Our policymakers need to focus more how shaping and managing fiscal expectations can help us get our fiscal house in order while supporting growth at the same time. (Hint: No, it’s not magic. It’s thoughtful policy design – which basically means taking great care with timing and composition.)

Today’s disappointing employment report (unexpectedly, June was revised downward and July was weak) prompted a Treasury rally, attributed by the financial press to safe haven flight once again. Deflation concerns however may have also driven investors. With prices rising for the benchmark 10-year note (and for most maturities), yields headed even lower on Friday after drifting downward most of the week. The unemployment news also resulted in stock market losses and a weakening of the dollar (as the prospect of lower interest rates in the US drove investors to seek higher returns elsewhere.)

The weak employment data appears to have increased downside risk concerns of market players. But, it is still early and there is a lot more July data to come. Another important signal about the outlook and policy stance may come next week when the Fed’s monetary policy setting body (the FOMC, or Federal Open Market Committee) meets (August 10).

Market players are focused on many of the same burning questions as the American taxpayer and our policymakers. In a nutshell, what is the outlook for the economy? Are we firmly entering recovery territory, will we go back into recession, or will we see positive but subpar growth (in earlier years, the term “growth recession” was used)? Are the risks on the side of deflation, inflation or neither? And what about persistent high unemployment and the still troubled housing market? When will our financial system get back to “normal”?

And what should policymakers do: should there be more fiscal stimulus (Zandi, Blinder, and Stiglitz have been making the case) or less (consider the debt, near peacetime highs as a share of the economy); can the two fiscal positions be reconciled; should there be additional monetary stimulus, possibly through more quantitative easing – or an unwinding of the Fed’s positions (newspaper leaks in the run-up to next week’s FOMC meeting suggest there may be a debate on precisely this question within the Fed)?

Treasury auctions may also be affected by diminishing supply over time. The Treasury Department has announced that it is gradually downsizing the amount of notes and bonds offered in its quarterly refunding auctions based on its economic projections. According to Treasury officials, future borrowing forecasts will also be based on the assumption that the 2001 upper tax bracket cuts will be allowed to expire as scheduled (President Obama’s budget proposals). Based on borrowing projections, Treasury does not expect to hit the debt ceiling limit (always controversial) until the first or second quarter 2011.

CRFB has been calling for policymakers to set fiscal targets for some time. Apparently we haven’t been clear enough on what that means.

Unfortunately, some in Congress have put a bullseye on the few legislators courageous enough to offer ideas to reduce our mounting debt. The Hill today reports on leaders within the House Democratic caucus tearing into four junior members who were naïve enough to offer a measure to moderately reduce spending.

Congressmen John Adler, Gary Peters, Jim Himes, and Peter Welch were castigated for introducing an amendment to the Transportation, Housing and Urban Development spending bill that would have cut a few programs totaling $1.4 billion, out of a $126.1 billion spending bill. The four Democrats came under intense pressure from their own party and ultimately withdrew the amendment.

This episode not only proves how we got on an unsustainable budget path, but also underscores the utter dysfunction of Congress and why it is so difficult to change course. The overbearing reaction to a modest proposal to trim spending is completely irresponsible.

The U.S. faces a difficult situation. We must support a fragile recovery in the short term while keeping an eye on the long-term debt trajectory that threatens to precipitate an economic crisis somewhere down the road if left unchecked. True leadership and cooperation on sensible solutions will be required to overcome these challenges. Slapping the “stimulus” label on favored spending and tax cuts and brow-beating those brave enough to put reasonable ideas on the table is not leadership; it is the business-as-usual that got is into this predicament.

“The whole point of putting specific cuts on the table was to start a discussion. And boy, did we ever start a discussion. Discussion is maybe a euphemism for some of the pressure we came under,” The Hill quotes Himes. He is later quoted in the piece, “[i]n a sense, [the] experience has only reinforced what we believe, which is that we have a long way to go toward a sane discussion about fiscal responsibility.” Sadly, that is true.

The article also quotes Adler, “[w]hat I advocate, and what I think some other members of both parties advocate, is a more rigorous review of our current spending to eliminate unnecessary programs, or even programs that may be useful, but that aren’t vital right now, and aren’t stimulative to our economy but might end up just increasing our deficit in ways we can’t sustain.” Is this really such a revolutionary concept?

The four Congressman are also sponsors of the REDUCE Acts, which propose to cut the deficit by $70 billion over the next decade. Maybe they should bring bodyguards to the next caucus meeting.

When we call for fiscal targets, we mean that policymakers must set goals for reducing the debt and act within those goals; not set their sights on those willing to be fiscally responsible. Kudos to the four lawmakers who proposed modest measures to get the ball rolling on reducing the debt; let’s hope the terribly disappointing response from their colleagues is not a sign of what we can expect when we start talking about the much larger types of changes that will be necessary to fully deal with our debt problems.

