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December 19, 2006

Is Pay-As-You Go A Good Idea?

From the front page of today's edition of The Wall Street Journal:

Democrats are taking sides in what is shaping up as one of the party's biggest divides -- its identity on economic issues.

The brewing debate has been overshadowed by the national focus on Iraq. But at stake is the legacy of Bill Clinton and his treasury secretary, Robert Rubin, who in the 1990s redefined the formerly protectionist, free-spending party as a champion of free trade and balanced budgets. That "establishment" view now is under challenge from party populists and organized labor, who have been emboldened by gains in last month's elections to press their case against globalization and fiscal austerity.

My own leanings are probably no secret to anyone who reads this blog on a regular basis -- I'm solidly in the "free trade and balanced budgets" camp.  But there is at least one counterpoint about which I might have some sympathy:   

While liberal groups believe they have the party establishment on the defensive on trade, they complain that on budget and spending issues, fiscal conservatives have the upper hand. That stems in large part from Democrats' 2006 campaign promise to restore a "pay as you go" budget rule, which would require that any new spending, or tax cuts, be accompanied by offsetting revenue increases or spending cuts to avoid widening the deficit.

Robert Borosage, co-director of the liberal Campaign for America's Future, objects that by insisting on a pay-as-you-go approach Democrats are tying their own hands as they turn toward addressing "decade-old pent-up demands" for domestic spending.

Republicans, he says, never worry about deficits when they cut taxes. "What pay-go says is that the nation's first priority is the budget deficit, and that's just not true," Mr. Borosage says, citing instead the war in Iraq, global warming, energy dependence and trade deficits as bigger problems than the budget shortfall. "When you have a national crisis, you spend the money."

I'm a fan of pay-go rules, but there is a reasonable case to be made for the proposition that deficits have their place.  Tom Sargent explains:

Robert Lucas and Nancy Stokey, as well as Robert Barro, have studied this problem under the assumption that the government can make and keep commitments to execute the plans that it designs. All three authors have identified situations in which the government should finance a volatile (or unsmooth) sequence of government expenditures with a sequence of tax rates that is quite stable (or smooth) over time. Such policies are called "tax-smoothing" policies. Tax smoothing is a good idea because it minimizes the supply disincentives associated with taxes. For example, workers who pay a 20 percent marginal tax rate every year will reduce their labor supply less (that is, will work more at any given wage) than they would if the government set a 10 percent marginal tax rate in half the years and a 30 percent rate in the other half.

During "normal times" a government operating under a tax-smoothing rule typically has close to a balanced budget. But during times of extraordinary expenditures—during wars, for example—the government runs a deficit, which it finances by borrowing. During and after the war the government increases taxes by enough to service the debt it has occurred; in this way the higher taxes that the government imposes to finance the war are spread out over time. Such a policy minimizes the cumulative distorting effects of taxes—the adverse "supply-side" effects.

Or consider policies that have short-term costs but long-run benefits.  Think growth-promoting free trade policies that nontheless displace some domestic jobs and production today.  Or, perhaps, a health-care program (prescription drug benefit?) that immediately raises spending, but offers the promise of better health and less expensive remedial treatments down the road.  In cases such as these, you might think that because the benefits accrue to future taxpayers it would be sensible to have them bear some -- maybe even most -- of the costs as well.  And that is exactly the nature of deficits -- they shift the tax burden from today to tomorrow.

That is also, of course, the problem.  You might have noted the "under the assumption that the government can make and keep commitments " clause in the Sargent quotation above.  That is one big "if" in this discussion.  And you might suggest that it would be awfully easy for a government to claim that there are big future benefits to some set of policies, even when said benefits are suspect or highly speculative.  Or you might reasonably argue that the burdens of future taxation are already inappropriately skewed to future generations (and getting more so by the minute). 

For all these reasons, I lean to the pay-go solution.  But the contrary view is at least worth considering.

December 19, 2006 in Federal Debt and Deficits , This, That, and the Other | Permalink


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I'm hoping Brad DeLong weighs in on this but in the meantime - PAYGO as I understand is not a rigidly balanced budget proposition. One can be for countercyclical fluctuations in the deficit and also for long-run fiscal sanity. Also - why aren't we relying more on monetary policy ala William Poole (QJE 1970)? Oh yea because the FED is in a really tough bind thanks to the spend and borrow fiscal policies of those who trashed PAYGO. Yes, put me down as a liberal Robert Rubin - fiscal sanity, free trade, and all my warts.

Posted by: pgl | December 19, 2006 at 07:37 PM

I still want to know when the Democratic party was
"formerly protectionist"?

Does anyone have any evidence to support this claim?

Posted by: spencer | December 20, 2006 at 12:51 PM

Spencer - maybe folks are talking about those 19th century Democrats. Oh wait - southern Democrats wanted free trade to boost the demand for their agricultural crops whereas it was the GOP representing the import competing industrial sector (up north) that was for trade protection. Since the 1962 Kennedy rounds, it seems some influential Democrats have pushed for lower trade barriers and succeeded. OK, there are some Dem protectionists but the kings of protection have been Reagan and Bush43. But these two Presidents pretended to be free trade, so I guess that makes it all right.

Posted by: pgl | December 20, 2006 at 03:26 PM

I see the right wing trying to create a new meme out of whole cloth that the Democrats are
protectionists. It should be countered at every opportunity.

The only protectionist policies I remember seeing implemented since WW II are the ones by the Bush administration.

Has another president actually raised tariffs?

Posted by: spencer | December 20, 2006 at 03:58 PM

Spencer - the answer to your question is yes. Reagan imposed steel tariffs. He also put quotas on Japanese autos.

Reagan - liberal Democrat!

Posted by: pgl | December 20, 2006 at 04:22 PM

Guys -- I haven't gone back and reread the entire article, but the excerpts I chose certainly do not peg the Democrats as traditional foes of free trade. Maybe my view is skewed by the campaign platform of my own newly elected home state senator, but it seems to me there is no denying that this statement is accurate: "That "establishment" view now is under challenge from party populists and organized labor, who have been emboldened by gains in last month's elections to press their case against globalization and fiscal austerity."

Better we address the debate that confronts us now than revisit the sins of the past (beyond learning from them, of course).

Posted by: Dave Altig | December 21, 2006 at 09:20 AM

We have an environment where the trade deficit is created by a large structural federal deficit on one side and central bank intervention on the other side to distort the exchange rate and subsidize exports.

It may be that populist democrats are right to question if this is a "free market solution"?

Posted by: spencer | December 21, 2006 at 09:38 AM

David - there are some Democrats who are in favor of less free trade. And yes, there are some Democrats who'd vote for more spending without having the courage to tell us the implications for future tax rates. But aren't there a few Republicans guilty of both? As in the President. What we need to see is a bipartisan consensus among the true fiscal conservatives in each party (your main point) that hopefully spills over into a bipartisan consensus of how to deal with poverty and job insecurity problems without resorting to trade protection. But blaming one party? Why does the press do this kind of finger pointing when it could do a better job of real reporting?

Posted by: pgl | December 21, 2006 at 02:33 PM

Prices of foreign imported goods into the US are being subsidized by massive foreign government intervention and manipulation of the international currency markets. Does that qualify as free trade ?

I'm puzzled why the economics profession conveniently overlooks this fact. What is called "protectionism" would seem to be more consistent with true free trade than defence of the status quo. If trade collapses in the absence of currency manipulation, how can it be called "efficient" ?

Posted by: zinc | December 21, 2006 at 09:10 PM

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