U.S. Fiscal Policies and Priorities for Long-Run Sustainability
Japan and the IMF
United States and the IMF
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MR. COLLYNS: Good afternoon. Before opening the floor to questions I'd like to very quickly summarize the purpose of our report, and to highlight the main messages for you. The report aims to present a consolidated picture of the IMF staff's recent analysis of U.S. fiscal policy, focusing on both the short and long-term effects of rising deficits, and emphasizing the international as well as domestic perspective. As is widely recognized, recent U.S. fiscal policy has been extremely expansionary. The federal fiscal balance has swung from a surplus of 2½ percent of GDP in fiscal year 2000 to a deficit just under 4 percent of GDP in fiscal year 2003. This will provide extremely valuable short-term support to the U.S. economy, cushioning the extent of the downturn, after the unprecedented collapse of the asset price bubble and the September 11th attacks. It has also put the economy on a path for what now looks to be a robust expansion. This fiscal support has been especially timely since the global economy has generally lacked other sources of growth.
Nonetheless, as the report underlines, the emergence of large fiscal deficits and signs that they will be sustained at substantial levels unless corrective action is taken, raises a number of longer term and multilateral concerns.
First, sustained fiscal deficits lower national savings in the United States and will eventually raise real interest rates both in the United States and abroad, thus crowding out private investment. The eventual cost will be lower global productivity and income growth. These effects are discussed in Section 2 of the report.
Second, higher U.S. fiscal deficits means that federal debt will not be brought down as had previously been envisaged, making the impact of an aging population on Social Security and health care programs even more difficult to deal with.
With respect to Social Security, the United States is in not as quite a difficult situation as some other industrial countries whose populations are aging more rapidly, but the prospects for health care spending are particularly serious, given that the U.S. already has substantially higher health care spending as a share of GDP and the well-known political impediments to meaningful reforms in this area. These issues are dealt with in Sections 3 and 4 of the report.
Third, sustained higher fiscal deficits are likely to exacerbate the global imbalances that are reflected in the very large U.S. current account deficit and corresponding large financing needs. To be sure, the U.S. current account deficit partly reflects the underlying strength of the U.S. economy and the willingness of foreign investors to seek profitable investments in the United States. However, the scale of these flows implies rapidly rising U.S. net external liabilities, and thus an increasing risk of disorderly external adjustments, including through movements in exchange rates.
What can be done? The report offers some suggestions and a broad strategy for addressing the U.S. fiscal problem. A key element must be to re-establish a clear and credible framework for balancing the federal budget, excluding Social Security, over the economic cycle, and restoring discipline over expenditures. With a budget deficit, excluding Social Security, of more than 5 percent of GDP, this cannot be done overnight, but it can be achieved over the next 5 to 10 years, which would still enable a sharp reduction in the debt-to-GDP ratio in the coming decade, allowing more time to fix Social Security and Medicare. If you look at Figure 1.7 in the first section, it is a good illustration of that.
In part, the deficit will be reduced by the cyclical expansion that is now under way, which will absorb spare capacity in the economy. But even assuming tight spending limits and a sharp rebound in revenues, this would still leave a structural deficit of around 2 percent of GDP with the economy operating at full capacity. This is shown in Figure 1.5 of the report.
How to deal with this structural deficit? This undoubtedly will require both tax and spending initiatives. Spending cuts will be difficult especially given already tight limits on non-entitlement spending growth and in the face of increased pressures for security and military-related priorities. In order to make progress in this area, greater weight could be given to reintroducing and strengthening the budget rules contained in the Budget Enforcement Act that have now expired. In particular, we would welcome the reintroduction of caps on discretionary spending and the reintroduction of the so-called Pay-Go limits which require that measures with permanent impact on the budget to be fully offset by savings elsewhere. This is discussed in Section 6 of the report.
On the revenue side, our recommendation would be to focus efforts on tax changes that as far as possible work towards expanding the tax base while maintaining work incentives and simplifying the tax code. Options here include reducing corporate and personal income tax preferences or possibly increasing consumption based taxes, including those on energy.
