Fiscal Responsibility: Obama Takes the Reins

Includes: SPY, TLT
by: Jeffrey Frankel

Now I am a believer.

Few readers of my blog will be surprised to hear that I supported Barack Obama in the election. But I was always skeptical that he would be able to achieve fully his promises to bring candor, responsibility, and bipartisanship to Washington. Experience had convinced me it wasn’t possible. OK, I am still dubious whether it is possible to achieve bipartisanship – even for Obama. The evidence was his failure a week ago to get a single Republican vote for his fiscal stimulus in the House (and only three votes in the Senate) despite his substantial election mandate, the severity of the current recession, and the concessions he made to the other side.

When it comes to honesty and responsibility, however, what he did at the Fiscal Responsibility Summit yesterday was breathtaking. Obama didn’t just promise to cut the budget deficit in half over the next four years. Both his predecessors promised to do that. He provided enough details to make one believe that he actually might be able to do it, despite the remarkably adverse circumstances that he has inherited.

Before I elaborate on how he apparently plans to bring fiscal sanity back to Washington, let me explain what to us policy wonks is the most amazing thing of all: With a few bold waves of his hand, Obama has brought down all the cobwebs of misleading and dishonest budget math that have hopelessly obscured and encumbered the making of fiscal policy at the White House. This is a risk: it means admitting that the budget situation is far worse than the Republicans have been claiming. They could try to blame the appearance of worse numbers on him. But he is doing the right thing. And this is the right time.

To get more specific, here are three kinds of tricks that his predecessor used in order to pretend to be on a path back to fiscal solvency. They sound childish, but they fooled most of the country. (I am skipping the wilder claims, that didn’t fool as many people.) Obama and his team are voluntarily giving up these tricks, even though he probably won’t get much credit for it:

  • Trick #1: Omitting from future budget estimates the cost of the wars in Iraq and Afghanistan. Every year, for the past 5 years, the expensive wars have continued; and every year the White House and its allies in Congress pretended that this was a surprise. Obama is putting the estimated future costs of the wars into the forecasts right now.
  • Trick #2: Pretending in every succeeding budget forecast that you will allow temporary tax cuts such as the “AMT patch” to expire in a few years, thereby bringing in more tax revenue, even though everyone knows you will renew them when the time comes and this is in fact your declared policy. The White House forecasts will now include honest forecasts of future taxes. Gone also will be the similar trick of pretending in the budget forecasts that the government will in the future cut Medicare payments to doctors even though you have no intention of doing so (because it would result in the doctors dropping out of Medicare).
  • Trick #3: Using as the base line for a promise to “cut the budget deficit in half” an artificially high budget deficit that you yourself proposed. This is what Bush did in the fine print of his promise in the 2004 campaign. (Not that he cut the budget deficit at all, in the end. But we will get to actual policies below. Right now we are just talking about ways to fooling the press into reporting misleading claims with a straight face.) Obama has explicitly said that he plans to cut the deficit in half relative to the $1.3 trillion deficit he inherited, not relative to the much higher deficit that will occur in the coming fiscal year as a result of the recession….that is, as a result both of inevitably lost tax receipts and of the fiscal stimulus that Obama correctly deemed necessary to moderate the recession’s severity. This choice of benchmark was brave. After all, he would have been within his rights to say that because he inherited the recession from his predecessor, the corresponding rise in the deficit in 2010 should not count as his responsibility.

Turning from word to deed, how will Obama move the country back toward fiscal responsibility? It won’t be easy, so deep is the current hole we are in. But I perceive four categories of initiatives, each of them encompassing further breaths of fresh air: (1) limiting spending growth, (2) increasing tax revenue, (3) making new initiatives more cost-effective, and (4) long-term entitlements reform.

(1) Limiting spending growth

Three examples of measures that Obama mentioned in his speech that I particularly like:

  • Cut unneeded federal payments to agribusiness. This one is high on the wish list of virtually every economist.
  • Withdraw combat troops from Iraq. Enough said.
  • Reinstate PAYGO (Pay as You Go). This means that if some Congressman proposes a new outlay, they have to show how to pay for it by proposing someplace else to cut. The provision was originally adopted by the first President Bush in 1991 (as part of a courageous budget agreement with congressional Democrats that probably cost him re-election); it was extended by President Clinton in 1993 (without a single Republican vote); it helped a lot to deliver fiscal surpluses by the latter part of the decade (1998-2000); and it was allowed to expire by the second President Bush in 2001 (with the result that the rate of spending growth tripled thereafter).

(2) Increasing tax revenue

Two examples (among other possibilties):

  • Tax investment income earned by hedge fund partners at the same ordinary income tax rates that the rest of us pay. It’s about time.
  • Let Bush’s tax cuts on income for those earning above $250 million expire as scheduled after 2010.

(3) Seeking cost-effectiveness when addressing priorities that the Democrats consider neglected, such as health care and global climate change.

Two examples:

  • Increase the efficiency with which health care is delivered.
  • By 2012, require that companies buy permits for Greenhouse Gas Emissions, rather than giving them all the permits for free. Free allocation would be a big windfall to utilities and others because they will in any case pass on much of the increased cost of energy to consumers.

(4) Long-term entitlements reform.

The overwhelming problem in the longer term is the coming deficits of Social Security (big) and Medicare (much bigger). The easy thing for Obama to do would have been to put off any attempt to deal with them until after he had put behind him the financial crisis, recession, and first steps toward budget responsibility. But he has now said that he wants to put in place during his first year in office the process to deal with the entitlements problems.

Everybody familiar with the facts has always known how to fix Social Security. The solution is not all that hard, but is politically painful to enact. The answer is some combination of three changes:

(i) progressive indexation of benefits. (Current retirees would not have their benefits cut, not even relative to what they otherwise would have been. Really);

(ii) raising the retirement age. (Just a little. Really. And let’s exempt workers who do heavy manual labor); and

(iii) making upper-income workers pay higher payroll taxes than those earning $107,000.

I have no inside knowledge if this is what Obama is planning. The game in the past has always been that no politician would propose any combination of these three things, because if he or she did, members of the opposite party would promptly attack him. So the thing to do is to form a study group comprising knowledgeable members of both parties in the Congress, have them meet for one year, and then come out holding hands and simultaneously declaring their support for a precise package of this sort.

This was the strategy Bill Clinton chose to address Social Security, after having successfully delivered on his earlier promises to cut the budget deficit in half in his first term and then to eliminate it entirely. Before the year was up, the Republicans decided they would rather impeach him than solve the Social Security problem. In this sense Obama is taking up where Clinton left off eight years ago. Too bad the country sank $5 trillion in the hole in the meantime.