IMF Continues to Criticize U.S. Fiscal Policy

A speech by the International Monetary Fund’s First Deputy Managing Director (John Lipsky) at the American Economic Association Annual Meeting on “The United States in the World Economy” provided continuing warnings about U.S. fiscal policy.  This was not the first such warning. For example, last summary, the IMF effectively reported that the U.S. is Broke.

Here are the highlights of the current warnings:

…federal debt held by the public has risen from about 36 percent of GDP in 2007 to about 62 percent of GDP in 2010, while prospective debt dynamics have worsened significantly. In the absence of corrective measures, and taking into account underlying fiscal pressures that predated the crisis, debt could reach about 95 percent of GDP by the end of this decade—a level last reached immediately following World War II. Without policy adjustments, subsequently the debt simply would keep rising. From this perspective, the need for urgent action to secure medium-term fiscal sustainability appears to be self-evident. … Indeed, the challenges facing U.S. public finances should not be underestimated, given the sluggish recovery and the prospect of significant increases in aging and health-related spending.”

Optimistically, the IMF gave the Obama Administration credit for listening to its own Commission for Fiscal Responsibility and Reform. The reality is that the Administration is not taking these hard-to-swallow ideas seriously.  Nevertheless, the IMF reports:

The ongoing debate on how best to achieve medium-term fiscal consolidation has received an important boost from the National Commission on Fiscal Responsibility and Reform. In its recent report, the Commission proposed an ambitious consolidation plan, emphasizing the need for broad-based revenue and spending measures. The plan sets very ambitious targets—to stabilize public debt by FY2014 and return it to its pre-crisis level of about 40 percent of GDP by 2035. Under the Commission’s proposals, tax expenditures would be scaled back, allowing marginal tax rates to be reduced. Social Security would be put on a sound financial footing through measures such as means-testing benefits and increasing the retirement age. And to contain health care costs, significant medium-term savings would be attained through a reform of cost-sharing rules and of certain public programs, and also by setting limits—beginning in 2020—on the growth of all federal health-related transfer programs. Another widely-cited idea to support fiscal consolidation—although not put forward by the Commission—is to introduce a national consumption tax, such as a value-added tax—or VAT. Such a measure could enhance national savings while raising revenue with limited economic distortions.

The Commission also calls for reforming budgetary processes to help keep deficit reduction on track. These would include caps on discretionary spending through 2020—with the goal of bringing such spending in real terms back to 2008 levels by 2013; and from then onwards limiting its growth to one-half the projected inflation rate. More generally, by enshrining fiscal targets (including the debt-to-GDP ratio) in budget proposals and by enacting concrete legislation relatively soon, private sector expectations could become progressively more optimistic about fiscal policy prospects, helping the sustained effort that will be needed to anchor fiscal credibility.

The IMF stresses that the total U.S. situation is worse when state and local finances are considered. In this regard, the IMF’s warning is similar to warnings we previously reported involving “Disastrous Predictions for State and Local Government Pensions”. The IMF’s similar warning is:

Fiscal consolidation not only is a challenge for the federal government, but also for state and local governments. State and local debt currently amounts to about 20 percent of GDP, or about a third of the size of the federal debt. However, unfunded state and local pension and retirement health care entitlements pose significant medium-term risks, as they are estimated at anywhere from $1 trillion to $3 trillion, or possibly equal in size to their outstanding debt. In some states and localities, servicing such a debt burden under current constitutional and other legal strictures would require significant cuts in discretionary spending and/or huge tax increases. Although many states and localities already have started facing these issues, for example by scaling back retirement benefits for new employees, much more decisive action will be required over time in order to reduce medium-term solvency risks.”

The IMF encourages action while there is still relatively easy sailing. Specifically:

In fact, there may be a brief near-term window of opportunity opening for U.S. fiscal policy adjustment that shouldn’t be missed. For now, U.S. interest rates remain low by historical standards—in part due to low growth and inflation prospects, but also reflecting a low risk premium on U.S. government debt. As a result, total public debt service payments have not risen relative to GDP, despite the sharp rise in the U.S. debt-to-GDP ratio. Moreover, as the economy gains momentum, automatic stabilizers will help to lower the deficit—at least in the short run. In our view, the United States needs to make the most of this window of opportunity to tackle structural fiscal problems—especially entitlements—before real rates begin to renormalize, and the positive impact of the automatic stabilizers on the deficit recedes, adding to the perceived difficulty of making progress on longer-run fiscal challenges.”

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    • math games on February 6, 2011 at 8:22 AM
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    • Kierra on July 5, 2011 at 4:14 AM
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    What a neat article. I had no inkilng.

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