Finally, and most importantly, there is an urgent need to reform Social Security and Medicare. As regards Social Security, we believe the problem is serious but can still be addressed by relatively small changes in the present system to slow the growth of benefits or increase contribution rates, but the longer such action is delayed, the greater the scale of the measures that will eventually be required. As regards Medicare, the size of the problem is considerably larger, especially now with the addition of a new drug benefit, and the solutions will undoubtedly be more difficult to design. Measures are needed to slow the growth of expenditures and make medical spending more cost effective. Difficult social and political choices will have to be faced, but again, the simple fact is that delaying action will only increase the size of the problem.
Summing up, the recent expansionary stance of the U.S. fiscal policy has certainly been beneficial, supporting the global economy at a difficult juncture. However, it will be important to develop a credible and robust framework to assure that the U.S. fiscal position is a strong one over the long run. This will require determined action to reduce the federal deficit over the next 5 to 10 years and to tackle the difficult long-term problems of Social Security and Medicare.
I will be very happy to respond to your questions.
QUESTION: Good afternoon. I was struck by the recommendation that the U.S. Government focus on consumption taxes in the energy field. This is of course politically sensitive in this country and everywhere else, but could you elaborate a little bit about why you think that's a fruitful area to explore.
MR. COLLYNS: I think just to clarify, the basic message we have is that it will be important to take actions across a full range of areas, both on the spending side and on the revenue side. There's no magic bullet that will solve the deficit problem, whether energy taxes or any other area.
On the tax side, clearly there are difficult social and political issues that need to be faced, including the distributional consequences of any set of tax changes, and those are choices that the United States will have to make. What we can do is provide advice on the sort of tax changes that from an economic point of view would be desirable, and as I say, there are a number of criteria here. It's important to maintain incentives to work. It's important to ensure a broad tax base. And to the extent that taxes can support other social objectives, then that can be a further argument. For example, on energy taxes, increasing taxes on energy would help support environmental objectives both in the United States and more globally. So for that reason we think that it's certainly worth considering energy taxes, but we're not saying that that is necessarily the way that the United States should go.
MR. TOWE: Just to jump in, I think that the reason that we looked at this issue—and you'll see it dealt with in some detail in Section 5 of the report—is that the administration and congress have looked at these issues very closely during the past year. The administration's Clear Sky Initiative has set, I believe, a target for reducing greenhouse gas emissions by 18 percent over a 10-year period, if I recall correctly. The energy bill is obviously before congress. So these are issues that are extremely salient in the present context.
I would just point readers to that section where we summarized some of the research that's been done by the CBO that addresses what the optimal way in which to achieve some of these objectives is. They make the point very clearly that taxes on energy, if you are looking to achieve these environmental aims, can be a very efficient instrument to apply.
QUESTION: This may be in the printed report, but have you attempted to quantify how much interest rates would go up vis-à-vis a certain level of deficit in the deficit-to-GDP ratio?
MR. TOWE: You'll find that detailed in Section 2. I think the amounts were in the range of half a percent to a little over 1 percent. I think the interesting aspect of the analysis there is that—and I think it's somewhat novel —is that we do not simply look at this issue with regard to domestic interest rates. There are a host of studies out there that address that issue, and you'll see them summarized nicely in Table 2.4, but the focus of the analysis in Section 2 is to look at global interest rates because we thought that was an interesting additional insight that we could offer to this issue. And there we were able to find some empirical support for the argument that increases in U.S. public debt can have significant impacts on global interest rates.
QUESTION: I have essentially a two-part question. First of all, what was the impetus for writing the report and releasing it today? Just sort of a housekeeping question.
And then secondly, could you expand a little bit on just the point you were just raising, the global impacts? For instance, you say in your nice preface about the global issues that the--the part on the dollar that it's these--rates--adjustment rates--are disorderly, as you've put it, it could lead to adverse consequences, domestically and abroad. Could you describe what those adverse consequences would be.
