A Debt Limit Strategy Rather Than Tactics

The recent debate about the debt limit focuses on the negative economic impact of a decision by the government not to increase the debt limit. That’s why President Obama says he is asking for clean debt limit increase—one not linked to spending reductions, saying that a default would cause economic harm, and that we should not play chicken with the American economy.

But with current high and growing debt levels a clean debt limit increase would also hurt the economy. If politicians just increase the debt limit now without reducing the rapid growth of spending, then they will be expected to do so in the future and the debt explosion will continue to create a drag on the economy with a likely future crisis. The time pattern may be different with a clean debt limit increase–if kicking the can down the road postpones the harm, but the overall impact is negative, and it could be worse if there is a debt crisis.

There is an obvious way to prevent both evils: follow a policy strategy which links debt limit increases to reductions in the growth of spending. By focusing on tactics–games of chicken, leverage and threats—Washington is ignoring this sensible policy strategy.

In a recent technical paper my colleague Bob Hall, rigorously works out the effects of severing the link between debt increases and deficit spending. He defines a parameter which he calls “alpha.” It’s simply the amount by which politicians reduce the deficit when they increase the debt, measured as a fraction of the debt to GDP ratio. In other words, alpha is an indicator of how much the government “leans against” the debt. As Bob puts it: “Alpha is all-important in the analysis….Governments with no tendency to lean against debt, with alpha = 0, face a likelihood but not a certainty of debt crisis.” The problem with a clean debt limit increase is that it effectively sets alpha to 0.

A much better value of alpha, as Bob shows, is around .1, which, if you measure spending reductions on a ten year basis, translates to .1X10 or 1, or, in other words, a strategy like the one-to-one link sometimes called the Boehner rule. So while some may think of such a rule a threat, it is really a strategy, and a sensible strategy in my view.

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.

Visit: John Taylor's Page, Blog

Be the first to comment

Leave a Reply

Your email address will not be published.


*