“Virtually all advanced economies are likely to conduct fiscal consolidation at some point in the future to put their fiscal positions back on a sustainable footing.” - International Monetary Fund, World Economic Outlook, October 2010, p.21

The United States, like a number of other countries, needs to figure out how to best design a fiscal recovery package that will not derail a lackluster recovery, while at the same time, phases in debt reduction policies soon enough and aggressively enough to reassure credit markets.

Helpfully, the International Monetary Fund’s chapter “Will it Hurt? Macroeconomic Effects of Fiscal Consolidation” in the most recent World Economic Outlook provides some answers.

The benefits of fiscal consolidation. For a start, the Fund confirms the bulk of research that shows that fiscal consolidation in high-debt countries will be beneficial and likely increase output over the long-run. A reduction in government debt will reduce the crowding out of private investment as the economy approaches full employment. In fact, the reduction in government debt will “crowd in” private investment - which ultimately raises underlying growth - by lowering inflation-adjusted interest rates and reducing debt service payments. This lesson is clearly relevant for the United States.

But what about the short-run? Fund economists also take a close look at the mixed evidence on short-run costs to the economy from fiscal consolidation. The IMF identifies two things that are likely to help mitigate contractionary effects in the short run and over time: focusing on policy changes that are conducive to growth, including what many refer to as structural policy changes (we have suggested, for example, fundamental tax reform including broadening the tax base significantly, in our paper on reforming tax expenditures, and shifting from a consumption-focused to an investment-focused budget), and increased coordination with other nations.

For advanced economies as a group, policies that have relied on spending cuts, particularly cuts in transfers, have tended to be less contractionary than tax-based adjustments—in part because central banks often have responded to spending cuts by lowering interest rates. Given how low rates are in the U.S., though, this may be less relevant now than it would be normally. Moreover, it is not clear how relevant these findings are to the US now – most of the other advanced economies have started with far higher spending and taxes as a share of the economy, which can reduce the scope for adjustment on the tax side and increase incentives to have spending-heavy programs. It is also not at all clear what motivated the central banks to act in response to spending shifts. These points are critical for the US – and it is important to get them right.

The IMF also found that the contractionary effects are worse when many nations engage in debt reduction all at once. This is why, while we watch what is going on in Britain with admiration and awe and keep our fingers crossed it will work, we realize it may well make our own job even more difficult. If the shaky global economy is a table with each country serving as a stabilizing leg, the risk is that the U.S. will be left as one of the only support systems for demand as other countries engage in debt reduction more aggressively. This is, in part, because they have to, since they do not have our dollar and safe-haven advantages, which our creditors perceive as lowering our sovereign risk (at least for the time being – history shows that confidence can shift suddenly). Under these circumstances, competitive currency devaluation can get nasty, as countries try to boost their exports as much as possible to help their economies when fiscal adjustment is underway. More global coordination would be wise, and it can take many forms.

The IMF finds that even in the bulk of the cases in which fiscal consolidation had a contractionary effect on the economy in the short-run, the negative effects on aggregate demand were often offset through stronger growth in net exports and the easing of monetary policy by the central bank. In the current environment however, there may be limits to these offsets: many major trade partners have fiscal adjustment under way simultaneously and not everyone can boost exports through a depreciating currency at the same time; and because interest rates are near zero, central banks may not be able to provide monetary stimulus as they did in the past.

Luckily, the Fund suggests policy actions to increase fiscal adjustment credibility, which could help limit negative short-run effects: strengthening fiscal institutions, reforming pension entitlements and reforming public health systems. “To the extent such measures improve household and business confidence and raise expectations about future income, they could help support activity during the process of fiscal adjustment”. No question, this won’t be easy and it will not be painless, but there are steps we can take to make the transition easier.

Today, Standard and Poor’s reaffirmed their rating of the U.K.'s AAA debt instruments in response to the UK’s recently devised fiscal consolidation plan that is projected to reduce their deficit from around 11 to 3 percent of GDP in 2014. Within the AAA credit rating, S&P raised their outlook of U.K. debt from "negative" to "stable". Their ratings improvement comes as a result of the increased economic growth (by 0.8 percent) that has followed the coalition-implemented new budget and the expectations of future growth to come.

