Linking the Debt Limit Hike To Spending Cuts Is Good Economics

For months now top economic officials in Washington have been arguing that the Congress should vote to increase the debt limit without any reductions in the growth of spending—in other words a “clean debt limit hike.” Just last Thursday Ben Bernanke compared linking the debt limit and spending reductions to playing a game of chicken with U.S. credit worthiness, adding “I think using the debt limit as a bargaining chip is quite risky.” CEA Chairman Austan Goolsbee and Treasury Secretary Timothy Geithner have been saying much the same thing.

But these arguments do not take account of important economic advantages of linking the debt limit to spending reductions. Such a link is good economics in theory and in practice. It is essential to a credible return to sound fiscal policy and an end to the ongoing debt explosion.

Here’s why. In the current political and economic environment—where more people than ever in the United States and around the world are aware of, and paying attention to, the country’s debt problem—the decision about the debt limit will be precedent-setting. They also know that government spending has increased rapidly in recent years, rising from 18.2 percent of GDP in 2000 to over 24 percent now. If Washington does not change the budget game now, people will sensibly reason, it will never change the game. If politicians just increase the debt limit now when spending has been growing so rapidly compared to revenues without correcting that rapid growth of spending, then they will be expected to do so in the future. In contrast if they tie any increase in the debt limit to a halt in the explosion of spending, then people will be more likely to expect them to control spending in the future. Linking the debt limit vote with spending establishes a precedent and valuable credibility.

Another way to think about this approach is to contrast it with the debt failsafe mechanism that President Obama has proposed. Under the debt failsafe plan, if spending grows too rapidly in the future (after 2015) relative to forecast, and the debt thereby rises more than budgeted for, then there would be an automatic reduction in spending. In other words, debt increases and spending reductions are linked in future. But if there is no link in the present, as in a case of a clean debt limit increase, how can one expect one to be followed in the future? How can today’s politicians expect future politicians to adhere to such a policy if they can’t do so today? This is a common problem in economics, called the time inconsistency problem, covered from principles courses to Ph.D. courses.

The principle of linking the debt increase and spending reductions—put forth in a recent speech to the New York Economics Club by Speaker John Boehner—is therefore an important goal which is worth trying to achieve. True, it may run some risks as the deadline is approached, but those risks are far smaller than the risks caused by the debt explosion which is likely if the Boehner link is severed.

About John B. Taylor 117 Articles

Affiliation: Stanford University

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the Bowen H. and Janice Arthur McCoy Senior Fellow at the Hoover Institution. He formerly served as the director of the Stanford Institute for Economic Policy Research, where he is now a senior fellow, and he was founding director of Stanford's Introductory Economics Center.

Taylor’s academic fields of expertise are macroeconomics, monetary economics, and international economics. He is known for his research on the foundations of modern monetary theory and policy, which has been applied by central banks and financial market analysts around the world. He has an active interest in public policy. Taylor is currently a member of the California Governor's Council of Economic Advisors, where he also previously served from 1996 to 1998. In the past, he served as senior economist on the President's Council of Economic Advisers from 1976 to 1977, as a member of the President's Council of Economic Advisers from 1989 to 1991. He was also a member of the Congressional Budget Office's Panel of Economic Advisers from 1995 to 2001.

For four years from 2001 to 2005, Taylor served as Under Secretary of Treasury for International Affairs where he was responsible for U.S. policies in international finance, which includes currency markets, trade in financial services, foreign investment, international debt and development, and oversight of the International Monetary Fund and the World Bank. He was also responsible for coordinating financial policy with the G-7 countries, was chair of the working party on international macroeconomics at the OECD, and was a member of the Board of the Overseas Private Investment Corporation. His book Global Financial Warriors: The Untold Story of International Finance in the Post-9/11 World chronicles his years as head of the international division at Treasury.

Taylor was awarded the Alexander Hamilton Award for his overall leadership in international finance at the U.S. Treasury. He was also awarded the Treasury Distinguished Service Award for designing and implementing the currency reforms in Iraq, and the Medal of the Republic of Uruguay for his work in resolving the 2002 financial crisis. In 2005, he was awarded the George P. Shultz Distinguished Public Service Award. Taylor has also won many teaching awards; he was awarded the Hoagland Prize for excellence in undergraduate teaching and the Rhodes Prize for his high teaching ratings in Stanford's introductory economics course. He also received a Guggenheim Fellowship for his research, and he is a fellow of the American Academy of Arts and Sciences and the Econometric Society; he formerly served as vice president of the American Economic Association.

Before joining the Stanford faculty in 1984, Taylor held positions as professor of economics at Princeton University and Columbia University. Taylor received a B.A. in economics summa cum laude from Princeton University in 1968 and a Ph.D. in economics from Stanford University in 1973.

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