10
For three decades, six Presidents have come before you to warn of the damage deficits pose to our nation. Tonight I come before you to announce that the federal deficit, once so incomprehensibly large that it had 11 zeros, will be, simply, zero.
—BILL CLINTON, STATE OF THE UNION ADDRESS, JANUARY 1998
As noted at the end of the last chapter, once the large Reagan budget deficits were firmly in place, all thoughts of using fiscal policy as a stabilization tool vanished into the political sands. Instead, discussions of federal spending and taxation focused almost exclusively on how to bring down the yawning budget deficit. One consequence of this fixation on deficit reduction was that monetary policy became, quite literally, “the only game in town” when it came to stabilizing the macroeconomy.
The political consensus to reduce the federal deficit was shared by both parties, at least at the level of lip service. But bipartisan agreement ended right there. Democrats and Republicans battled incessantly over budget priorities for about a decade and a half, with the Democrats arguing for lower defense spending and resisting civilian budget cuts while the Republicans wanted to trim social spending and defend the Defense Department.
To illustrate how the fiscal norm changed after Reagan, figure 10.1 displays data for the thirty-two years prior to 1982. Panel (a) shows the federal deficit as a share of GDP. Deficits clearly outnumber surpluses, but the average deficit over this period was only 1.1 percent of GDP, and the deficit exceeded 3 percent of GDP only during the deep recession that spanned fiscal years 1975 and 1976.1 As panel (b) shows, the debt-to-GDP ratio was mostly declining during that era. In brief, the budget norm prior to the Reagan presidency was clearly to run deficits but small enough to keep the debt-to-GDP ratio declining.
Figure 10.2 displays the same sort of data over the years of partisan wrangling over the deficit that are the focus of this chapter, 1982 through 1998. The differences are stark. In particular, over the twelve fiscal years from 1982 through 1993, the deficit averaged 4.1 percent of GDP and fell below 3 percent of GDP only in one boom year (fiscal 1989). The debt-to-GDP ratio naturally rose during those years, as did political attention to the deficit.
Economists, editorial writers, and politicians alike all railed against large federal budget deficits over the decade that spanned the early 1980s to the early 1990s. Deficits would be a burden on our children and grandchildren (an inchoate claim). Deficits threatened the nation with insolvency (silly). Deficits could crowd out business investment (a real possibility). But it was all to no avail. Not that anyone in America thought deficits of 4 percent, 5 percent, and 6 percent of GDP represented sound public policy. It was just that politics seemed to block any path toward smaller deficits. The conventional wisdom was that cutting the deficit—which meant raising taxes, reducing spending, or both—was a political loser. “Root canal economics,” supply-sider Jude Wanniski had called it.2
The political logic was simple and apparently compelling. The pain from deficit reduction is visible and immediate. Voters don’t want to see their taxes raised or their favorite government expenditure programs cut, and politicians understand that. Besides, what would elected officials gain in return? According to conventional economic thinking, lower deficits would reduce real interest rates and, by dint of that, lead to higher levels of business investment and thereby (eventually) to higher real wages via improvements in productivity. But that chain of reasoning is a bit subtle for politics, and the benefits accrue gradually over a protracted period of time. They are unlikely to be apparent by the next election.
(a) Federal budget deficit (−) or surplus (+) as percent of GDP
(b) National debt as percent of GDP
FIGURE 10.1. Federal budget deficit and the national debt as percent of GDP, 1950–1981.
Source: Congressional Budget Office.
(a) Federal budget deficit (−) or surplus (+) as percent of GDP
(b) National debt as percent of GDP
FIGURE 10.2. Federal budget deficit and the national debt as percent of GDP, 1982–1998.
Source: Congressional Budget Office.