The positive results of the British fiscal consolidation prove the importance of fiscal sustainability for the U.S. as well—we must focus on similar deficit reduction planning if we want to ensure long-term economic growth. Furthermore, this shows that devising plans now for future fiscal consolidation can have positive economic effects in the short-run too, increasing consumer and investor confidence in the overall health of the economy.

With the November elections just two weeks, demagoguing has reached a fever pitch. So, predictably, when the SSA sent a letter to Rep. Earl Pomeroy about how different reform provisions would affect benefit levels, reform opponents (or at least spending side reform opponents) took aim at the most notorious reform plan in Washington right now: Paul Ryan's Roadmap.

The letter estimated the effect of instituting progressive price indexing, raising the retirement age, and switching to the chained CPI-U for COLAs (which by the way, are the proposals we include in our Let’s Get Specific on Social Security paper). All the proposals showed cuts in average benefits, leading CBPP and Pomeroy (who you might recognize from the ad-hoc COLA debacle) to go on the offensive against Ryan's plan, which includes progressive indexing and an increase in the retirement age.

There are a few problems with the attacks. Let's go through them.

• Comparisons to promised benefits: SSA compared benefit levels under different reform options to scheduled benefits. Scheduled benefits assume that all the current benefit calculations remain the same. The problem with this is that the system doesn't have the money to pay these benefits. If no changes are made to Social Security, scheduled benefits won't happen: once the Trust Fund runs out, the SSA will only be able to pay less than 80% of scheduled benefits (and that assumes immediate cuts for all those already retired, which no reform plan would do).
• Using wage-indexed dollars: SSA also used wage-indexed 2010 dollars to measure benefit levels. If you don't look closely enough to realize this, the letter makes it look like these provisions drastically cut the nominal benefit level over time when, in fact, that's not the case. Even if progressive price indexing and an increased retirement age were implemented, nominal benefits and real benefits would still increase over time, since real benefits by definition account for price inflation. The only people who might see their real benefits decrease would be the highest earners. Reform plans merely slow the growth of benefits relative to the scheduled benefits baseline.
• Attacking (and misrepresenting) Ryan's plan specifically: Even though CBPP claims the Goss letter "allows one to calculate the size of the benefit reductions that Rep. Paul Ryan’s budget plan would generate" that is not true. This only measures some of the benefit reduction  provisions of the Roadmap plan, but doesn't include many of the benefit increases, such as the low earner enhancement or the benefits from private accounts. It’s like attacking your company for cutting health insurance benefits while ignoring a big wage increase they also gave you. Listen, Social Security is unsustainable. Just about any credible plan is going to show a reduction in benefits. Critics need not stack the deck against reform—the reality is that benefits will have to be lower than what we have promised.

^{Source: Congressional Budget Office}

• How about producing a plan instead of throwing stones: It's perfectly fine to disagree with a reform plan, but then provide an alternative.. For those who have not, we have to assume the plan is to drain the budget of resources over the next few decades to repay the Trust Funds and then abruptly cut benefits across the board by more than 20% in 2038, when the Trust Funds run out. That must be little comfort to those who will be depending on Social Security for the bulk of their retirement income. Pomeroy to his credit points out that "a cut in benefits after 2037 can be avoided if steps are taken by Congress before that time to improve the financial status of the program over the long-term" but the longer he and others delay action of any kind, the more drastic the "steps" need to be.

On a more positive note, though, an alternative plan was just recently scored by the SSA from Rep. Ted Deutch. Basically, it's a no-benefit-cut scenario. Deutch would eliminate the payroll tax cap (currently at $106,800) and he would provide a small benefit credit--an "AIME+" for the earnings above the cap. Also, it would use the CPI-E for COLAs--which is about 0.2 percentage points higher than the CPI-W--and provide a $250 payment whenever there is no COLA (you know our thoughts on this). 

We applaud Deutch for getting specific on how he thinks we should fix the program. That said, his plan does not do nearly enough to put the system on a sustainable track. Though it technically makes the system solvent through the 75-year period, it does not achieve sustainable solvency since it doesn't get to permanent (near) cash balance. Beginning in 2024, under the Congressman's plan, costs exceed revenue and the system draws on the trust fund (meaning the rest of the budget has to pay for it) until the point when it empties in the 2080s. Keeping the system solvent and achieving cash-flow balance would require eventually raising payroll taxes by another 2 percentage points or so. Effectively, looking to the 75th year, Congressman Deutch's plan would only solve about half the problem.