MR. COLLYNS: Referring to the first part of your question, this report basically comes from our work on the United States economy. It comes within the framework of our annual consultation with the U.S. Government. This consultation took place during the summer and over the last few months we've been putting together and editing the report, and it just happened to come out today. There's no particular reason why it came out today rather than next week or before Christmas. It's just a matter of the timing of the publication.
In terms of the global impacts of the U.S. deficit, I think this is really a key area driving our concern. We see a very large current account deficit as well as a very large fiscal deficit and believe there is a relationship between the two. The large current account deficit implies that the United States has a need for continuing inflows of foreign financing. As long as those funds are willing to come in, things can move fairly smoothly, but the reality is that the magnitude of the current account deficit is very large and that the net external liabilities of the United States are rising quite rapidly relative to both U.S. GDP and relative also to global savings.
Therefore, we feel there is a substantial risk that the foreign investors' appetite for U.S. assets, and particularly U.S. Government assets, will over time diminish. And we think, at least to some degree over the past year, this has occurred, and this is one of the reasons why there has been weakness in the U.S. dollar.
So far the downward movement of the U.S. dollar has been fairly orderly. It's been substantial certainly against a number of currencies, particularly the euro and the yen, but it has been orderly in the sense that financial markets have not been substantially disrupted. In fact, U.S. asset prices have continued to increase.
But already, even the orderly movement that has occurred has certainly complicated macroeconomic policy management in other countries such as the euro area and Japan. And we are concerned if the U.S. fiscal problem is not addressed, then the problem could become even more difficult. There is some risk of a disorderly situation emerging in which you could have a rapid movement in exchange rates that could have an impact on asset prices and equity prices in the United States and equity prices abroad and would be even further difficult to manage, both in the U.S. and in other countries.
Already, as I mentioned, the euro area and Japan have had difficulties responding to the strengthening of their exchange rates, and the levers that they would have to respond to further appreciation of their rates are somewhat limited.
There would also be problems if there were substantial movements in bond prices or equity prices. When the U.S. dollar weakens, that means the value of foreign investments in the United States weakens as well. We have net negative wealth affects on foreigners that affect their consumption decisions. So it tends to have a dampening effect on the global economy, as well as potential negative asset price effects in the United States.
So, if this were to occur in a dramatic and disorderly way, it would clearly have negative consequences for the global economy.
QUESTION: I have three interrelated questions. The first is you've quantified the impact on global interest rates of the fiscal situation in the United States. Have you quantified the impact on global growth?
My second question is do you see a rising risk of a disorderly resolution via the exchange rate of the U.S. current account and fiscal deficit situation?
My third question is if, in fact, there is a disorderly resolution, would that actually de-link the impact on interest rates between the U.S. and the rest of the world? One could envision a situation in which a rapidly falling dollar leads to a tightening in monetary conditions overseas, and therefore a decline in interest rates or perhaps even a flight to, you know, sovereign debt assets which would also nudge down foreign interest rates.
MR. COLLYNS: I can answer some of those questions and let Chris follow up.
In terms of whether the risk is rising, I think the risk is substantial, but I'm not sure it's rising. There has already been a substantial adjustment of the U.S. dollar over the past year that has occurred in a relatively orderly way. So the overvaluation of the U.S. dollar that we observed a couple of years ago is certainly no longer nearly as dramatic as it was.
The other point I think that's important is that recent data on the U.S. economy have been very strong. I mean that in a fundamental way, not just in a short-term cyclical way, in the sense that very strong productivity and profitability growth over the past few quarters, despite the relatively weak economy, really underlines the underlying strength of the U.S. economy. I think that will help to maintain U.S. investor interest in the United States.
Nevertheless, as I was saying before, the fact that there is this very large U.S. fiscal deficit remains a source of tension. On that front, I guess the news over the past year has not been so good in the sense that the deficit has widened further and that major new policy initiatives have been taken that have not been self-financing; in particular, the expansion of the Medicare program to include prescription drug benefits.