Policies that produce subtle—and probably unnoticed—benefits years in the future hardly constitute a recipe for political success. For years, public opinion polls consistently showed that the public wanted lower deficits in principle but opposed virtually anything that might actually get them there in practice, such as higher taxes or cuts in spending programs. For example, “a 1981 Harris Survey found that in no instance were a majority of respondents willing to reduce spending on any domestic program rather than unbalance the federal budget” (Blinder and Holtz-Eakin 1984). Ronald Reagan, it appeared, had discovered a winning political formula: offer the voters tax cut goodies right away and worry about the consequences of budget deficits later. Doing the opposite risked incurring immediate political pain in return for distant, abstract, and uncertain gains.
For a long time, Reagan’s assessment looked exactly right, and the problem festered. The federal budget deficit had ballooned to an average of about 5 percent of GDP in the first five fiscal years after the Reagan tax cuts, and it was still 4.7 percent of GDP in 1992. Zero progress. Economists and other advocates of fiscal prudence despaired that nothing would be done. Not that there weren’t numerous false starts.
The first manifestation of serious concern about future deficits came already with the aforementioned Tax Equity and Fiscal Responsibility Act, which President Reagan signed into law, probably reluctantly, in September 1982. The act basically repealed most of the corporate tax cuts that had been passed amid the frenzied euphoria of 1981. Its aim was clearly to ameliorate the huge budget-busting consequences of the 1981 tax bill. Further to this end, the president also exacted a pledge from Congress that it would enact three dollars of spending cuts for every dollar of tax increase. That pledge was not redeemed, however, and the combination of the Reagan tax cuts that were not repealed (about three-quarters of the total) and the deep recession of 1981–1982 ballooned the deficit to almost 6 percent of GDP in fiscal year 1983. By fiscal 1985, with the economy recovering strongly from the recession, the deficit was still a whopping 5 percent of GDP.
False Starts: Gramm-Rudman-Hollings
Back in those days, politicians in general, especially conservative politicians, were appalled by such large budget deficits, which, of course, the Reagan team had promised would not occur. In the context of one of the many squabbles over raising the national debt ceiling—something Congress was forced to do early and often because of the large Reagan deficits—Senators Phil Gramm (R-TX), Warren Rudman (R-NH), and Ernest “Fritz” Hollings (D-SC) cobbled together a bipartisan majority in the Senate to pass the Balanced Budget and Emergency Deficit Control Act of 1985, which became known as Gramm-Rudman-Hollings (GRH) or sometimes just Gramm-Rudman. The bill passed the House too, and President Reagan signed it into law in December 1985.
The central idea behind GRH was simple—far too simple, in fact. The law created a series of allegedly binding annual targets for the federal budget deficit over the next five fiscal years. These targets laid out a sequence of declining deficits that, if followed, would lead to a balanced budget by fiscal 1991. If the GRH deficit targets were not met by congressional actions, a series of across-the-board spending cuts (called sequestration) would come into effect automatically in the form of equiproportional reductions in most categories of spending. At least that’s what the law said. However, there were three titanic sets of problems.
The biggest problem was clear to economists immediately, and it eventually became clear to members of Congress as well. GRH set annual targets for an endogenous variable—the budget deficit—that Congress cannot control any more than King Canute could control the tides. What Congress can control are the volume of discretionary spending on the programs that receive annual appropriations (a minority of the budget), the rules governing eligibility for and generosity of entitlement programs, and tax rates and other provisions of the tax code. Wisely, these were precisely the three items on which the Budget Enforcement Act of 1990 would eventually focus congressional attention. But that came years later.
Notice also that had the letter of the GRH law actually been followed, it would have not just short-circuited the automatic stabilizers but also set them in reverse as automatic destabilizers. Weaker economies breed larger deficits, mainly via lower tax receipts but also via increased spending on a variety of entitlement programs, unemployment insurance being the most obvious example. We call that automatic stabilization because fiscal policy becomes more expansionary automatically, without any need for congressional action. But if Congress actually adhered to fixed deficit targets, members would have had to cut government spending anytime the economy slumped. That’s automatic destabilization: fiscal austerity at just the wrong time.