Nonetheless, we very much appreciate Deutch's willingness to get specific on Social Security. It is certainly more constructive than election year demagoguery and is exactly the type of specific plan we need to start the comparison between different approaches to reform. Thank you, Congressman Ryan and Deutch. Anyone else ready to step up?

David Chavern of the Chamber of Commerce and Christina Romer, former chair of the Council of Economic Advisors (CEA), both joined the Announcement Effect Club this month. Interesting that two people on very different sides of the economic debate have something in common.

First, Romer in a New York Times article on Sunday:

Such backloaded deficit reduction would not hurt growth in the short run — and could raise it. If uncertainty about future budget policy is harming confidence, as some business leaders suggest, spelling out future spending and tax changes could be helpful. More important, showing that policy makers can come together and make essential decisions about our fiscal challenges would reassure all Americans that our economic future is better than the current grim reality.

She notes that backloaded plans have been done before with regards to Social Security and taxes, with some changes not taking effect until years or even decades (think 1983 Social Security changes) after the plans were passed.

It's also important to note that Romer makes this point in an article in which she calls for more stimulus (the title of the article is "Now Isn't the Right Time to Cut the Budget Deficit"). It cannot be stressed enough that short-term stimulus and deficit reduction are not mutually exclusive; in fact, pairing them can make each separate component more effective.

Now on to Chavern, who takes a little different approach to the AEC:

Now, imagine if you will, that we took our biggest and most politically intractable domestic problem - long term deficits and entitlement reform - and solved it!  Not solved it completely or immediately, but adopted a reasoned compromise plan that gave high assurance that long-term deficits would be dramatically reduced over next several decades. All of the sudden, the future of the U.S. doesn't look so bleak. We would have a reasonable fiscal outlook (unlike Europe), a favorable demographic outlook (unlike Europe or China), some of the best creative talent and entrepreneurs in the world and continued access to tremendous natural resources. Where would you want to put your money then?  Maybe, in fact, the pain of long-term deficit reduction could lead to a large short-term economic gain.

While many Club members have advocated for medium-term deficit reduction, few have put solving our long-term problem as a way to stimulate growth. Certainly it would need to be backloaded, since the twin problems of aging and health care cost growth can't be solved overnight. And as reducing medium-term deficits would reduce pessimism about the outlook of the next decade, so would alleviating our long-term imbalances reduce pessimism about the next half-century or so. Imagine: no more of those ubiquitous exponentially growing debt projection charts! Obviously, it's easier said than done.

For a full list of members in the Announcement Effect Club, see here. 

We at CRFB applaud Treasury Secretary Tim Geithner’s support of medium-term fiscal targets, in the run-up to this weekend’s meeting of G-20 finance ministers. In the context of correcting external imbalances, Treasury Secretary Geithner sent a letter (excerpts from the Financial Times) indicating three steps that he believes G20 countries should commit to:

1. Reduce external imbalances. Countries "should boost national savings by adopting credible medium-term fiscal targets consistent with sustainable debt levels and by strengthening export performance."
2. Don't undervalue currencies. Countries should commit to refraining from weakening their currencies, or preventing undervalued currencies from appreciating.
3. IMF Involvement. The IMF should monitor progress on these commitments.

As budget wonks, we find the first goal especially important – although history shows that the importance of avoiding competitive currency devaluations should not be underestimated.

Credible medium-term fiscal targets are a way to begin signaling to markets that we are serious about deficit reduction. With a reasonable target path agreed to (a sort of budget constraint), the challenge will be for policymakers to work together with taxpayers to figure out how the U.S. can sensibly meet our fiscal goals so that we can bring our debt back down to sustainable levels. The Peterson-Pew Commission has argued for a fiscal target of a 60 percent debt-GDP ratio by 2018, and other groups have argued for similar goals.

