Fiscal policy will matter

Challenge, Jan-Feb, 1998 by Wynne Godley, George McCarthy

CBO assumes that policymakers will continue to abide by the discretionary spending limits set in law through 2002. Doing so will entail a competition for increasingly scarce resources, since the legislated level of spending for 2002 is not much higher than this year's level. Compared with the amount necessary to keep up with inflation, discretionary spending will have to be reduced by $60 billion by 2002 to comply with the statutory cap.

The CBO predicts increases in outlays for mandatory spending, particularly Medicare, Medicaid, and Social Security, which account for about three-quarters of all federal outlays. These expenditures will prop up federal outlays through 2002 and, coupled with the tax reductions, will generate a mildly rising fiscal stance.

The CBO projects that outlays will be reduced by $198 billion from 1997 to 2002 while revenues will be decreased by $80 billion. based on these estimates, the federal budget is expected to move into surplus by 2003.

State budgets have been roughly in balance for the past five years. State-level estimates for 1997 show higher-than-expected revenues (something noted but not accounted for at the federal level by the CBO), which will generate small surpluses. Although the states have run surpluses for long periods in the past, it seems reasonable to assume that their budgets will remain in balance during the next five years. Combining the sluggish federal fiscal stance forecast by the CBO with a neutral stance for the states means that the general government fiscal stance is forecast to grow at an average annual rate of less than 1.3 percent between 1996 and 2002. This is far below the annual growth of productive potential, which has probably averaged above 2.3 percent in recent years.

Conclusion

Using the model described above, we have carried out hundreds of simulations of developments over the next five years, using a wide range of assumptions about the key variables. We do not show any of these simulations here because, over a wide range of possible outcomes, we are not convinced that one is more likely to occur than another. Our model is nothing more than a way of organizing six or seven crucially important factors to make them relatively easy to think about quantitatively and consistently; it tells us nothing that we cannot express in words.

While our predominant concern is with strategic developments over a four- or five-year period, it seems clear that we have already entered a period of what our late colleague, Hyman Minsky, called "financial fragility" - that is, borrowing, particularly by households, has been proceeding at such a pace that the burden of indebtedness now represents a serious threat to stability. While another credit crunch like the one in 1991 is not inevitable, the average household debt-to-income ratio is now so high, and the servicing requirement already so burdensome, that one is bound to take seriously the possibility that the credit flow will at some point go abruptly into reverse. This could happen at any time. Interest rates, for instance, could jump again. But even if interest rates do not rise, the level of indebtedness is so high that a severe fall in income would be compounded in its disinflationary impact by the continuing need to make interest payments. But our main conclusion rests not on the view that there will be another debt deflation, but simply on the opinion that the growth of net lending cannot continue much longer.(11)