Rudman himself labeled GRH “a bad idea whose time has come” (Romano 1986, C2). I wrote shortly thereafter that “the idea’s magnificent simplicity was matched only by its simplemindedness” (Blinder 1987a, 102). Many others shared that sentiment. Nonetheless, “somehow an unholy alliance of Republicans and Democrats took utter nonsense and treated it like gospel” (Blinder 1987a, 103). GRH passed the House by a vote of 272–154 and the Senate by an overwhelming 61–31 margin.
The second set of problems with GRH was political: the act ignored two well-known facts about American government, perhaps about any democratically elected government. First, no Congress can bind a succeeding Congress. In fact, future Congresses failed to take the actions necessary to meet the 1985 GRH targets, even though they had mostly the same members. Second, most senators and representatives, then as now, liked to preach fiscal discipline without practicing it. So, when push came to shove, the House and Senate either set aside the GRH targets or postponed them.
The third set of problems was legal. The U.S. Supreme Court ruled in 1986 (in Bowsher v. Synar) that the sequestration mechanism in GRH was unconstitutional because the process it created to enforce budget cuts gave executive authority to an agency of Congress, the General Accounting Office (GAO), thereby violating the separation of powers. To fix this legal problem, Congress passed GRH II (officially the Balanced Budget and Emergency Deficit Control Reaffirmation Act) in 1987. This version had a revised sequestration process that passed constitutional muster by making the White House Office of Management and Budget (OMB), rather than the GAO, the enforcer of sequestration. GRH II also offered revised—less strict, of course—deficit targets and pushed back the target date for budget balance to 1993.
While the legal change satisfied the courts, the other two problems remained. King Canute had not learned how to control the tides, and Congress did not abide by its own rules. As a result, the annual budget deficit hung around the $150 billion range in fiscal years 1987–1989 and then moved up to over $200 billion. Those numbers were far above the annual GRH targets. GRH had failed.
First Landmark: The 1990 Budget Agreement
The election of 1988 elevated Reagan’s vice president, George H. W. Bush, to the presidency. While vying for the Republican nomination in 1980, Bush had derided supply-side economics as “voodoo economics,” and as president he took the deficit problem more seriously than Reagan ever had. Bush was hemmed in, however, by both the potentially harsh spending limits mandated by GRH (even though they were typically ignored) and by his famous (or infamous, in Republican circles) campaign pledge: “Read my lips, no new taxes.”
Perhaps more important operationally, the Democrats maintained their majorities in both the House and the Senate in 1988 despite Bush’s landslide victory over Democrat Michael Dukakis, the governor of Massachusetts. Hard negotiations between the White House and Congress were inevitable, and they did not bear fruit in Bush’s first year in the White House. By the summer of 1990 after many failed attempts, Bush was growing desperate to cut the Gordian knot because sequestration under GRH would have reduced fiscal 1991 spending drastically and indiscriminately (by 35% for nondefense spending and 31% for defense). Given that the Persian Gulf War had just started, that was intolerable.
Against this background, Bush agreed to hold a September 1990 budget summit with congressional leaders from both parties at what was then Andrews Air Force Base (now Joint Base Andrews). The idea was for everyone to leave Capitol Hill and start afresh. Since everything was on the proverbial table at Andrews, even tax increases were within the realm of the possible, although they were anathema to Republicans. Their majorities in both Houses of Congress gave Democrats an important advantage in the bargaining, but President Bush had his veto pen.
Skeptics saw the summit as a futile exercise. Like so many budget negotiations before it, they believed, Andrews would end in failure and acrimony.3 The skeptics were proven wrong, however, and a bipartisan agreement emerged. The 1990 budget agreement naturally included a variety of spending cuts, including some to Medicare. But the most salient aspect politically was Bush’s agreement to some tax increases in violation of his well-known 1988 campaign pledge. The so-called Bush tax hikes had many components, including an increase in the top bracket rate from 28 percent to 31 percent (although the capital gains rate was capped at 28%), a limit on itemized deductions for high-income taxpayers, a phase-out of personal exemptions for even higher-income taxpayers, and more. All told, the tax hikes agreed to at Andrews amounted to roughly 0.5 percent of GDP—not that much.
