A Budget Freeze?

Here I offer some thoughts on President Obama’s new proposal.

Let me start with a statement of what I see as the core challenge facing monetary and fiscal policy at the moment. How can we successfully stimulate the economy in the short run and still maintain confidence in the longer-run reliability of the dollar and solvency of the U.S. government? In terms of monetary policy, the task is to persuade the public that the Fed will achieve 3% inflation over the next two years and yet subsequently contract its balance sheet sufficiently to prevent inflation from getting out of control afterwards. In terms of fiscal policy, the task is to support demand at the moment but then be able to phase out the fiscal stimulus over time as investment and net exports rise to take the place of government spending. Obviously this is not so easy to accomplish, but I feel that Carlo Cottarelli has been thinking along the right lines:

The challenge for policymakers is to formulate strategies for fiscal solvency– what we often call “exit strategies”– and communicate these strategies to the general public….

First, governments can reform their institutional fiscal framework to make it more likely that fiscal adjustment takes place when the time for action arrives. The precise framework will depend on country-specific circumstances. Possible reform options include fiscal responsibility laws, numerical fiscal rules (to take effect only when conditions normalize), fiscal councils tasked with monitoring fiscal developments, improvements in budgetary procedures, and increased fiscal transparency…

Second, various reforms in health and pension entitlements, though politically not easy, can be undertaken without jeopardizing economic recovery. These reforms will not have a large impact on the today’s deficit, but can dramatically improve long-term fiscal trends and signal commitment to fiscal sustainability.

Here is the New York Times’ description of the President’s new proposal:

President Obama will call for a three-year freeze in spending on many domestic programs, and for increases no greater than inflation after that, an initiative intended to signal his seriousness about cutting the budget deficit, administration officials said Monday.

The officials said the proposal would be a major component both of Mr. Obama’s State of the Union address on Wednesday and of the budget he will send to Congress on Monday for the fiscal year that begins in October.

The freeze would cover the agencies and programs for which Congress allocates specific budgets each year, including air traffic control, farm subsidies, education, nutrition and national parks.

But it would exempt security-related budgets for the Pentagon, foreign aid, the Veterans Administration and homeland security, as well as the entitlement programs that make up the biggest and fastest-growing part of the federal budget: Medicare, Medicaid and Social Security.

That sounds like a cosmetic and explicitly short-term approach to the budget problem, and therefore exactly the opposite of what we should be doing. The concern should not be the 2011 deficit, but the deficits in 2015 and beyond. But I see that others have found ways to put this more eloquently, so I outsource to my cyber colleagues:

Brad DeLong: this is a perfect example of the fundamental unseriousness of Barack Obama and his administration: rather than make proposals that will actually tackle the long-term deficit in a serious way– either through future tax increases triggered by excessive deficits or through future entitlement spending caps triggered by excessive deficits– he comes up with a proposal that does short-term harm to the economy as an alternative to tackling the deficit in any serious and significant way.

Paul Krugman: It’s bad economics, depressing demand when the economy is still suffering from mass unemployment…. It’s bad long-run fiscal policy, shifting attention away from the essential need to reform health care and focusing on small change instead.

King Banaian thinks the near-term fiscal contraction will in fact be insignificant:

The president is proposing a partial budget freeze that saves $250 billion over a decade…. That comes out to about 0.6% reduction in spending over a decade, and in the early years about $10-15 billion per year.

But in an update, Brad DeLong opines:

If it really is as small a deal as it now looks, it is not a budgetary and economic disaster– it is a rhetorical, political, and messaging disaster.

A budget freeze?

About James D. Hamilton 244 Articles

James D. Hamilton is Professor of Economics at the University of California, San Diego.

Visit: Econbrowser

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