Would interest rates in the United States and in other countries be de-linked? I think that's a difficult question. There are interest arbitrage conditions that would continue to hold between currencies, but because you could have expectations built in of large movements in currencies, then it would be possible for nominal interest rates to be de-linked to that extent.
However, it's not clear exactly what would happen. It would really depend on the reaction of foreign investors to the events in the United States and on the reaction of foreign central banks, as well as central banks in the United States.
One could paint I think a series of different scenarios that would have different sorts of patterns in them.
Chris, do you want to comment further on that, and also the question on the impact on global growth?
MR. TOWE: I guess I would just add that my sense is that interest rates—and this is the short end—are not necessarily linked, not at a policy level, presently. So I'm not sure whether or not one could then comment on whether or not there might be a subsequent de-linking.
The purpose of our discussion, obviously, is a focus on the U.S. But just as background, I would presume that central banks in other major currency areas are principally concerned with monetary conditions in their own economies. And to the extent that exchange rate developments impact on those conditions, then their interest rate settings might be affected, but I certainly couldn't go beyond that.
In terms of your second question about the analysis of the global impact on growth of U.S. fiscal policy, that wasn't really a focus of the analysis. As I said, in terms of the specific analytical work we did, it was principally with regard to the impact of fiscal policy on a global interest rate.
But, clearly, in that context, the impact of large fiscal deficits on the rest of the world, in the longer term, is likely to be negative. As world interest rates go up, as the U.S. drain on global savings goes up, then, in some sense, there's a crowding out not just in the United States, but spilling over to the rest of the world, adversely impacting investment and also productivity.
that said, I think what we give due weight in the first section to the fact that U.S. fiscal policy, insofar as it stimulates demand in the U.S., also has favorable short-run effects on global growth, and I think we have to acknowledge that.
I should also add that my understanding is that the next World Economic Outlook will contain a focus on just this very topic. I would stay tuned for coming attractions.
QUESTION: Treasury Secretary Snow gave a speech today in which he repeated the administration's pledge to cut the deficit in half within five years, but he specifically linked that to the percentage of GDP and talked about that a goal of 2 percent would be a good goal and that's what they could reach.
You seem to be saying in your report that that would still be a dangerous level. Could you elaborate on that?
MR. COLLYNS: Yes, I think it's certainly welcome that the administration is aware of the deficit problem and is intent on cutting the deficit.
Reducing the deficit to 2 percent of GDP I think can be achieved on the basis of current policy, as the Secretary said. It would rely, to a substantial degree, on the continued cyclical upswing, as I mentioned in my earlier remarks.
The elimination of the output gap in the expansion of the U.S. economy over the next three or four years by itself would reduce the deficit quite substantially. Provided that continued restraint was exerted over discretionary spending on defense and on security-related discretionary spending, as is embedded within the U.S. administration's projections, and provided there is a substantial rebound in revenues as the economy strengthens, then, indeed the deficit should be reduced more or less in half over the next few years. There are certainly risks to the projections, but I think these are reasonable projections.
However, in our view, that's not enough. The baseline projections we present in the paper are, in fact, assuming that that reduction is achieved, but as is shown in the first chapter, despite that reduction in the federal deficit, there would be, over time, further increases in the federal debt-to-GDP ratio. The problem is considerably more difficult when one takes out the Social Security and Medicare system. Indeed, to give rough orders of magnitude, clearly the Social Security and Medicare assistance are the bulk of the problem.
So we think the federal deficit should be reduced as far as possible. We are recommending that it be reduced to balance the economic cycle, but that by itself is not sufficient to solve the problem. It provides some breathing space for the more difficult and the more long-term actions that will inevitably be needed to address the problems of Social Security and Medicare assistance.
QUESTION: So your point is that just that we have this looming Medicare/Social Security crisis, and that's the reason that getting to 2 percent of GDP is not sufficient, and indeed even getting the balance is not sufficient in your view?
MR. COLLYNS: Right. I think if the Social Security problem and Medicare problem did not exist or had been solved, then there would be much less urgency in reducing the deficit below 2 percent of GDP than there is.