Nonetheless, this obvious retreat from the “no new taxes” pledge enraged many Republicans. According to the New York Times on October 2, 1990, “Civil war broke out among Republicans today as dozens of House members insisted that White House lobbying would not stop them from seeking to thwart the budget package announced on Sunday” (Berke 1990). One of those rebels was the firebrand congressman from Georgia, Newt Gingrich. About two years later, the Cato Institute’s Stephen Moore dubbed the Andrews agreement “the crime of the century” (Moore 1992). (A bit polemical, perhaps?) He suggested, as did many other observers, that it might cost President Bush the 1992 election.
Whatever your opinion then or now, it is certain that the 1990 tax hikes garnered far more media attention than any other aspect of the budget agreement. The Congressional Budget Office (CBO) estimated in December 1990 that the tax increases amounted to just under one-third of the total deficit reduction in the Andrews package (CBO 1990). But measured by column inches in newspapers, it must have been at least 95 percent.
Economically, however, the most important item to emerge from the Andrews summit was not the tax hikes but rather the Budget Enforcement Act of 1990. In this act, Congress gave up its futile attempts to legislate overall deficit targets as in GRH and enacted instead what it was actually capable of legislating: caps on discretionary spending. The caps excluded revenues and spending on entitlements, two obviously endogenous variables that are sensitive to the state of the economy. Instead, the Budget Enforcement Act instituted a pay-as-you-go rule to cover these two categories. This meant, in practice, that any proposal to reduce tax receipts or raise entitlement spending had to be paired with an accompanying proposal to recoup the lost revenue or pay for the increased spending. In short, any changes in taxes or entitlements had to either leave the projected budget deficit unchanged or decrease it. PAYGO, as it came to be called, did not post a target path for deficit reduction, a path Congress could not achieve in any case. Instead, it created a major procedural asymmetry: policy actions could reduce the deficit but not increase it.
The early judgment on PAYGO was negative but decidedly wrong. As Janet Yellen and I wrote some years later,
The 1990 budget agreement was much maligned at the time, and proved to be a political albatross around the neck of President Bush.… Despite its bad press, the agreement marked the first giant step down a path that would eventually lead the federal government to sizable budget surpluses. Unfortunately, contemporary observers did not see it that way. What they saw, instead, was a budget deficit that was on the rise despite the so-called deficit reduction package. That simple arithmetic made the 1990 budget agreement look bad, and it was prematurely and unfairly pronounced a failure. (Blinder and Yellen 2001, 5)
The critics were mistaken for two main reasons. First, and to Bush’s great credit, the government finally decided to bite the bullet and shoulder the inevitable costs of cleaning up the savings and loan mess discussed in the previous chapter. That decision alone added about $60 billion to the budget deficits of fiscal years 1990 and 1991. Second, a recession began in July 1990 and lasted until March 1991. Though it was a mild one, the CBO estimated that the slump raised the deficit by about $160 billion between fiscal years 1991 and 1993. These events conspired to increase the deficit despite the roughly $100 billion per year in deficit reduction negotiated at Andrews. That apparently perverse budget behavior plus the hostility to tax hikes conspired to give the 1990 budget agreement a bad name.
It was a bad rap, however. In particular, PAYGO proved to be the sleeper in the Budget Enforcement Act. Though it was ignored by many and derided by others as a meaningless gesture, the new approach worked. Even I, then writing a column in Business Week magazine, expressed skepticism that Congress would stick with “this giant step toward rationality” (Blinder 1990, 29). The right-wing press was much harsher. For example, Heritage Foundation economist Daniel Mitchell later opined in the Wall Street Journal that “Mr. Darman [Bush’s budget director] is either ignorant of the budget law or is deliberately being deceptive” (Mitchell 1992, A16).
