The American Economy

Van Doorn Ooms
Senior Vice President and Directory of Research
Committee for Economic Development

April 17, 1999

I’m honored to join this panel on the American economy. Since I’ve spent much of the last two decades working on fiscal policy, first as a practitioner in the Congress and OMB and more recently at the Committee for Economic Development, I’ll talk briefly about that experience.

First, however, I must confess that I don’t understand all this “new economy” talk. I did a little deep research on the economy and the federal budget a few days ago and discovered the following. When I received my Yale Ph.D. in 1965 the civilian unemployment rate averaged 4.5 percent, the CPI rose 1.6 percent, the NAIRU (as now estimated by the Congressional Budget Office) was 5.6 percent, and the high-employment budget was effectively balanced. Last year, the unemployment rate averaged 4.5 percent, the CPI rose 1.6 percent, the NAIRU was estimated at 5.6 percent, and the high employment budget was effectively balanced. Clearly the economy has been in a steady-state equilibrium for 33 years. Since we all knew how the 1965 economy worked (or thought we did), what’s the problem?

Bill Brainard asked us to tell war stories. I will therefore identify the high point of my career in public service. This was when, as Chief Economist at OMB, I made Life magazine’s select list of the ten or twenty dumbest things anyone said in 1980. Fortunately, time and modesty do not permit me to go into detail. Those who must know can do their own research.

Like others here, I would like to acknowledge the superb training I received here at Yale nearly forty years ago, and especially the debt I owe to Jim Tobin and the late Art Okun. Jim and Art were in fact at the CEA when I did most of my course work, but I later had the extreme good fortune to serve as Jim’s teaching assistant, where I learned what little macro I once knew. I continued to learn from Art after I moved to Washington in 1976. Art was without peer in doing political economy, and his untimely death was a serious loss for sensible national policymaking.

Although it is wonderful to be back at Yale, I must make one final introductory observation, lest the development office become unrealistic about the fund raising potential of this weekend. My excellent training by a superb Yale economics faculty has also entailed heavy costs. Like all of you, I have been deeply influenced by the work of Yale professors over the years. Unfortunately, however, my faith in them went too deep, and I eventually took Robert Shiller’s work on asset pricing seriously enough to act on it. As a result, I figure that Yale owes me some tens of thousands of dollars. I will, of course, factor this into my plans for charitable giving.

Turning now to my area of comparative advantage (isn’t it encouraging that everyone has a comparative advantage?), I will attempt a thumbnail sketch of the evolution of federal fiscal policy over the last two-plus decades. Since the creation of new Congressional budgetary organizations in the mid-1970s -- the Budget Committees and the Congressional Budget Office -- that evolution has been governed largely by changes in the procedures loosely identified as “the Congressional budget process.”

The central story here, of course, is the demise -- some would say death -- of stabilization policy and the shift of macro budget policy from stabilization to longer-term resource allocation. The allocation issues concern not only the familiar contemporaneous choices between guns and butter and between public consumption and investment goods, but also choices regarding national saving, investment, and growth that have profound implications for intertemporal resource allocation and generational equity. An important part of this story, to which I will return, is the replacement of discretionary policy action by formulas and rules.

The demise of stabilization policy, as Keynes would have observed, had its origins in the minds of economists, including the gentleman on my left, Ned Phelps. The Phelps-Friedman-Lucas revolutions substantially weakened the foundations of stabilization policy as understood in the 1950s and early 1960s, which was strongly identified with relatively naive models of Keynes and the Phillips Curve. (Those models now survive principally as straw men for the editors of the Wall Street Journal, but that’s another story.) That weakened foundation then began to crumble under the weight of actual economic experience in the late 1960s and the 1970s, as we learned the hard way about inflationary expectations and momentum and large sacrifice ratios between unemployment and inflation.

The stagflation of the 1970s then sharply eroded public confidence in economic policy and, of course, economists. By the end of the decade, the policy book was open for stories about supply-side economics or, indeed, whatever tales policymakers wished to tell. Vestiges of Keynesianism remained (of necessity) among the number crunchers at CBO and OMB, but they were under incessant attack from those offering new wrinkles in rational expectations and supply-side thinking. So the theoretical and conceptual policymaking environment in the 1980s and 1990s contained no consistent paradigm; Babel had replaced the earlier ivory tower consensus.

This eclecticism was convenient, of course, for the players, who indeed did have many tales to tell. I remember one remarkable set of House Budget Committee hearings in the early 1980s where I learned, in quick order, that the Kemp-Roth tax cut would pay for itself (Congressman Jack Kemp), the defense buildup would pay for itself (Defense Secretary Cap Weinberger), and a large public service jobs program would pay for itself (Chairman Gus Hawkins). The relatively new CBO won no popularity contests for refusing to adopt such imaginative economics in its fiscal projections, but fortunately it was largely successful in protecting the integrity of its old-fashioned estimates.

I find it instructive to divide budget policymaking since the mid-1970s into four (fuzzily defined and overlapping) periods, each roughly characterized by the “principal” by which fiscal policy -- principally the projected post-policy budget deficit -- was set. At the risk of gross oversimplification, I label these periods as: (1) Follow-the-Chairmen; (2) Follow-the-Leader; (3) Follow-the-Numbers; and (4) Follow-the-Rules.