Yesterday morning, Richard Berner of Morgan Stanley, Simon Johnson of MIT, and Joel Naroff of Naroff Economic Advisors testified before the Senate Budget Committee on the state of the economy in the short-term and prospects down the road. All three displayed some concern about the vitality of the economy in the next few years, but they each focused on different aspects: the housing market, financial markets, and consumer spending, respectively.

Berner said that in the short run, the government should take steps improve both the housing situation and the employment situation. He noted that the Home Affordable Modification Program (HAMP) did not have sufficient scope (and has in fact shrunk in recent weeks) to address the foreclosure issue. He suggested both strengthening this program and other housing refinance programs, in addition to attempting to get borrowers to refinance government guaranteed loans. As for employment, he suggested a payroll tax credit (although there is already one in place through the end of this year) and job retraining efforts to mitigate the effects long unemployment has on workers' skills. Also, he said that extending the tax cuts "should reduce uncertainty as well as sustain fiscal stimulus."

Berner also re-affirmed his membership in the Announcement Effect Club when he discussed the positive effects that removing uncertainty would have on the economy.

Mr. Chairman, Ranking Member Gregg, your work as Commissioners on the National Commission on Fiscal Responsibility and Reform is critical. I know you agree that crafting a long-term credible plan to restore fiscal sustainability will ease concerns and uncertainty about future tax hikes and the potential loss of our safety nets.

Johnson focused on the importance of financial crises in the context of fiscal policy. As he notes, the serious deterioration in the medium-term fiscal outlook is mainly due to lower tax revenues from the financial crisis, and the crisis necessitated many actions which added significantly to the debt. He said that the Dodd-Frank bill would not do enough to prevent excessive risk-taking and future financial crises, so we might be in danger for another large jump in debt as a result. As for direct fiscal policy, he brought up the "big three" of new revenue sources: a VAT, carbon tax, and a financial activities tax levied on big banks. On the long-term situation, he said that to get Medicare spending under control, lawmakers should focus more on cutting the cost of health care rather than reducing the amount of health care Medicare pays for, since the latter would simply shift costs around and would be unproductive. Also, during questioning, he said that it was quite possible that there could be a shift away from US bonds (as Treasuries lose their safe haven status) as soon as next year, which underscores the importance of acting--though not actually cutting--now.

Naroff focused somewhat on consumer confidence in the short-run and how it relates to economic performance. He pointed out that there is a cycle between consumer confidence and business confidence, where depressed spending lowers business confidence, which limits their hiring, which hurts consumer confidence further. He added that uncertainty further aggravates this cycle. As for fiscal policy, he offered few specific recommendations, but seemed to be less bullish on demand-side stimulus measures than the other two, saying that "alternatives that produce less initial bang but more long term bucks should be considered....Public capital must be used judiciously and should maximize long term growth potential." Also, he repeated a line that we have said many times: we shouldn't wait until a crisis to deal with our long term debt problem, because then the fiscal adjustment will need to be drastic.

These testimonies came in the first of a series of hearings on the economy by the Budget Committee. This is truly important, because how we deal with both economic weakness and our deficit problems will be critical to the economic future of the U.S.

Finally, the Senate got it right: we have a deficit-neutral stimulus. In fact, the bill would even slightly reduce deficits by $1.4 billion over the coming decade, according to CBO. After months of failed attempts to pass deficit-increasing stimulus packages, Senate Democrats just cleared a hurdle this morning by successfully invoking cloture on the $26.1 billion package, and final passage in the Senate is expected shortly. The package includes an education jobs fund, which was previously attached to (and subsequently removed from) a supplemental bill and an extension of the increased Medicaid payments to states -- previously dropped from HR 4213.  The two provisions would cost $10 billion and $16 billion, respectively. According to CBO, transfer payments to state governments have among the highest bang-for-buck (its multiplier ranging from 0.7 to 1.8), so it's good that in doing a stimulus, the Senate chose both effective policies and a fiscally responsible way of doing them.

Since the cost is not that big, it isn't hard for Senators to find offsets. The most notable offset is an early termination of the ARRA increase in food stamp benefits. The one-time increase was supposed to last until 2014, when the normal inflation-adjusted benefit caught up and overtook the ARRA benefit; however, CBO estimated earlier this year that the benefit would not catch up until 2018. This offset would simply terminate the ARRA benefit in March 2014. Another spending offset is a minor change to the Medicaid AMP, the drug reimbursement formula. Other deficit-reducing changes are mostly minor tax provisions, including the elimination of the advanced EITC -- a move the Administration has called for since last year--and many changes relating to the taxation of foreign income and subsidiaries.