For why fiscal goals are important and how they can help bring down future debt, see CRFB president Maya MacGuineas's testimony from July before the Fiscal Commission. We hope other policymakers join the Treasury Secretary in supporting fiscal goals.

^{Photo Credit: Chip Somodevilla / Getty.}

Update: This blog has been updated to reflect additional information.

A new report by the Federal Housing Finance Agency shows the agency's first look at how much the government’s financial backing of Fannie Mae and Freddie Mac may cost. The report, released Thursday, provides three scenarios demonstrating the Government Sponsored Enterprises' (GSEs) financial  condition and how much they will cost the taxpayers through 2013.

As a reminder, Fannie Mae and Freddie Mac are two GSEs that back mortgage loan guarantees. They allow banks to sell the mortgages that they make, providing the banks with more capital for loans. This creates a market distortion in which money lent by banks for mortgages is less expensive and less risky for the banks but more risky for Fannie and Freddie. With the 2008 economic collapse and the housing sector calamity that followed, the GSEs required a insignificant infusion of cash through purchases from the U.S. Treasury. This program remains in place today. The Treasury, through authority granted to it in the Housing and Economic Recovery Act of 2008, has provided $148 billion (in gross terms) in assistance to Fannie and Freddie.

Going forward, uncertainty remains with how much more support both GSEs will require. In the August update CBO projects that over the 2011-2020 period, outlays to Fannie and Freddie will run about $53 billion, on top of the $137 billion (in net terms) that has gone out the door already.

FHFA detailed three scenarios in its report: a low-cost, medium-cost, and high-cost scenario. All three scenarios rely on the same assumptions on interest rates, securities pricing, Agency MBS swap spreads, credit growth guarantees, and non-performing loan portfolio growth. The scenarios differ in their treatment of the three different Moody’s housing pricing scenarios:

• The low-cost scenario assumes Moody’s "Stronger Near-term Recovery" house price path, which leads to higher housing prices in a housing market economy;
• The medium-cost scenario assumes Moody’s “Current Baseline” house price paths, which leads to slightly lower future housing prices and then improvement;
• The high-cost scenario assumes Moody’s “Deeper Second Recession” house price paths, which assumes a second economic recession resulting in deep housing price reductions.

^{See Page 5-6 of the FHFA report for a discussion of Moody's projected housing pricing.}

With the uncertainty of the housing market, it is hard to know for sure which of these three scenarios is the most likely, nor is it recommended that the middle scenario be used as a realistic measure since it is no more likely than the other two (see here for a new report from the Fed on the housing market). With the uncertainty of the economy, continued uncertainty over tax policy, problems with the mortgage market (such as the foreclosure legal problems arising now), it is very difficult to project what the housing market will look like over the next three years.

With the current outlays by the government already at $148 billion, the three estimates predict the federal government ultimately will spend billions more. The low-cost estimate adds $73 billion, the medium-cost adds $90 billion, and the high-cost adds $215 billion by 2013. Putting these estimates on par with CBO, which looks at net outlays, FHFA projects $22 billion less than CBO in the low-cost scenario, $9 billion less than the middle-cost scenario, and $96 billion more for the high cost scenario for the next three years.  Also, see Stimulus.org for up-to-date tracking of Fannie and Freddie costs, and all other Fed and economic stimulus actions.

These two GSE are vital to the housing market and we remain quite hopeful about President Obama’s plan for reforming these two entities, which will be released in January. We welcome all other reform plans that  policymakers propose. GSE reform is vital and it should be done sooner rather than later to better insulate taxpayers from exposure and additional cost. Until then, it's just another reason to hope that our economy does not sink into a new recession.

Getting to real solutions to the fiscal challenges facing the country requires asking the right questions. Today CRFB offered “Ten Questions to Ask the Candidates” in order to move the election rhetoric away from the grandstanding and finger-pointing that are dominating the campaign.

Candidates of all stripes are talking about the deficit, yet few are offering specific ideas that will address the issue in a significant way. This new reference from CRFB was designed to help voters identify truly fiscally responsible candidates. The questions involve critical topics such as extending the tax cuts, Social Security, health care, and defense spending.

The deficit has become a top campaign issue, which is promising, but such prominence for the topic will only be helpful if it gets policymakers and candidates for office to seriously talk about the issue and what will be required to address it.