MR. MUHLEISEN: Let me just add that our target is to get the deficit down to balance, excluding the Social Security account surplus, basically because we see the Social Security surplus as something that will eventually be needed to lower the pension liabilities of the system. In addition to that, reform on the Social Security and especially on the health side, which will see even a more dramatic increase in expenditure over time—will obviously require some fiscal [inaudible] because they first need time to be implemented, and second, it may also be easier to achieve agreement on these very difficult issues when one has the fiscal means to buffer the impact in some respect. So that increases the urgency of getting the deficit down.
QUESTION: I have a couple of questions. The first is I'm wondering if you could prioritize your concerns in terms of how do you weigh the threat to global economic security versus the threat from the deficit to Social Security and Medicare? That's the first question.
The second question is: to what extent are you concerned that the U.S. budget deficit is setting a bad example for member countries that the IMF is advising to cut spending and also reduce their budget deficit depth?
MR. COLLYNS: On your first question, it is not within our
Expertise to prioritize between security and the budget deficit. We recognize that there are security concerns,which in the short term have pushed up spending, and those are legitimate concerns. What we're pushing for is a longer term framework for fiscal sustainability, and I think that longer term framework can be constructed while taking into account the immediate security concerns.
QUESTION: I mean Social Security—which is--
MR. COLLYNS: Oh, Social Security.
QUESTION: Yeah. I was trying to figure out what you were more concerned with, the risks that the budget deficit posed to global economic stability in terms of the threat of increased interest rates and crowding out investment versus the domestic problems of Social Security and Medicare? Which do you see as the greater concern of threat?
MR. COLLYNS: I don't think they're separate problems in the sense that the reason why the U.S. fiscal situation is of concern to the rest of the world is because it would push up interest rates, because of the very substantial problem in the Social Security system and the Medicare system on top of the federal deficit excluding the Social Security and Medicare systems.
It's the combination of those three that makes the situation particularly difficult to handle and that could lead to—as our calculation suggests—substantial increases in interest rates over the years ahead. This is a problem which, if not addressed, could create conditions for disorderly conditions in exchange markets.
In terms of whether the U.S. is a bad example, I would put it the other way around. I think the U.S. should be a good example for other countries by putting in place a good institutional framework. This is something that the IMF has put a lot of emphasis on recently, on building strong institutions, and in many ways the U.S. is a good example for other countries. This fiscal system in the U.S. is extremely transparent. We give it very high marks, and in fact, there's a box in the paper talking about the transparency of the U.S. fiscal system. And there's a lot of scrutiny over U.S. fiscal activities, and this is all very positive.
One area though where we do think there's been a step backwards recently has been the lapsing of the budgetary rules, the Pay-Go limits and the caps on discretionary spending. We thought those limits were very useful during the 1990s in helping to bring the deficits down, and we have recommended that a similar approach be used in other countries, and other countries are indeed following similar approaches. And we think it would be appropriate for the U.S. to reinstitute those particular provisions, and indeed, the U.S. administration has stated that it would like to do that. We would certainly support moves in that direction.
QUESTION: I have a follow-up question, a technical question. In Section 4 there are some figures that are projections of the fiscal imbalance. I'm not quite sure how they were calculated and into what timeframe they refer to. Something about the balance could be as high as 47 trillion, and nearly 500 percent of current GDP, and that closing this fiscal gap would require—this is from the first page of Part 4 in the last paragraph—that closing the fiscal gap would require an immediate and permanent 50 percent hike in the federal income tax yield or a 50 percent cut in Social Security and Medicare benefits. Could you explain that to me, what exactly that's saying?