CBO estimated that the bill would reduce deficits by about $1.4 billion from 2010-2020. It was tabled earlier in the week after it was discovered that it would increase deficits by $5 billion. Subsequent changes were made.

We're glad that legislators are getting the message. Lawmakers have decided that additional state support was necessary and then offset those costs over the coming decade, providing short-term spending boosts without further jeopardizing our fiscal health -- exactly what CRFB has been recommending should lawmakers and economists agree that additional spending is needed. After the debacle with HR 4213, when provision after provision was stripped away until a deficit-financed unemployment extension was passed, this bill provides stimulus in a fiscally responsible way. But this is just the beginning of fiscal responsibility -- when you're in a hole, the first thing you need to do is stop digging. There will be plenty more for both Democrats and Republicans to do over the coming months to actually begin reducing deficits in significant ways.

We will have this package up on Stimulus.org as soon as it becomes law.

With Peter Orszag leaving OMB last Friday and Jacob Lew yet to be sworn in, Jeff Zients has been called in to fill the gap as acting director of OMB. Zients currently serves as Chief Performance Officer of the Federal Government, the first person ever to hold that position.

Naturally, his first blog post on OMB's website focused on program performance evaluations. His post linked to a memo written to agencies by OMB on Thursday (when Orszag was still director), directing them on how to conduct voluntary program evaluations that OMB has set aside some money for. As Zients said, "Running rigorous evaluations takes money, but investments in rigorous evaluations are a drop in the bucket relative to the dollars at risk of being poorly spent when we fail to learn what works and what doesn’t."

While his tenure may be very short, we hope that his emphasis on program evaluation is taken to heart by the next OMB director. This emphasis on program efficacy, combined with an eye towards what our priorities are, can be very useful as the government shifts from stimulus to cutting back over the next few years.

Welcome to OMB, Jeff, even if it's only for a short time.

A few weeks ago, Fiscal Commission co-chair Erskine Bowles suggested that in designing a plan, "revenue as a percentage of GDP [should not] be much higher than 21%... [and] we have to work to make the tough choices to bring spending down to the same level" 

Earlier this week, both Matt Miller and the Center on Budget and Policy Priorities criticized this spending target as far too low.  Though we agree that spending cannot be brought down to its historical average overnight, we think that Bowles' goal of letting revenues rise to 21 percent of GDP and eventually bringing spending down to that level is perfectly reasonable. If we don't get spending under control, we can't hope to control our rising debt over the long-run.

In criticizing this 21 percent goal, Miller argued that "federal spending under Ronald Reagan averaged 22 percent of GDP. Under Bowles's view, therefore, the outer limits of the Democratic Party's 21st-century aspirations would be to run government at a size smaller than did a 20th-century conservative icon... [and] Reagan ran government at this size at a time when 76 million baby boomers weren't about to hit their rocking chairs."

CBPP relies on three basic arguments:

• Population aging and health care cost growth means that our biggest programs will cost more than they used to.
• The government has taken on new responsibilities by enacting new programs.
• Interest on the debt will cost more in the future than it has historically, due to higher levels of debt

 Let's address these arguments one at a time.

Miller suggests that bringing spending down to 21 percent of GDP would mean having a smaller state than we did under "conservative icon" Ronald Reagan. Well Reagan may have been a conservative icon, but he did not oversee a small government by any means. In fact, spending as a percent of GDP was larger under Reagan than any other time since World War II, save the current situation. In other words, getting spending down to 21 percent of GDP means spending less than during an era where spending was at its highest, not at its lowest as Miller implies.

During the Clinton Administration spending averaged less than 20 percent of GDP. And by the end of his presidency, it was down to just over 18 percent of GDP. So spending at 21 percent of GDP means spending 1 to 3 percentage points more than our last Democratic president.

That brings us to Miller's second argument (which is also CBPP's first argument): that health care cost growth and population aging threaten to make the same government programs cost far more -- and are already doing so. This is a fair point; as the baby boomers retire and health care grows faster than the economy, the cost of Social Security, Medicare, and Medicaid will skyrocket. But here, we as a society need to make a choice: do we want to maintain historical levels of services, historical levels of spending (and therefore taxes) for these services, or do something in between?

The answer is almost definitely the third, since the first choice is unsustainable and the second choice is unrealistic. In other words, as certain programs tend to become more expensive, we need to do a better job of targeting spending toward where it is needed most -- making hard choices about what we are and aren't willing to spend our scarce resources on. At the same time, of course, we should be trying to attack these drivers directly by encouraging longer working lives and more savings, and by bending the health care cost curve.