Why is this so important? Our national debt is headed toward previously unseen levels. It is rapidly rising as a share of our economy. The primary drivers are rising health care costs, our aging population, and an imbalance of government revenue and spending.

Soaring debt will cause multiple problems:

Economic: Crowds out private investment, driving up the cost of capital and credit, slowing economic growth, lowering standards of living.

Budgetary: Growing interest payments squeeze out other spending and room for future tax cuts.

Fiscal: Loss of fiscal flexibility for when we need to respond to the next emergency.

Psychological: Uncertainty for individuals and businesses.

Risk: Increases the likelihood of a fiscal crisis.

So ask your candidates the tough questions and demand answers. While you are at it, challenge them to do CRFB’s Stabilize the Debt budget simulator and make their results public.

On Friday, Fed Chairman Bernanke provided a lesson that fiscal policymakers should take to heart: Expectations matter.

In a much anticipated speech at the Federal Reserve Bank of Boston, Bernanke confirmed that the Federal Open Market Committee (FOMC), the Fed's decision making board, is likely to move toward generating more liquidity and adding more downward pressure on interest rates. Fed-watchers were anxious to learn whether Chairman Bernanke would support additional easing (now commonly referred to quantitative easing, round two--or just QE2 for short). That question seems to have been answered with a resounding "yes." With inflation trending too low and unemployment too high, Bernanke said taking further monetary policy steps are warranted.

But then he went on to note:

"To address such concerns and to ensure that it can withdraw monetary accommodation smoothly at the appropriate time, the Federal Reserve has developed an array of new tools. With these tools in hand, I am confident that the FOMC will be able to tighten monetary conditions when warranted, even if the balance sheet remains considerably larger than normal at that time."

Call this the Announcement Effect Club: Monetary Policy version.

Just as a lack of an "exit" from expansionary fiscal policy can lead to big trouble when the economy recovers, the perception that the Fed is a helicopter that perpetually drops money also can cause trouble. Perceptions of both fiscal and monetary policy can be affected by actions that, on their own would seem to be small, but, in fact, “anchor” basic views of where we’re headed in the future. So the Fed has talked about keeping rates low "for an extended period," meaning "we will not raise interest rates for awhile." At the same time,  Bernanke has talked about ways to tighten monetary policy effectively when we reach that point, in an effort to show that the Fed's expanded balance sheet will not be permanent.

This strategy in monetary policy is easily adaptable in fiscal policy. Budget blueprints such as the President's Budget and the Congressional budget resolution (or the lack thereof this year!) show when, how, and to what extent fiscal policy may be expanded or tightened in the future. Legislative actions, such as how Congress deals with the President's Fiscal Commission's recommendations or how the House and Senate handle a possible ad-hoc Social Security payment, can idicate how serious policymakers are about getting the nation's fiscal policy back on a sustainable track.

Expectations matter – and expectations of policy can be extended into the future, as far as the eye can see, whether we’re talking monetary policy – or fiscal policy.

The fiscal world can learn plenty from the Fed here. Fiscal policymakers have been unable to constructively shape expectations that policy will be well- managed. Of course, the number one indication of seriousness would be to enact a medium-term deficit reduction plan that kicks in slowly once the recovery is on firm footing.

To take some lessons from the Fed, just try substituting “fiscal” for “monetary” – and the appropriate fiscal concepts and institutions where applicable – in Bernanke’s remarks:

“To evaluate policy alternatives and explain policy choices to the public, it is essential not only to forecast the economy, but to compare that forecast to the objectives of policy. Clear communication about the longer-run objectives of monetary policy is beneficial at all times but is particularly important in a time of low inflation and uncertain economic prospects such as the present. Improving the public's understanding of the central bank's policy strategy reduces economic and financial uncertainty and helps households and firms make more-informed decisions. Moreover, clarity about goals and strategies can help anchor the public's longer-term inflation expectations more firmly and thereby bolsters the central bank's ability to respond forcefully to adverse shocks.”

Loads of BCS – The first edition of this season’s rankings from the much-maligned BCS is now out. The system uses computer algorithms and polls to determine which two teams will ultimately face off for the college football championship. So, we at The Bottom Line fired up our supercomputers to rank some of the recent developments regarding the political football of fiscal policy.

