The Debt Crisis in Historical Perspective
The panels that John and I organized for these meetings will explore our fiscal future, focusing on the growing debt crisis in the U.S. We thought that a good way to begin these discussions is with a brief history of the debt crisis.
Over the past half century virtually every developed country has experienced a growth in debt in excess of the growth in income. The upward trend in debt in the long term reflects a persistent bias toward deficit spending and debt, with the growth in spending outpacing the growth in revenue. The fiscal rules and institutions, both formal and informal, that historically constrained debt have proven to be ineffective in many countries.
What has emerged over this period of time is a new era of fiscal rules. The origin of these fiscal rules can be traced to sharp recessions experienced in Switzerland and Sweden in the late 1980s and early 1990s. The fiscal stress experienced in these countries led them to begin experimenting with new fiscal rules, often referred to as debt brakes. A debt brake was first enacted at the cantonal level and then at the federal level in Switzerland. By the early 2000s the debt brakes enacted in these countries were effectively constraining deficits and debt, and this led to the enactment of new fiscal rules at both the national and supranational level in Europe.
The effectiveness of the new fiscal rules in constraining debt varied considerably, especially during the financial crisis that began in 2008. The fiscal rules did not prevent heavily indebted countries, such as Italy, from continuing to pursue unsustainable fiscal policies. Critics questioned whether the new fiscal rules were a credible commitment to fiscal stabilization in Europe, and the default, or threatened default, in several countries reinforced this view.
But the critics were too pessimistic regarding the effectiveness of the new fiscal rules in constraining debt. Some countries, such as Germany, modified their fiscal rules to make them more effective constraints on deficits and debt. Some countries, such as Sweden, introduced new fiscal institutions, such as Fiscal Responsibility Councils to provide more transparency and accountability in the budget process. What emerged is a second generation of fiscal rules that has proven to be more effective in addressing the debt crisis.
We have learned a great deal from the experience with this second generation of fiscal rules, and at least on some issues, there is a growing consensus among economists. The debt crisis cannot be explained as the outcome of optimal fiscal policies in orthodox public finance theory. Whatever the relevance of orthodox theories in explaining fiscal policy in the short run, they have little explanatory power in understanding the last half century of debt accumulation. As Eusepi and Wagner argue, understanding the deficit bias in a democratic society requires piercing the veil of public debt to reveal its transactional nature. When monopolistic elements enter the polity, the preferences of elected officials in deciding to issue debt may differ from the preferences of their constituents. In a society characterized by political capitalism, economic and political elites may influence debt decisions to maximize their welfare, at the expense of taxpayers.
Economists interested in the debt crisis have increasingly turned to political economy theories. Political economy models are based on the shortsightedness effect on elected officials in the decision to issue debt. From this perspective the debt crisis is a public sector failure, the failure to constrain fiscal policy in democratic societies. These studies find evidence that a number of political variables contribute to the shortsightedness effect and deficit bias; including an aging population, political polarization, and electoral uncertainty.
Political economy models are also used to explore the role of fiscal rules in democratic societies. The leviathan model is based on time inconsistency in government preferences. A current government wants to be fiscally irresponsible, but wants future governments to be fiscally responsible. Current governments have an incentive to enact fiscal rules that are easily circumvented in the short run, but that are binding on future governments, restricting their ability to issue debt.
Other studies relax the assumptions of the leviathan model to explore the role of citizens in enacting fiscal rules to constrain fiscal policy. For example, the medium voter model is used to capture the influence of citizens as well as elected officials and special interests in the design and enforcement of fiscal rules. The dynamics of this decision process is observed in the enactment of debt brakes in Europe. Debt brakes are an institutional innovation that can increase the ability of citizens to constrain the issuance of debt. But, in a monopolistic state, elected officials designing fiscal rules will be influenced by special interests as well as their own interests. Thus, the effectiveness of debt brakes will depend upon these different transactions, which change dynamically over time.
The effectiveness of the second generation of fiscal rules differs considerably in different European countries. There is a growing divergence between the European countries that have successfully enacted debt brakes, and the highly indebted countries where debt brakes have had little impact in the long run. Highly indebted countries, such as Italy, continue to pursue unsustainable fiscal policies, despite sanctions from the European Union for violating fiscal rules. Recent fiscal stress tests suggest that Italy has little if any fiscal room to respond to financial crises and other economic shocks.
Analysis of the success and failure of the second generation of fiscal rules focuses on both the design of the rules, and on the political institutions within which the rules are enacted. There is a growing consensus regarding the design of effective fiscal rules. The second generation of fiscal rules is a hybrid, linking the instruments of fiscal policy to fiscal targets. For example, linking expenditures rules to debt targets is considered essential for fiscal sustainability in the long term. Tolerance levels are set for deficits and debt that can trigger more stringent spending constraints in the short term. The deficit and debt brakes provide guardrails to keep fiscal policy from going off track. This hybrid approach incorporates other fiscal rules that can resolve the tradeoff between commitment and flexibility, rules such as emergency funds, escape clauses, and capital investment funds. With these fiscal rules in place countries can not only achieve debt targets in the long run, but also pursue fiscal stabilization policies in response to financial crisis and other economic shocks in the near term.
