Washington’s Democratic Process Has Us at Fiscal DEFCON

The Washington democratic process is actively undermining U.S. fiscal policy. This is not a uniquely American ailment: all democratic political systems tend towards myopia. Legislators usually have to face the voters sooner than they have to face the consequences of myopic decisions.

When short-term political pressures undermine long-term economic welfare, it is time re-learn the lesson of Ulysses. He ordered his sailors to tie him to the mast to avoid steering his ship onto the Sirens’ rocks. Policy-makers now need to bind themselves to a sustainable fiscal policy, protected against immediate political temptations.

But the strong anti-technocrat instinct of the United States stands in the way of adopting more binding fiscal commitments. It’s a fine instinct – but now stands in the way of effective policy.

In the breathing space offered by the recent deal, we must build some defenses against a possible recurrence of the dangerous and unedifying spectacle we have endured this year. We may want to give up a little democracy in exchange for a dose of technocracy and buy ourselves more sanity in the process.

The level of fiscal commitment should be proportionate to the threat level for national economic welfare just as is with the defense readiness conditions that govern national security policy. The five “defcon” levels of fiscal commitment are as follows:

DEFCON 5: Reputation and information. When a government has high credibility in the financial markets, a triple-A credit rating, a history of fiscal discipline, and political leaders attuned to the risks of imprudence, no commitment device is needed. Nothing, at least, beyond the commitments of independently-produced data on the public finances, an orderly budget process accepted by both parties, and the scrutiny of the bond markets is needed.

DEFCON 4: A Deficit Reduction Target. One way for policy-makers to bind themselves to the mast is to set a target for reducing deficits or public debt by a certain amount by a specific date. Most nations have such targets. Countries in the European Union, for example, have annual deficit targets as a proportion of GDP: and the long-term goal is to get below 3%. In many cases, these targets are missed, and in most cases there is no immediate penalty. But they remain valuable as commitments nonetheless. Progress towards them is assiduously tracked and debated: failure to hit them requires public, often painful, explanations from political leaders. They must persuade voters that there are good reasons why the targets have been missed – for example, a recession – or pay a political price.

DEFCON 3: A ‘Golden Rule’. Many countries have adopted a rule stating that the public finances, excluding investment, should balance over the economic cycle. In other words, they only borrow to invest. Many nations, including the UK, were forced to suspend the rule during the recent recession. But a number of countries have introduced a golden rule since the recession, to help restore market confidence. The degree of commitment implied by either a target or a rule is significantly enhanced by bipartisan agreement of course, but also by the establishment of an independent agency charged with holding the government to account. The IMF recently praised the work of the six year old Swedish Fiscal Policy Council in holding the government to account for progress against its three-year deficit targets. The CBO performs a similar role in the U.S., but without any targets to track or rules to evaluate.

DEFCON 2: A ‘Fiscal Fed’. A tighter binding is to give responsibility for some elements of fiscal policy to an independent agency. After all, we did that for monetary policy a century ago. Perhaps it is no surprise that it is a former Vice Chair of the Fed Alan Blinder, who has led calls for an independent federal tax authority. Congress could set broad parameters for the level of revenues along with specific outcomes related to fairness, growth, and simplicity and then delegate the details to the authority to design a new tax code that achieved these explicit goals, with an up-and-down vote on the results. Blinder believes that lack of technical expertise and myopia undermine the ability of legislators to do tax policy properly. As he wrote, “I believe that Americans have decided, almost subconsciously, that we have drawn the line in the wrong place, leaving too many policy decisions in the realm of politics and too few in the realm of technocracy.” That was in 1997. Nobody listened then. Perhaps somebody will now.

DEFCON 1: A Balanced Budget Amendment. Any of the previous commitments can be overturned with a simple legislative majority – which makes them both more democratic and less credible. The next step is to weave fiscal discipline into the very fabric of democracy, by enshrining a balanced budget in the constitution. In the U.S., this is an idea that comes and goes with the political seasons: most recently, the Republican economists Glenn Hubbard and Tim Kane have argued for a 29TH Amendment requiring balanced public finances over a seven-year time horizon. The commitment value of such an Amendment is clear: since it would take a two-thirds majority and a huge political row to remove it, you can count on it surviving if enacted. That’s not to say that it is impossible to untie the bindings, just very difficult and very unlikely – as unlikely, perhaps, as Congress using its existing powers to overrule any decision by the Fed. By passing such an amendment, the U.S. Federal Government would be following on the heels of France, Germany, Spain and Italy, all of whom, since 2009, have entrenched a ‘golden rule’ into their constitutions.

So what’s the threat level today? Well, we are certainly not down at DEFCON 5 anymore. Political polarization and myopia pose a clear and present danger to the country and its effectiveness in dealing with the rest of the world.

Our view is that we should, at this stage, move to DEFCON 4, and set a clear target for deficit reduction. To go further would represent overreaction. The current congressional fever could break. And the difficulty with very rigid commitment devices for the public finances, such as a constitutional amendment is not only the loss of democracy, but the loss of flexibility. Most countries with ‘golden rules’ were forced to suspend them in the last financial crisis, along with the principal elements of the EU’s Stability and Growth Pact.

As part of the final deal struck this year, both parties should agree to the target set out by the Domenici-Rivlin Debt Reduction Taskforce: federal debt below 60% of GDP by 2020 along with a path for achieving it. To give this target real teeth, we should also legislate an automatic decrease in the cost of living adjustment (COLA) used to adjust taxes and benefit payments, including Social Security, in the fiscal year following any year in which the interim targets were not met (and assuming the economy was not in recession). This would mean pain for everyone in the event of political failure – which should concentrate legislators’ minds.

Now is the moment to bring credibility and commitment to the conduct of fiscal policy. The immediate crisis has passed. Let’s build some defenses now against the danger of a repeat episode.