FRB: Speech--Chairman Ben S. Bernanke
At the Annual Meeting of the Rhode Island Public
Expenditure Council, Providence, Rhode Island
October 4, 2010
Fiscal Sustainability and Fiscal Rules
The recent deep recession and the subsequent slow recovery have created
severe budgetary pressures not only for many households and businesses, but for
governments as well. Indeed, in the United States, governments at all levels are
grappling not only with the near-term effects of economic weakness, but also
with the longer-run pressures that will be generated by the need to provide
health care and retirement security to an aging population. There is no way
around it--meeting these challenges will require policymakers and the public to
make some very difficult decisions and to accept some sacrifices. But history
makes clear that countries that continually spend beyond their means suffer
slower growth in incomes and living standards and are prone to greater economic
and financial instability. Conversely, good fiscal management is a cornerstone
of sustainable growth and prosperity.
Although state and local governments face significant fiscal challenges, my
primary focus today will be the federal budget situation and its economic
implications.1
I will describe the factors underlying current and projected budget deficits
and explain why it is crucially important that we put U.S. fiscal policy on a
sustainable path. I will also offer some thoughts on whether new fiscal rules or
institutions might help promote a successful transition to fiscal sustainability
in the United States.
Fiscal Challenges
The budgetary position of the federal
government has deteriorated substantially during the past two fiscal years, with
the budget deficit averaging 9-1/2 percent of national income during that time.
For comparison, the deficit averaged 2 percent of national income for the fiscal
years 2005 to 2007, prior to the onset of the recession and financial crisis.
The recent deterioration was largely the result of a sharp decline in tax
revenues brought about by the recession and the subsequent slow recovery, as
well as by increases in federal spending needed to alleviate the recession and
stabilize the financial system. As a result of these deficits, the accumulated
federal debt measured relative to national income has increased to a level not
seen since the aftermath of World War II.
For now, the budget deficit has stabilized and, so long as the economy and
financial markets continue to recover, it should narrow relative to national
income over the next few years. Economic conditions provide little scope for
reducing deficits significantly further over the next year or two; indeed,
premature fiscal tightening could put the recovery at risk. Over the medium- and
long-term, however, the story is quite different. If current policy settings are
maintained, and under reasonable assumptions about economic growth, the federal
budget will be on an unsustainable path in coming years, with the ratio of
federal debt held by the public to national income rising at an increasing
pace.2
Moreover, as the national debt grows, so will the associated interest
payments, which in turn will lead to further increases in projected deficits.
Expectations of large and increasing deficits in the future could inhibit
current household and business spending--for example, by reducing confidence in
the longer-term prospects for the economy or by increasing uncertainty about
future tax burdens and government spending--and thus restrain the recovery.
Concerns about the government's long-run fiscal position may also constrain the
flexibility of fiscal policy to respond to current economic conditions.
Accordingly, steps taken today to improve the country's longer-term fiscal
position would not only help secure longer-term economic and financial
stability, they could also improve the near-term economic outlook.
Our fiscal challenges are especially daunting because they are mostly the
product of powerful underlying trends, not short-term or temporary factors. Two
of the most important driving forces are the aging of the U.S. population, the
pace of which will intensify over the next couple of decades as the baby-boom
generation retires, and rapidly rising health-care costs. As the health-care
needs of the aging population increase, federal health-care programs are on
track to be by far the biggest single source of fiscal imbalances over the
longer term. Indeed, the Congressional Budget Office (CBO) projects that the
ratio of federal spending for health-care programs (principally Medicare and
Medicaid) to national income will double over the next 25 years, and
continue to rise significantly further after that.3 The ability to control
health-care costs as our population gets older, while still providing
high-quality care to those who need it, will be critical not only for budgetary
reasons but for maintaining the dynamism of the broader economy as well.