1. FY 2010 Deficit Near $1.3 Trillion – On Friday, a joint statement from the Treasury Department and OMB put the official federal budget deficit for fiscal year 2010 at $1.294 trillion (See our short blog on this here). At 8.9 percent of GDP, this is the second largest deficit as a share of the economy (just behind last year’s 10 percent) since World War II. The statement attributed the $122 billion improvement over last year to a combination of higher receipts and lower outlays. While individual and payroll tax receipts actually declined, higher corporate income tax receipts and higher earnings from the Federal Reserve’s investment portfolio boosted receipts. The decline in outlays was mostly attributable to significant decreases in spending related to TARP, aid to Fannie Mae and Freddie Mac, and the deposit insurance activities of FDIC and NCUA. Excluding those three programs, outlays for other government agencies and programs increased 5.5 percent. In the statement, the heads of OMB and Treasury “underscored the Administration's commitment to getting Federal finances back on a sustainable path and ending emergency programs that proved instrumental to reviving growth while beginning the process of bringing down our deficit.”
    
2. This COLA War Won’t be So Refreshing – Also on Friday, the Social Security Trustees announced there would be no cost-of-living adjustment (COLA) for Social Security benefits for the second straight year. The automatic COLA was instituted in 1975 to ensure that inflation does not erode the value of benefits. Since a 5.8 percent adjustment was announced in 2008 for benefit levels in 2009, the economic recession brought consumer prices down significantly and they have yet to return to the previous level. Social Security benefits were not lowered when prices fell. House Speaker Nancy Pelosi and others are calling for a vote on a one-time payment of $250 during the upcoming lame duck session. CRFB is strongly against a one-time payment or an ad-hoc COLA (see here and here), seeing it as a fiscally irresponsible political ploy.
    
3. Concern for Deficit High in Poll; Support for Solutions, Not So Much – According to a Bloomberg poll released last week 55 percent of respondents believe that the federal budget deficit “is dangerously out of control and threatens our economic future.” Yet the poll also found that the public is fairly split over whether several possible solutions should be considered or taken off the table. A separate poll from The Hill newspaper found that 52 percent of independent voters see debt reduction as a priority, compared to 39 percent who prioritize increased federal spending to spur the economy.
    
4. Defensive About Defense Spending – Last week 57 members of Congress sent a letter to the White House fiscal commission asking that the defense budget not be immune from the “rigorous scrutiny” that the rest of the budget will be subject to. At the same time, others are warning that looking to defense for savings would be unwise.
    
5. Feldstein Gets Specific – Martin Feldstein has a new paper out with a three-part plan (subscription required) to reduce the national debt to less than 50 percent of GDP. The strategy includes reducing proposed spending increases and tax reductions over the next decade; augmenting “the tax-financed benefits for Social Security, Medicare and Medicaid with investment based accounts;” and reducing tax expenditures. Feldstein participated in CRFB’s recent “Getting Specific” forum and CRFB has encouraged specific ideas to address fiscal imbalances through its new Lets’ Get Specific series.
    
6. Cranford Gives the ‘Hook’ to Announcement Effect – CQ Weekly columnist John Cranford pans the “announcement effect” in his recent column (subscription required). He contends that trusting lawmakers to come together to enact medium and long-term fiscal rules, and especially to follow through on those rules down the road, is the stuff of fantasy. He concludes that “it might be easier to keep Tinkerbell alive.” CRFB, as Cranford notes, is a big proponent of the announcement effect, believing that announcing a credible plan now to reduce the long-term debt to be implemented as the economy recovers will be economically beneficial. Our “Announcement Effect Club” highlights those who agree with this view. Cranford’s skepticism that policymakers will have the political will to carry out such a plan is well taken. We understand that political will is the biggest obstacle and have no fantasies regarding how difficult that will be to overcome. Yet, after being accused by so many of being gloom and doom, it is nice that someone considers us to be wide-eyed optimists.
    
7. States Debate Taxes – USA Today points out that taxes will be on hundreds of state and local ballots in next month’s election. States like California, Massachusetts, and Washington will vote on revenue measures.