Economists have turned to political economy models to explore the role of institutions in determining the effectiveness of fiscal rules. There is less consensus on these issues, with some economists questioning whether the new fiscal rules are a credible commitment to fiscal sustainability. Critics point to the absence of supporting institutions, including a functioning capital market, a functioning interjurisdictional competition with tax and spending autonomy, and the absence of insolvency laws and no-bailout rules.
On the other hand, economists have identified some political institutions that can positively impact the effectiveness of fiscal rules. In Sweden effective fiscal rules are implemented in a budget process providing transparency and accountability. New budget institutions, such as Fiscal Responsibility Councils have proven to be effective in providing both transparency and accountability in the budget process.
In Switzerland strong institutions of federalism and direct democracy empower citizens at both the subnational and national level. Swiss cantons have tax and spending autonomy, and interjurisdictional competition. The initiative and referendum give Swiss citizens a voice in fiscal policy that is often missing in other countries which lack these institutions. Swiss economists maintain that decisive for the success of the debt brake has been the support for these rules within the polity. The Swiss debt brake was enacted through a referendum with an overwhelming majority vote. The Swiss debt brakes are supported by other institutions, such as a strict no-bailout rule. Over time, the success of the Swiss debt brake has contributed to what the Swiss economist, Blankert, refers to as ‘dynamically developing credence capital’.
Which brings us to the debt crisis in the U.S., and the issues that will dominate our panel discussions. The U.S. has virtually abandoned fiscal stabilization, and has emerged as one of the most heavily indebted nations in the world. Over the past half century the federal government has continuously incurred deficits, accumulating a debt that now totals more than $21 trillion. Addressing this massive public sector failure will require fundamental reform of our fiscal rules and policies. It will take decades for the federal government to balance the budget and restore a sustainable fiscal policy.
Stress tests reveal that the greatest threat to fiscal, and financial market, stability is not weakness in the balance sheets of private financial institutions, but rather in the growing debt burden and balance sheet of the federal government. Fiscal stress tests have been conducted by the Federal Reserve and by the International Monetary Fund.[i] The Federal Reserve study, using simulation analysis of fiscal policy, reveals that in a major recession the federal government could experience even greater fiscal instability than that during the recent financial crisis. The International Monetary Fund study estimates that in a major recession the federal government’s net asset position could deteriorate by 26 percent of GDP
In our research, John Merrifield and I simulate second generation fiscal rules to estimate their potential impact on deficits and debt in the United States over the next two decades.[ii] Our simulation analysis with these rules in place estimates the impact of a minor recession on revenue and spending. This stress test reveals that the United States has the fiscal space to pursue fiscal stabilization in response to a minor recession, and still reduce debt to a sustainable level. However, this would require stringent spending constraints, and significant savings earmarked for debt reduction. The United States now has little fiscal space to respond to a major recession.
Despite the growing body of evidence from stress tests, there is little debate on the fiscal reforms required to address the debt crisis. The debate in Congress between Republicans and Democrats is whether to cut defense spending or domestic programs. After the failed attempt to reform entitlement programs during the George W. Bush administration, the parties no longer even debate this fundamental driver of the debt.
Fiscal stress tests reveal that solving the debt crisis will require all of the above, i.e. effective constraints on all spending, including entitlement programs. If Congress can’t agree on a budget resolution for the next fiscal year, it is not surprising that they won’t discuss the essential reforms in fiscal rules and policies required to solve the debt crisis. Perhaps we have passed a tipping point, such that Congress is now incapable of solving the debt crisis.
Thus, we are left with unresolved questions, and the fiscal future of the U.S. is uncertain:
Will the U.S., like heavily indebted countries in Europe, continue to pursue unsustainable fiscal policies accompanied by retardation and stagnation in economic growth? If the U.S. now has limited fiscal space to respond to economic shocks, will the next recession result in even greater economic instability than that during the recent financial crisis?
The U.S. is clearly behind the learning curve compared to other countries that have enacted the second generation of fiscal rules. If current fiscal rules have failed, what reforms in fiscal rules and fiscal policies are required to solve the debt crisis? Should the U.S. enact our own debt brake to address the debt crisis?
What reforms in financial markets are required to put effective fiscal rules in place? Do we need supporting institutions in the form of insolvency laws and no-bailout rules?
Could budget process reforms to provide better transparency and accountability in fiscal decisions? Should the U.S. introduce new budget institutions, such as a Fiscal Responsibility Council?
What political reforms are required for effective fiscal rules? Do we need stronger fiscal federalism with interjurisdictional competition and tax and spending autonomy? Do we need to strengthen institutions of direct democracy, relying more on the initiative and referendum in tax and spending decisions?
If Congress fails to enact more effective fiscal rules, should citizens do so through an Article V amendment convention? Would such a referendum energize public support for effective fiscal rules in this country, as it did in Switzerland?
We will explore these and other issues as we discuss the debt crisis and the nation’s fiscal future over the next few days.
[i] International Monetary Fund, Fiscal Monitor: Managing Public Wealth, October 2018pp 11-13.
[ii] John Merrifield and Barry Poulson, Restoring America’s Fiscal Constitution, Lexington Press 2018.