The aging of the U.S. population will also strain Social Security, as the
number of workers paying taxes into the system rises more slowly than the number
of people receiving benefits. This year, there are about five individuals
between the ages of 20 and 64 for each person aged 65 and older. By 2030, when
most of the baby boomers will have retired, this ratio is projected to decline
to around 3, and it may subsequently fall yet further as life expectancies
continue to increase. Overall, the projected fiscal pressures associated with
Social Security are considerably smaller than the pressures associated with
federal health programs, but they still present a significant challenge to
policymakers.
The same underlying trends affecting federal finances will also put
substantial pressures on state and local budgets, as organizations like yours
have helped to highlight.4 In Rhode Island, as in other states, the retirement of state
employees, together with continuing increases in health-care costs, will cause
public pension and retiree health-care obligations to become increasingly
difficult to meet. Estimates of unfunded pension liabilities for the states as
whole span a wide range, but some researchers put the figure as high as $2
trillion at the end of 2009.5 Estimates of states' liabilities for retiree health benefits
are even more uncertain because of the difficulty of projecting medical costs
decades into the future. However, one recent estimate suggests that state
governments have a collective liability of almost $600 billion for retiree
health benefits.6 These health benefits have usually been handled on a pay-as-you-go
basis and therefore could impose a substantial fiscal burden in coming years as
large numbers of state workers retire.
It may be scant comfort, but the United States is not alone in facing fiscal
challenges. The global recession has dealt a blow to the fiscal positions of
most other advanced economies, and, as in the United States, their expenditures
for public health care and pensions are expected to rise substantially in the
coming decades as their populations age.7 Indeed, the population of the
United States overall is younger than those of a number of European countries as
well as Japan.8
The Need for Fiscal Sustainability
Let me return to the
issue of longer-term fiscal sustainability. As I have discussed, projections by
the CBO and others show future budget deficits and debts rising indefinitely,
and at increasing rates. To be sure, projections are to some degree only
hypothetical exercises. Almost by definition, unsustainable trajectories of
deficits and debts will never actually transpire, because creditors would never
be willing to lend to a country in which the fiscal debt relative to the
national income is rising without limit. Herbert Stein, a wise economist, once
said, "If something cannot go on forever, it will stop."9 One way or the other, fiscal
adjustments sufficient to stabilize the federal budget will certainly occur at
some point. The only real question is whether these adjustments will take place
through a careful and deliberative process that weighs priorities and gives
people plenty of time to adjust to changes in government programs or tax
policies, or whether the needed fiscal adjustments will be a rapid and painful
response to a looming or actual fiscal crisis. Although the choices and
tradeoffs necessary to achieve fiscal sustainability are difficult indeed,
surely it is better to make these choices deliberatively and thoughtfully.
Arguably, the imperative to achieve long-term fiscal sustainability is an
opportunity as well as a challenge. Opportunities for both taxing and spending
reforms are ample. For example, most people agree that the U.S. tax code is less
efficient and less equitable than it might be; moreover, the code is excessively
complex and imposes heavy administrative and compliance costs. Collecting
revenues through a more efficient, better-designed tax system could improve
economic growth and make achieving sustainable fiscal policies at least somewhat
easier. Likewise, many federal spending programs doubtless could be reformed to
achieve their stated objectives more effectively and at lower cost. Certainly,
continued efforts to reduce health-care costs and government health spending,
while continuing to ensure appropriate care for those who need it, should be a
top priority.
Failing to address our unsustainable fiscal situation exposes our country to
serious economic costs and risks. In the short run, as I have noted, concerns
and uncertainty about exploding future deficits could make households,
businesses, and investors more cautious about spending, capital investment, and
hiring. In the longer term, a rising level of government debt relative to
national income is likely to put upward pressure on interest rates and thus
inhibit capital formation, productivity, and economic growth. Larger government
deficits increase our reliance on foreign lenders, all else being equal,
implying that the share of U.S. national income devoted to paying interest to
foreign investors will increase over time. Income paid to foreign investors is
not available for domestic consumption or investment. And an increasingly large
cost of servicing a growing national debt means that the adjustments, when they
come, could be sharp and disruptive. For example, large tax increases that might
be imposed to cover the rising interest on the debt would slow potential growth
by reducing incentives to work, save, hire, and invest. Finally, a large federal
debt decreases the flexibility of policymakers to temporarily increase spending
as needed to address future emergencies, such as recessions, wars, or natural
disasters.