MR. TOWE: I also have the other author of that piece here, Roberto Cardarelli, and he's welcome to correct me if I misstate the facts, but essentially the calculations are of the present value of the future obligations of the Federal Government from the broadest possible perspective. As you know, the actuaries of the Social Security and Medicare systems put together long-term projections and calculate actuarial deficits. Those deficits are presently estimated over a 75-year horizon in the range of 160 percent of GDP. I think the value of this particular section is that it calculates present value or the actuarial value of the unfunded liabilities of the Federal Government, including Social Security and Medicare, but also Medicaid, education, other aspects of the government, and does it over, if you like, a much longer horizon. And as a consequence you get a much larger deficit figure, the figure that we quote here is 500 percent of GDP, very similar to those that were recently published by authors, Gokhali and Smetters last year. They came up with figures that were somewhat less, but were 400 percent of GDP.
But essentially it's the unfunded actuarial long-term liability of the Federal Government.
QUESTION: You mentioned earlier that the weakening of the dollar has complicated policy management in the Euro zone and Japan. Are we already in a situation in which those recoveries have been put at risk by the moves we've already seen?
MR. COLLYNS: I don't think those recoveries have been put at risk by the moves we've already seen. I think these are factors that need to be taken into account obviously by the monetary authorities in those countries in setting their monetary policies. However, the fact that the global recovery in general is gathering pace, led in large part by the United States, is also providing substantial impetus to the European and Japanese economies. So I think overall the global economic environment remains quite favorable to continue the recovery.
But it is more difficult for the Japanese and European authorities to manage their situations because of this very substantial decline in the dollar. That's the point we were making.
QUESTION: I wondered if this report was about a country like Argentina, would your recommendations be stronger?
MR. COLLYNS: Certainly the situation in Argentina some years ago was much more difficult than the United States. I think if one compares the United States to many emerging market countries, it's difficult to be quite as dramatic. We are raising these concerns with the situation in the United States, but the level of the deficit in the United States, the level of debt to GDP in the United States, are substantially lower than the deficit and debt levels in emerging market countries that faced economic crises in recent years.
One should also take account of the fact that the U.S. is a pretty strong economy. As I mentioned earlier, excellent fundamentals include strong productivity growth, profitability growth. The U.S. has a very well managed exchange rate system. It doesn't suffer from a range of vulnerabilities that emerging market countries have suffered from.
So we try to give balanced and measured advice. We are concerned about the situation in the United States, but we don't want to overstate the situation. We think that the situation is manageable. We think that with timely action and with determined action by the U.S. authorities the deficit problem can be resolved in an orderly manner. But we do like to emphasize that it is important that these actions are taken, and I think it's encouraging that these are issues that are now at play in the presidential campaign that's just now getting under way. And we're hoping to see a developing consensus for the need for fiscal action or a return to the consensus there was during the 1990s, that it was important to reduce the deficit. We're trying to contribute to persuade the climate of public opinion that this is an important issue that does need to be dealt with, and political capital will need to be expended.
QUESTION: You mentioned in the report that generational difficulties of an aging population are not as severe in the United States as in other countries.
I'm wondering how this horizon of deficits in the United States compares with, say, a Japan or Germany or Italy or another country where this has gotten a lot of attention.
MR. COLLYNS: I don't have the latest numbers. I'm sure there's another IMF publication that would provide a better answer to your question concerning the World Economic Outlook. We'll provide answers to that question.
I would say certainly Japan's fiscal situation is substantially more difficult than it is in the United States with gross public debt of over 125 percent of GDP compared to 35 percent of GDP in the United States, and a substantially higher fiscal deficit and a substantially weaker economy. The fiscal problems in Japan are extremely serious and, indeed, the Fund's staff has published a substantial amount of material on the fiscal problems in Japan.
Compared to the Euro Zone, as we say in the report, I think the longer-term aging problems are more difficult in Europe because there's more rapid population aging. The flow problem in the U.S. is now somewhat larger. As we mentioned earlier, the U.S. fiscal situation used to be very strong, with a fiscal surplus, but the very large swing in recent years means that the U.S. now has the second-highest fiscal deficit among all of the G7 countries. From that perspective, the U.S. situation is difficult. But as we said before, it's a situation that requires policy reactions, but with determined policy reactions, the situation should be manageable.
[There were no further questions posed. Whereupon, the conference call was concluded.]
IMF EXTERNAL RELATIONS DEPARTMENT