiplier effect.
No the problem is spending and for this we can thank our President and Congress.
Posted by: toddleem at October 13, 2008 12:05 PM
Okay, wrist slap noted, Professor. Please substitute 'cheerleader' for 'hack.'
Posted by: jg at October 13, 2008 12:14 PM
jg: Question: Would I be a cheerleader if I thought the proposals made sense, regardless of political affiliation? This is a serious question. Neither I nor Jim impugn any commenter's motives for believing what they believe. It would seem to me that that should be a guiding principle for all interacting here (although I am aware this is not true on all blogs, I would hope to elevate the level of discourse here).
Posted by: Menzie Chinn at October 13, 2008 12:36 PM
Yes, congratulations to Paul Krugman for a most, well deserved, overdue Nobel prize in economics. Republican party partisan 'hacks' may feel increasingly persecuted by this move. Understandably.
I would strongly urge that discretionary funds be spent on counselling and any legal, mind-numbing medication for the victims. Close to 50% of the adult population voted for the false prophet Bush, not once but twice. Letting these poor people fend for themselves could have disasterous effects on US labour productivity. Think of it as shoring up the social welfare safety net in order to protect the productive capacity of the US economy.
Menzie Chen: Agree that fiscal caution is in order and also strongly agree that shoring up existing infrastructure projects already on the books is an excellent idea.
Posted by: GNP at October 13, 2008 12:45 PM
Supply side has often been criticized on this forum but I would ask you all to consider how it is dominating this year's election from city, to county, to state and federal.
Obama and McCain, though neither would know supply side if it bit them, are fighting over who has the better tax cut plan. The Democrat pary in my state and in every other state is criticizing Republicans for raising taxes while praising their own candidates as tax cutters. Republicans are doing the same. There is virtually no other issue that comes close to this perversion of supply side economics.
I have said it before, it cutting taxes is the first thing you think of when you hear supply side you know nothing about supply side economics. I doubt there are a handful of politicians who have any idea what supply side economics is and yet the one thing they do understand is that it works and that it wins elections.
Now to those of us who do know, they accept the name now let's try to educate them into what it means. Can you say production (to address the uneasiness of man)?
Posted by: DickF at October 13, 2008 02:45 PM
DickF "In our comparisons to the Great Depression this could be a 21 Century version of Smoot-Hawley."
We seem to have something of a reverse Smoot-Hawley now. I think the net result of Asian currency distortions and what's left of trade restraints is an artificially expanded global trade. The notion that the U.S. "needs" this borrowing may be misplaced. It certainly is not helping U.S. workers. Krugman has rightly pointed to the major flaws in research that purported to show trade is not all that important in keeping U.S. wages down.
Posted by: don at October 13, 2008 08:09 PM
Laughter in middle of stock market madness. Details below:
Posted by: pete at October 14, 2008 12:59 AM
This morning's announcement of preferred investments in banks has very interesting implications for the deficit and policy going forward.
I suggested last week that the Paulson should lock in today's ultra-low interest rates on the liability side of the balance sheet by doing a massive 30-year Treasury auction. What he's doing now is the opposite: locking in ultra-low rates on the asset side of the balance sheet. Yes, the rate purportedly rises to 9% after five years, but that still may not be enough to compensate for one or two bank failures and/or long-run inflation. And can anyone doubt that the 9% rate will be renegotiated when the banks cry poverty and donate to Chris Dodd and Barney Frank's campaigns? Locking in low rates on assets takes inflation off the table and leaves default as the only solution to unsustainable government debt. Now, $250 billion of low-rate assets isn't enough to do it, but I suspect this is only the beginning.
Posted by: W.C. Varones at October 14, 2008 04:58 AM
The 9% dividend after 3 years is meant to be punitive, so that banks will raise private capital enough to buy back preferred shares issued to the Treasury. Treasury very likely does not expect to be paid a 9% dividend except in a handfull of cases.
There is good reason to want to issue long, but right now, our overseas creditors want to lend short. We have a very steep curve now, and it could get steeper if we try to drop a long-end bomb. There has been a long period during which issuing long would have been a good idea, and when doing os would have been better received abroad. Another opportunity missed.
Posted by: kharris at October 14, 2008 07:33 AM
Exactly. Overseas creditors want to lend short because they know that the government is destroying its balance sheet to bail out Wall Street, and rates will be a lot higher in the future.
And that 9% might look punitive to us, but it's a lower rate (and with less dilution!) than the one GS and GE jumped at from Buffett.
Posted by: W.C. Varones at October 14, 2008 08:08 AM
Krugman has rightly pointed to the major flaws in research that purported to show trade is not all that important in keeping U.S. wages down.
And you point is...?
Posted by: DickF at October 14, 2008 08:16 AM
Smoot-Hawley has given protectionism a bad name, but this doesn't mean U.S. workers should put up with asian currency mercantilism. That is not "free trade" either.
Posted by: don at October 14, 2008 10:25 AM