It would be difficult to identify a specific threshold at which federal debt
begins to pose more substantial costs and risks to the nation's economy. Perhaps
no bright line exists; the costs and risks may grow more or less continuously as
the federal debt rises. What we do know, however, is that the threat to our
economy is real and growing, which should be sufficient reason for fiscal
policymakers to put in place a credible plan for bringing deficits down to
sustainable levels over the medium term. The sooner a plan is established, the
longer affected individuals will have to prepare for the necessary changes.
Indeed, in the past, long lead times have helped make necessary adjustments less
painful and thus politically feasible. For example, the gradual step-up in the
full retirement age for Social Security was enacted in 1983, but it did not
begin to take effect until 2003 and will not be completed until 2027, thus
giving future retirees ample time to adjust their plans for work, saving, and
retirement.
Fiscal Rules
Amid all of the uncertainty surrounding the
long-term economic and budgetary outlook, one certainty is that both current and
future Congresses and Presidents will have to make some very tough decisions to
put the budget back on a sustainable trajectory.
Can these tough decisions be made easier for our elected leaders? At various
times, some U.S. Congresses and foreign governments have adopted fiscal rules to
help structure the budget process. Fiscal rules are legislative agreements
intended to promote fiscal responsibility by constraining decisions about
spending and taxes. For example, fiscal rules may impose constraints on key
budget aggregates, such as total government expenditures, deficits, or debt. In
the remainder of my remarks I will discuss the use of fiscal rules to address
longer-term budget problems, beginning with a review of the U.S. and foreign
experience.
The United States has seen several attempts to apply fiscal rules, with mixed
results. In 1985, the Congress enacted the Gramm-Rudman-Hollings law which,
among other things, specified a target path for the federal deficit, including
the elimination of the deficit by 1991. However, the target path proved to be
unattainable, and eventually the entire structure was abandoned. One problem
with this approach was that its primary focus and measure of success was the
current budget deficit. Although the emphasis on the current deficit was
understandable, the approach ran aground of the fact that the budget deficit is
driven not only by the choices of the Congress, but also by the performance of
the economy. If the economy is strong, for example, the deficit is almost bound
to improve, as tax revenues increase and spending on the social safety net
decreases; conversely, if the economy weakens, the deficit is likely to rise,
notwithstanding prior efforts by the Congress to better manage government
spending and taxes.
With fiscal concerns still prominent, in 1990 the Congress and the President
adopted a new approach, with two key elements. First, this alternative approach
capped the level of discretionary federal spending--that is, the spending
subject to annual appropriations, including defense and nondefense purchases of
goods and services. Second, it imposed a pay-as-you-go (PAYGO) rule on tax
revenues and mandatory spending, which is spending that continues automatically
without an annual reauthorization; entitlement spending such as Medicare,
Medicaid, and Social Security makes up most of this category. The PAYGO rule
required that any tax reduction or mandatory spending increase be "paid for"
with offsetting tax hikes or spending cuts, so that projected deficits over the
5- and 10-year horizons would not be worsened. Supported importantly by the
strong economic growth of the 1990s, these rules are seen by many observers as
having helped put the deficit on a declining path; indeed, the federal
government generated a few annual surpluses. The discretionary spending caps and
the PAYGO rule were allowed to expire after the 2001 fiscal year, in part
because concerns about deficits were waning at the time.
