A Budget Deal. Two Cheers.

When I left the Office of Management and Budget after eight years, I e-mailed all my colleagues (then and still among the best public servants in the country) that after all of that experience and hard work, I had the OMB thing nailed.  If you want to be successful here, I told them, just follow two simple rules:

  1. Don’t sweat the small stuff; and
  2. The devil is in the details.

Similarly today, if you believe some of the commentary about what appears to be an impending budget deal to forestall the “fiscal cliff,” our elected policymakers should follow just two simple rules:

  1. Get a deal that does as much as you can; and
  2. A bad deal is worse than no deal.

Clearly enough, in this instance as well as the earlier one, you have to choose your rule.  And in this instance, I vote for rule number one – noting that it is not the end of the story.

The compelling fact is that a ride over the fiscal cliff is not an option.  You cannot accept a 3 percent bite out of disposable income in an economy that is growing at only about 4 percent (nominal) per year and expect to walk away with all of your appendages intact.  Think recession – deep, painful recession – on top of the still-festering wounds of the financial crisis, and adjacent to the crises in Europe and elsewhere.  But this isn’t about only the direct macroeconomic impact.  Nothing would be worse for the vital, intangible confidence of the American people, the financial markets, and the world than if our elected leaders demonstrate that they cannot govern.  And the across-the-board (as opposed to tailored and targeted) cuts in annual appropriations, and the mechanistic tax increase (as opposed to fundamental reform), would fall far short of the policy needed to create a more efficient government that would serve the people in the years to come.

Many will argue, however, that the monster behind curtain number one does not fully justify choosing the blob behind curtain number two.  The deal being characterized in the press is not the budget solution for which we all have hoped.  The unstated premise behind the negotiations has been that there is some vague target ratio between the amount of revenue increase that Republicans will accept and the amount of spending cuts that Democrats will accept.  As each side has argued down the pain it will bear (a process which likely has not yet reached its end), the other has followed in step; so the total amount of savings has moved gradually downward.  The numbers now discussed are south of the putative targets discussed two years ago, which are themselves south of what is needed given the poor economic performance and worsening debt of those two years.

Furthermore, though the deal will be relatively specific with respect to the tax policy steps to achieve that portion of the deficit reduction, it will be well short of specific with respect to the spending cuts.  This is because the too-simple savings from reducing caps on future-year appropriations are pretty well tapped out – even without the problematic end-of-year across-the-board sequester that this entire anti-fiscal-cliff exercise is intended to avoid.  That leaves cutting the mandatory (or entitlement) portion of the budget, which is much more complex than merely capping appropriations or raising income tax rates (or otherwise passively allowing parts of the 2001 and 2003 temporary tax cuts to expire), and will require more detailed negotiations next year.  This rocky path has been clearly unavoidable for months, but that makes it no more comfortable for the advocates of large spending cuts, and it leaves the precise nature of the ultimate deal up in the air.  And perhaps most disheartening, the deal will include no specific idea to “bend the healthcare cost curve” and thereby address the long-term budget problem that we all fear.

In short, we likely will have not a budget solution, but rather a first step toward a budget solution.  Many will be disappointed.  Some already have begun to roll out the old dictum cited above that “a bad deal is worse than no deal.”

Here are two reasons, which I believe are compelling, to support the deal now – understanding that there will be much more work to do later.

First, it would have been great if the President and the Speaker over the last month could have negotiated a deal to bend the healthcare cost curve.  You should not be shocked that they haven’t.  Legislating fundamental healthcare reform is a long-term task.  Then achieving savings through that fundamentally reformed system will be a long-term process.  That leaves us with a two-step challenge: first, to hold the debt under control in the short term, until the healthcare system can be transformed; and then, to formulate and implement that transformation in the long term.

The kind of deal that appears to be evolving today is a decent first step toward the short-term imperative of taking a bite out of debt growth.  It should not be rejected because it is not the long-term answer, complete with a brand new healthcare system.  Only Santa Claus could get that present down the chimney over the next six days.

And second, a reasonable first step on the debt problem could punch above its weight in terms of economic performance and consequent deficit reduction.  Some macroeconomic forecasters are saying, in private if not in public, that the economy is one reassurance away from a reasonable expansion.  Consumers are holding back in part because they are enormously uncertain about the future; business investors (that is, those who build factories and buy equipment) are holding back because consumers are holding back.  Actually seeing Washington act on the budget – even though that action will be fundamentally restrictive – will resolve that uncertainty.  If that action is carefully and gradually phased in to avoid a hard initial impact, the economy could move from hesitant recovery into solid expansion, giving us the wherewithal to grow and reduce the deficit too.

That is what happened after the large-scale deficit-reduction effort in 1993.  That legislation was derided by some on the grounds that its initial estimates showed the budget deficit actually rising again as a percentage of the GDP by the end of the then-customary five-year forecast horizon.  In fact, however, the deficit not only shrank, it disappeared and became a surplus in the fifth year.  Similarly, the 1993 package initially was estimated only to slow, not actually reverse, the growth of the debt relative to the GDP.  Instead, not only did the debt shrink as a percentage of the GDP, but by the end of the estimating horizon, the federal government was paying down the public debt in dollar terms.  For one brief shining moment, the Treasury actually had to go into the markets and buy back outstanding debt to make the best use of its surplus cash.  (See the two charts below for details.)

Chart1

Chart2

A counter-argument to the improvement in the budget after 1993 is that it occurred because of the strong economy of the 1990s.  However, the parallel argument in 1993 was that the budget legislation would kill investment and work effort, and make such a strong economy impossible.  There is no doubt that the technology boom of the 1990s helped the budget.  Even the “Year 2000 Problem” was in a sense felicitous, because it motivated many firms (and even individuals) to update computer hardware and systems, increasing investment.  But the 1993 deficit reduction clearly did not render such an investment boom impossible; indeed, the legislation in part facilitated investment by helping to hold interest rates down.

Such an economic bonus is of course not guaranteed.  But there is a tendency for economic turnarounds to benefit the budget more than originally estimated.  When the economy outperforms the forecasts, the analysts at OMB and the Congressional Budget Office make formulaic “economic reestimates” of the budget outlook.  But after the fact, the real action in the numbers comes from “technical reestimates,” a term which a late former colleague of mine once translated as “the extent of our ignorance.”  The technical reestimates often move the budget more at major economic turning points than the simple economic rules of thumb would predict.  And this economy could be close to a major turning point.  Economists have been sobered by the finding of Carmen M. Reinhart and Kenneth S. Rogoff that economic slowdowns after financial crises last on average seven years – for the last six years, since our financial crisis.  (It is reminiscent of Melvyn Douglas in the classic 1939 movie “Ninotchka” teasing Greta Garbo, playing a stern Soviet agent, with “Comrade, I’ve been fascinated by your five-yearplan for the last fifteen years!”)  It is time for something to give.

So the correct position on the emerging budget deal – with the caveat that it is still emerging, and so no one has seen the final product – is arguably in favor.  But it is only a first step, and both sides must recognize that there will be much more work to do.  The wrought-iron healthcare cost curve must be bent.  And even after that problem is “solved,” we will need eternal vigilance.  We must remember that there was a time when some people worried that the federal government would pay off the national debt too fast.  We should long for such a worry, and perpetuate it if it (thankfully) returns.

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