We also can't help but point out that while costs of Social Security and Medicare tend to rise faster than GDP, there is no reason that the costs of other programs need to. Defense has already come down significantly since President Reagan was in office, and can come down far more as the wars in Iraq and Afghanistan wind down and as we actually begin to carefully scrutinize normal defense spending. There are many other areas of spending that can and should grow slower than the economy, and others which should shrink or be eliminated altogether.

But what about CBPP's second point, that the government has many new responsibilities now? Maybe so, but governing is about prioritizing. Would Americans be willing to pay higher taxes for a generous Medicare prescription drug plan? For more federal education spending? For larger farm subsidies? Maybe, but since most of these costs have been deficit-financed, we can't know for sure. And if there are newer needs which the government has had to meet, certainly there are older needs toward which the government should no longer be dedicating resources. Let's have that debate, and decide what the government should and shouldn't be spending its money on.

And then there is CBPP's interest argument: the debt is higher, and therefore interest payments are -- so spending will inevitably be a greater share of GDP. Yet if we actually move toward a balanced budget, this simply won't be true. As we bring down the debt, as a share of the economy, it will create a virtuous cycle of deficit reduction. Lower debt means less interest payments means lower spending means lower debt. Not to mention the potential for stronger economic growth (and therefore greater revenues and a higher GDP denominator) which many economists believe will accompany debt reduction.

All these arguments aside, let's keep in mind two things. First, bringing revenues up to 21 percent of GDP would suggest a 3 percentage point increase from the historical average for revenues, and it would mean higher levels of revenue than ever before. Given the fiscal situation, this new normal may indeed be warranted. But taxes cannot do all the lifting -- we need to first and foremost control spending growth. In addition, its important to think about 21 percent of GDP as an aspirational goal for spending; it is what is necessary to balance the budget. Even if we can't get all the way there, as long as our economy is growing faster than our borrowing, we can bring down our debt-to-GDP ratio.

While there is certainly no magic number, 21 percent sounds like a pretty reasonable goal to us.

Add another solid idea to the growing list of proposals to help improve federal budgeting and put the country on a sustainable fiscal course. Representatives Gabrielle Giffords (D-AZ) and Charles Djou (R-HI) yesterday introduced the Truth in Spending Act (H.R. 5954).

The new bill is a modest, yet important, step towards more fiscal accountability in Washington. It recognizes that while cost estimates of legislation from the Congressional Budget Office are objective and represent the best effort to project future costs, predicting the budgetary impact of a bill many years from now is tricky business.

The bill requires the Office of Management and Budget to review cost estimates of legislation five and ten years after it has been enacted. If the costs are higher or savings lower than initially projected, Congress must rectify the discrepancy through a fast-track legislative process. The measure also covers legislation adopted since 2005.

Giffords and Djou explained in The Hill, “We can get a handle on the federal deficit by putting teeth into the cost estimates that legislation is built upon.” It will take a lot more to overcome the mounting debt, but this a good step in the right direction. CRFB applauds the two Members and their over 30 co-sponsors for this thoughtful idea and we hope more lawmakers will follow suit in advancing specific solutions to improve our budget process and fiscal outlook.

Signaling their desire to be more austere, House and Senate appropriators continued pushing their Fiscal 2011 spending bills through the system this week, as the first measures went to the House Floor. The House passed its Transportation-HUD spending bill. It contains $67 billion in discretionary funding, which is $800 million below this year and $1.6 billion below President Obama's budget. House Republicans opposed the bill, saying the funding levels still were too high. The House also passed its version of the Military Construction-Veterans Affairs bill; its $76 billion in discretionary spending amounts to a 1 percent cut below the current fiscal year and is equal to President Obama's request.

Even the popular Labor-Health and Human Services and Education spending bill is more austere than in many years. The Senate Appropriations Committee approved its bill containing $169 billion in discretionary spending; a $5.9 billion boost from last year, but $986 million below the President's request.

Since there was no agreement on a Fiscal 2011 budget resolution, each committee is working from its own bottom-line discretionary spending total. The House Appropriations Committee's allocations total $1.121 trillion; the Senate's allocations total $1.114 trillion. In many past years, the Senate has proposed spending more on discretionary programs than the House proposed. This year, many allocations also are set below last year's funding level and below President Obama's budget request. The President requested a discretionary spending level of $1.128 trillion. Last year, Congress and the President agreed to spend almost $1.090 trillion. 

While the House and Senate committees appear to be slogging through the bills, the process is likely to grind to a halt sometime this fall. At that point, Congress may well pass a Continuing Resolution funding most programs at current levels until sometime after the election. The House and Senate are likely to make most critical funding decisions during a lame duck session.