However, unlike the uncomfortable and politically impossible budget corsets created by GRH I and II, the Budget Enforcement Act established rules with which Congress could and did live. As long as PAYGO remained the law of the land—a period that covered the rest of the Bush I years and all eight Clinton years—Congress generally abided by the rules it had written in 1990, and the deficit mostly fell. In fact, it turned into a surplus in fiscal years 1998–2001. Then when Congress abolished PAYGO to pave the way for the Bush II tax cuts, the deficit ballooned in fiscal year 2002 and thereafter. Coincidences? I don’t think so.
Given the themes of this book, it is noteworthy that barely any prominent voices at the time suggested using fiscal stimulus to ameliorate, much less end, the 1990–1991 recession. On the contrary, “It’s no secret that many of the President’s economists, along with much of the economics establishment, fear that economic stimulus of any kind is as likely to harm as help” (Passell 1991). Harm? If Keynesian ideas weren’t dead at the time, they were certainly moribund, replaced by the rantings of a large herd of “bond market vigilantes,” as they were called then, who drove interest rates higher at the slightest whiff of a larger fiscal deficit.4
The 1990–1991 recession may have marked the nadir of fiscal stabilization policy in America. The Fed fought the recession hard but fought it alone (see the next chapter). In the intellectual world, it is amazing that a large 1986 National Bureau of Economic Research conference volume titled The American Business Cycle: Continuity and Change (Gordon 1986) did not even include a chapter on countercyclical fiscal policy. In its place was a long essay by Robert Barro (1986) titled “The Behavior of United States Deficits” that focused on his tax-smoothing hypothesis (Barro 1979). Imagine that: a big, thick volume on the business cycle with no mention of fiscal stabilization whatsoever. Walter Heller could never have imagined that.
Interestingly, although the budget battles of the 1980s and 1990s were more about politics than economics, they were nonetheless reflected in the academic thinking and writing of the day. Scores of papers appeared on the effects (or lack thereof) and the sustainability (or lack thereof) of government budget deficits. One empirical finding got less attention than it should have, however: it proved to be surprisingly hard to find a reliable econometric link from larger deficits to higher interest rates.5 The seeds of the idea that the government could run large deficits without sending interest rates through the roof were sown. But in the hostile climate of the 1980s and 1990s, they didn’t germinate.
Second Landmark: The Clinton Budget of 1993
Bill Clinton left his biggest mark on U.S. fiscal policy by turning large, chronic budget deficits into surpluses, although those surpluses did not outlive his presidency. It is therefore easy to forget that candidate Clinton did not run on a platform of thoroughgoing deficit reduction in 1992. Rather, Clinton’s campaign slogan, “Putting People First,” stood for a detailed economic program that included a variety of new spending proposals (he liked to call them “investments”) and a middle-class tax cut (Clinton 1992). Nonetheless, Clintonomics wound up turning a large and growing fiscal deficit into a sizable budget surplus.
Prior to the Clinton presidency, including during the 1992 campaign, fiscal frugality was not what people typically associated with the Democratic Party. Rather, fiscal prudence and railing against the evils of budget deficits were deeply ingrained Republican traditions back then. (Remember Dwight Eisenhower?) Ronald Reagan’s budget-busting policies changed all that. But before Reagan, it was the Democrats who were thought of as the big spenders. Their traditional motto, which dated all the way back to Harry Hopkins in the New Deal, was “Tax and tax, spend and spend, elect and elect.” Clinton’s presidency flipped the script, suddenly and dramatically. Why? What happened? Several things.
First and perhaps foremost, the surprising electoral success of the gadfly third-party candidate, billionaire Ross Perot, in the 1992 election was sobering and, to a politician with antennae as finely tuned as Clinton’s, enlightening. Perot ran almost as a one-issue candidate: the supposedly urgent need to balance the budget and then to start paying down the national debt. Although this novice politician did not win any states, his popular vote count was impressive:
· Clinton: 43.0%
· Bush: 37.4%
· Perot: 18.9%.