Currently, the Congress operates under more-limited PAYGO rules. The rules
require that offsets for spending increases or tax cuts must be found within a
10-year budget horizon, but they also exempt a number of significant tax and
spending programs. Putting aside these details of implementation, given current
budgetary challenges, the key question is whether the traditional PAYGO approach
is sufficiently ambitious. At its best, PAYGO prevents new tax cuts and
mandatory spending increases from making projected budget deficits worse; by
construction, PAYGO does not require the Congress to reduce the ever-increasing
deficits that are already built into current law.
Many other countries have experience with fiscal rules. The European Union,
by treaty, established fiscal rules in the early 1990s, with the goal of
ensuring that all members would maintain sustainable fiscal policies. The rules
specified that countries should keep their government deficits at or below 3
percent of their gross domestic products (GDP), and that government debt should
not exceed 60 percent of GDP. Even before the recent financial crisis and
recession, however, the enforcement mechanisms for these rules did not prevent
these targets from being breached, and fiscal problems in several euro-area
countries have recently been a source of financial and economic stress. European
leaders are working to strengthen their tools for enforcing fiscal
discipline.
Although fiscal rules have not been panaceas in the United States or the euro
area as a whole, a number of other economies, in Europe and elsewhere, seemed to
have found fiscal rules to be helpful in achieving greater budget discipline.
For example, Switzerland, Sweden, Finland, and the Netherlands all realized
improvements in their fiscal situations after adopting rules that limit
spending. Canada saw improvement in its deficit after it implemented spending
limits in the early 1990s, and its ratio of public debt to national income fell
substantially after 1998 when it put in place a "balanced budget or better"
rule. A number of emerging market nations, such as Chile, have also applied
fiscal rules with some success. According to the International Monetary Fund,
about 80 countries currently are subject to national or supranational fiscal
rules.10
Clearly, a fiscal rule does not guarantee improved budget outcomes; after
all, any rule imposed by a legislature can be revoked or circumvented by the
same legislature. However, although not all countries with fiscal rules have
achieved lower deficits and debt, the weight of the evidence suggests that
well-designed rules can help promote improved fiscal performance.11 I will
discuss four factors that seem likely to increase their effectiveness.
First, effective rules must be transparent. By shining a light on the problem
and the range of feasible solutions, transparent policy rules clarify the budget
choices that must be made, help the public understand those choices, and
encourage policymakers to recognize the broader fiscal consequences of their
decisions on individual programs. In particular, transparent fiscal rules may
help solve what economists refer to as a collective action problem. When faced
with spending decisions, most elected representatives want to be seen as
garnering the greatest possible benefit for their constituents. But if a prior
agreement limits the size of the available pie, it may be easier to negotiate
outcomes in which everyone accepts a little bit less. Of course, transparency is
enhanced by good watchdogs. In the United States, the nonpartisan CBO has ably
served that role since 1974. Nongovernmental organizations that focus on budget
issues, such as nonprofit think tanks, can also promote transparency.
Second, an effective rule must be sufficiently ambitious to address the
underlying problem. As I mentioned, PAYGO rules, even when effective, were
designed only to avoid making the fiscal situation worse; they did not attack
large and growing structural deficits. In the current U.S. context, we should
consider adopting a rule, or at least a clearly articulated plan, consistent
with achieving long-term fiscal sustainability. Admittedly, an important
difficulty with developing rules for long-term fiscal sustainability in the
United States is that, given the importance of health-care spending in the
federal budget, the CBO would need to forecast health-care costs and the
potential effects of alternative policy measures on those costs well into the
future. Such forecasting is very difficult. However, any plan to address
long-term U.S. fiscal issues, whether or not in the context of a fiscal rule,
would have to contend with forecast uncertainties.
Third, rules seem to be more effective when they focus on variables that the
legislature can control directly, as opposed to factors that are largely beyond
its control. For example, as I noted, actual budget deficits depend on spending
and taxation decisions but also on the state of the economy. As a result, when a
target for the deficit or the debt is missed, ascribing responsibility may be
difficult. Current congressional procedures generally require the CBO to "score"
proposed spending and tax programs for their budget effects over a specified,
longer-term horizon; this approach, although not without its problems, has the
advantage of linking budget targets directly to legislative decisions.