(1) Follow-the-Chairmen (1975-1980) was Congress’s guiding principle in the infancy of the budget process. The new budget committees had little power (by design), and Congressional budgets -- which had few effective enforcement mechanisms -- largely accommodated the priorities of the chairmen of the appropriating and authorizing committees. The Congressional budget was principally a tool for (at last) organizing revenue and spending estimates, not for setting policy targets, despite the use of terminology such as “appropriate deficit” in the budget resolutions. Considerable lip service, and some attention, were given to deficits and inflation, and these concerns grew as inflation accelerated in the late 1970s after the second oil shock.

(2) Follow-the-Leader (1981-1985) became the game with the arrival of the Reagan Revolution and its legacy of large structural budget deficits. Congress suddenly discovered the fiscal implications of the supply-side extravaganza almost immediately after enacting it in August, 1981, and a seventeen-year preoccupation with “the deficit problem” began. In this political environment, the President’s proposed deficit became the de facto fiscal policy target. Congress dared not adopt a larger deficit--but had no similar qualms about adopting its own budget priorities. So began the interminable, sharply partisan, Guns versus Butter Wars of the 1980s.

Fiscal policy targets, of course, are not results, and the ex post deficits vastly and consistently exceeded the targets. This resulted in part from budgetary “smoke and mirrors,” because it was infinitely easier politically to forecast a thriving economy or massage a cost or revenue estimate than to cut a program or raise taxes. (Here was born Gresham’s Law of Budgeting: bad numbers drive out good.) Nevertheless, CBO resisted creative budgeting with reasonable success. What it could not do was to repeal or successfully model Murphy’s Law. Congress and the President nibbled away at the deficit each year, but, in spite of all the rhetoric, the fiscal problem never frightened the politicians enough to compel compromise on a large and effective deficit reduction package.

(3) Follow-the-Numbers (1986-1990) Frustrated by large deficits, alarming deficit projections, and fiscal political gridlock, Congress in 1985 enacted the Gramm-Rudman-Hollings law, which provided a formula for “automatic” cuts in spending if projected deficits did not meet a five-year set of deficit targets fixed by law. Thus we entered the King Canute era of budgeting. This highly countercyclical contraption was described aptly by one of its authors as a “bad idea whose time has come.” Targeting deficits was folly, of course, but few policymakers understood the acute sensitivity of the deficit to small and inevitable errors in economic forecasts and expenditure and revenue estimates. Since automatic spending cuts were triggered only by prospective, rather than retrospective, excess deficits, Gramm-Rudman-Hollings raised the rewards for budgetary evasion and did nothing to deal with Murphy’s Law, so long as Murphy was left out of the estimates. Congress remained impressively resistant to its own efforts to save itself from itself. New, higher deficit targets, of course, had to be legislated when the original set proved unattainable, which only added to the frustration. At the end of the 1980s the deficit remained untamed either by man or formula.

(4) Follow-the-Rules (1991-- ) became the rule in the 1990s. The new Bush administration and the Democratic Congress began an intricate political dance towards compromise in 1989, which led to a major budget agreement in 1990. This agreement produced not only a large package of policies to reduce the deficit, but a new set of budget control rules to replace Gramm-Rudman-Hollings. Unlike the latter, these new rules were fashioned to target variables, and legislative actions, that actually could be controlled. First, legal limits were placed on discretionary appropriations for the five-year period 1991-1995. Second, legislative proposals to cut revenues or increase entitlement expenditures could not be considered unless they provided revenue or spending “offsets” to prevent an increase in estimated deficits. In effect, the new rules locked in current policies, although the discretionary spending caps were set to provide immediate political relief but unrealistically severe longer-term pain.

To the surprise of the failure-fatigued Congress, the new rules worked quite well to contain the deficit, although they of course reduced policy discretion and flexibility. They were extended when a second large deficit-reduction package, heavily weighted towards upper-income tax increases, was enacted in 1993, and again when a much smaller package was enacted in 1997. In effect, the new rules “protected” the budget for several years while policymakers finally took long overdue fiscal action and more recently have blocked legislation (at least to date) that would threaten the newly projected budget surpluses. The surprisingly rapid emergence and large size of those surpluses, however, cannot be credited to the new budget rules. Rather, they result from a long and sustained economic expansion and, especially, the impact of the extraordinary stock market on capital gains, pensions, and other incomes that drive federal revenues.

I would close with two observations:

First, although the budget is no longer an important instrument of discretionary stabilization policy, the automatic stabilizers remain in place. They have successfully survived a series of attempts to amend the Constitution to require balanced budgets. While these attacks are now in remission, eternal vigilance may be required to defend them.

Second, while the new budget rules have improved the fiscal outlook and the prospects for higher national saving, investment, and growth, they are a two-edged sword. In some respects they exacerbate the problem of inter- generational equity that arises from the impending retirement of the baby boomers. Under the best of circumstances, it would be politically very difficult to reduce the growth of social security and Medicare or ask the baby boomers to finance more of their benefits. The new budget rules add to this difficulty by, in effect, holding these programs on “automatic pilot” and pushing the burden of spending restraint onto annual appropriations. Gene Steuerle of the Urban Institute summed up the problem succinctly in recent testimony: “It is ironic that the legacy that the [generally idealistic] baby boomers would now bequeath is one where almost the sole purpose of the federal government would be to care for their consumption needs in retirement.”

The budget landscape is therefore certainly far more attractive than it was only two or three years ago, before the fiscal fruits of this extraordinary expansion began to ripen. But budget challenges, like death and taxes, will be with us always.