To be sure, Clinton defeated Bush decisively. But Perot’s 19 percent vote share was the best by a third-party candidate since Theodore Roosevelt in 1912. Remarkably, Perot garnered about half as many votes as Bush! Furthermore, for several months during the summer of 1992, Perot actually led both Clinton and Bush in the polls. To Clinton, the political message must have been clear and sobering: there was more grassroots support for deficit reduction than he and other political “experts” had imagined.
Second, during the 1992–1993 transition period, Clinton was apparently convinced by his economic advisers—somewhat to the dismay of his political advisers—that reducing the deficit was an urgent national priority that could not wait. Coupled with the stunning Perot vote, Clinton may have concluded that he should and could turn good policy into good politics, despite the electorate’s well-known aversion to both tax increases and spending cuts.6 He knew it was risky—I was among those who told him so—but he took the gamble.
Clinton’s original economic team was led de facto by Robert Rubin, who had left his position as a prince of Wall Street (cochair of Goldman Sachs) to become the first director of the National Economic Council, a Clinton creation.7 I was part of that team, as a member of Clinton’s first Council of Economic Advisers, and I distinctly remember Rubin citing, time and time again, possible dire consequences that might occur in the financial markets if the federal government didn’t curb its borrowing. Rubin was always careful to hedge his wording, and he delivered his message with far more sobriety than Perot’s high-pitched rants. But it carried the authority of (in Rubin’s pet phrase) “my 26 years on Wall Street.” That said, the warning was substantively similar to what Perot had claimed: if the deficit was not reduced, something terrible might happen in the financial markets. Rubin was always careful not to forecast Armageddon or to spell out what Armageddon would look like. But he not-so-subtly suggested that the danger was palpable. The bond market vigilantes had, after all, often shown their teeth during the Bush I years.
For OMB director Clinton chose Leon Panetta, an affable (and funny) career politician from northern California who had previously chaired the House Budget Committee. Panetta knew the budget inside out, both substantively and politically, and both he and his knowledgeable deputy, Alice Rivlin, were self-declared deficit hawks. I got to know Panetta well, and I came to believe that he saw deficit reduction as at least in part a moral issue. Congress had shirked its solemn duty by letting the deficit grow so large. In sharp contrast, Clinton’s political team could be characterized as deficit doves who were not eager to pursue root canal economics. They viewed Panetta and Rivlin as adversaries, competing for the mind and soul of the newly elected president.8
The top economic official on the Clinton economic team, at least de jure, was the secretary of the treasury, Lloyd Bentsen, a wily Texan who had chaired the Senate Finance Committee. Those of us (like me) who were excluded from the innermost loops of the administration learned later, from Bob Woodward’s The Agenda (1994), that Bentsen had opened an active back channel to his longtime friend, Fed Chair Alan Greenspan, who was urging strong deficit reduction. Even before inauguration day, Bentsen had informed Greenspan that Clinton and his economic team supported deficit reduction. “The Fed chairman, first among deficit hawks, smiled at the news” but offered no deal on interest rates (Woodward 1994, 98). Yet Greenspan participated in formulating the fiscal plan from a distance, using Bentsen as a conduit. It was an odd form of coordination between monetary and fiscal policy.
Although Greenspan promised nothing, his involvement went well beyond mere moral support for smaller deficits. The new president gave his economic team just four weeks to redo the entire federal budget, line by line. To make this Herculean task manageable, we decided to focus our attention on fiscal year 1997. The other years could be filled in by spreadsheet. The budget numbers that the outgoing Bush administration left us suggested a whopping deficit of $346 billion in fiscal year 1997, roughly 4 percent of GDP, if current policies were continued. With Clinton participating actively in every decision, we decided, after much internal debate, on an ambitious but attainable target: to reduce that number by $140 billion.
Why 140? To me (and others), that particular number just popped up one day, seemingly out of the blue, at one of our endless series of budget meetings. Prior to that day, an active debate had raged over what the 1997 target should be, a debate informed and given texture by the specific cuts necessary to reach any particular target. Yet all of a sudden, the debate was over; the target was $140 billion. We later learned from Woodward’s book that the magic number had come not out of the blue but instead out of the Fed, passed on from Greenspan via Bentsen.