Fourth, and perhaps most fundamentally, fiscal rules cannot substitute for
political will, which means that public understanding of and support for the
rules are critical. For example, the fiscal rules that Switzerland adopted in
2001 had overwhelming popular support; the widespread support no doubt
contributed to their success in helping to reduce that country's ratio of public
debt to national income. Conversely, in the absence of public support and
commitment from elected leaders, fiscal rules may ultimately have little effect
on budget outcomes. Educating the public about the consequences of unsustainable
fiscal policies may be one way to help build that support.
Conclusion
Today I have highlighted our nation's fiscal
challenges. In the past few years, the recession and the financial crisis, along
with the policy actions taken to buffer their effects, have eroded our fiscal
situation. An improving economy should reduce near-term deficits, but our public
finances are nevertheless on an unsustainable path in the longer term,
reflecting in large part our aging population and the continual rise in
health-care costs. We should not underestimate these fiscal challenges; failing
to respond to them would endanger our economic future.
Well-designed fiscal rules cannot substitute for the political will to take
difficult decisions, but U.S. and international experience suggests that they
can be helpful to legislators in certain circumstances. Indeed, installing a
fiscal rule could provide an important signal to the public that the Congress is
serious about achieving long-term fiscal sustainability, which itself would be
good for confidence. A fiscal rule could also focus and institutionalize
political support for fiscal responsibility. Given the importance of achieving
long-term fiscal stability, further discussion of fiscal rules and frameworks
seems well warranted.
1. For a discussion of fiscal pressures at the state
and local levels, see Ben S. Bernanke (2010), "Challenges for the
Economy and State Governments," speech delivered at the Annual Meeting of
the Southern Legislative Conference of the Council of State Governments, held in
Charleston, S.C., August 2. Return to text
2. For example, see the alternative fiscal scenario in
the Congressional Budget Office (2010), The Long-Term
Budget Outlook (Washington: CBO, June (revised August)).
Stabilizing the ratio of federal debt to national income requires that spending
on everything other than interest payments on the debt be brought into rough
alignment with tax revenues over time. Equivalently, the so-called primary
budget deficit (the budget deficit exclusive of interest payments) must be
reduced to zero. Return to text
3. See the two long-term scenarios for mandatory
federal spending on health care shown in figure 2-3, p. 41, in CBO, The
Long-Term Budget Outlook, in note 2. Return to text
4. See Rhode Island Public Expenditure Council (2010),
Analysis of Rhode Island's Debt Including Pension and OPEB
Obligations (Providence, R.I.: RIPEC). Return to
text
5. See Alicia H. Munnell, Richard W. Kopcke,
Jean-Pierre Aubry, and Laura Quinby (2010), Valuing
Liabilities in State and Local Plans 
(Chestnut Hill,
Mass.: Center for Retirement Research at Boston College, June). Return to text
6. See Pew Center on the States (2010), The Trillion Dollar Gap: Underfunded State Retirement Systems
and the Road to Reform (Washington: PCS,
February). Return to text
7. See International Monetary Fund (2010), Navigating the
Fiscal Challenges Ahead, IMF Fiscal Monitor Series
(Washington: IMF, May). Return to text
8. For example, see Neil Howe and Richard Jackson
(2003), The 2003
Aging Vulnerability Index (Washington: Center for
Strategic and International Studies and Watson Wyatt Worldwide, March). Return to text
9. See Herbert Stein (1997), "Herb Stein's Unfamiliar
Quotations," Slate, May 16, www.slate.com/id/2561. Return to text
10. See the International Monetary Fund (2009), Fiscal
Rules--Anchoring Expectations for Sustainable Public Finances (779 KB
PDF) (Washington: IMF, December). Return to text
11. See IMF, Fiscal Rules, in note
10. Return to text
Last update: October 4, 2010