There were opposing, more dovish voices but not many in the top economic positions. As just noted, the political crowd (James Carville, Paul Begala, George Stephanopoulos, and others) were never keen on proposing politically perilous spending cuts and tax hikes. Carville famously quipped that “I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody” (Wessel and Vogel 1993, A1).
Robert Reich, a longtime Clinton buddy who was secretary of labor, worried out loud that we were overdoing it and, in the process, threatening many of the “putting people first” initiatives on which Clinton had campaigned. Reich didn’t argue against deficit reduction, only for less of it. He battled Rubin early and often at National Economic Council meetings and elsewhere. But ensconced as he was a mile and a half away at the Labor Department, Reich scored precious few victories over the clever Wall Streeter whose tiny office was just feet from the Oval Office. Proximity matters.
As part of my job as the incoming CEA’s “macro member,” I had delivered at a transition-period briefing in Little Rock the conventional message that tighter fiscal policies reduce aggregate demand and could therefore slow down or even destroy growth. Backed by Laura Tyson, the incoming CEA chair, I displayed numerical estimates showing that too much deficit reduction could produce “a recession similar to the Bush recession.” As Woodward reported, “the effect on Clinton was electric”—and not joyful (Woodward 1994, 95). The president-elect knew full well what the recession of 1990–1991 had done to President Bush’s popularity.
My briefing hastened to add, however, that either the Fed or the bond market could obviate this danger by pushing interest rates sufficiently lower. That thought brought a scowl to Clinton’s face. “You mean to tell me that the success of the program and my reelection hinges on the Federal Reserve and a bunch of f___-ing bond traders?” (Woodward 1994, 84). Everyone around the table nodded in agreement. As we know now, the bond traders came through big-time. But nobody knew that in January 1993.
Looked at broadly, however, the internal disagreements on the Clinton economic team were minor. The difference between deficit hawks such as Panetta and deficit doves such as Reich was, roughly, between reducing the deficit by $140 billion or $120 billion four years later. Twenty billion over four years? That wasn’t even rounding error in macroeconomic terms. In the end, the president surprised many of us by opting for the larger number. Clinton announced his new budget plan in his first major speech as president on February 17, 1993. The date chosen for this address was interesting, by the way. Reagan’s first budget plan was unveiled on February 18, 1981. We would beat them by a day!
After years of being handed phony plans built with noncredible numbers and laden with gimmicks, the budget Clinton proposed in February 1993 made the fearsome bond market vigilantes practically delirious with joy. The numbers were judged to be highly credible (more on this shortly), and the thirty-year Treasury rate, which was then the benchmark, dropped from 7.3 percent on Clinton’s inauguration day to just below 5.9 percent in early September 1993. This remarkable bond market rally had major implications for both the economy and monetary policy, which I’ll get to in the next chapter. For now, let’s stick with the fiscal policy.
Clinton’s economic advisers shared the young president’s belief that the 1990–1991 recession and the “jobless recovery” that followed had probably cost George H. W. Bush the election. (Bush certainly thought so.9) We did not want a repeat performance. Furthermore, the U.S. economy in early 1993 did not look nearly as strong as it would look a few years later. The unemployment rate, which had peaked at 7.8 percent in June 1992, was still 7.3 percent in January 1993. Not much progress. The GDP growth rate had stumbled to 0.7 percent in the first quarter of 1993, though no one knew that in January because of data lags. Finally, Clinton’s economists, Keynesians all, were worried about stifling aggregate demand by cutting spending and raising taxes.
This macro concern affected the budget plan in two main ways. First, the original February 1993 budget proposals tacked a small short-run fiscal stimulus—around $30 billion over two years—onto a substantial deficit-reduction program of nearly $500 billion over five years. This strategy of one step backward, five steps forward proved to be too clever by half, however, and the stimulus part was quickly rejected by Congress. Instead, Congress subsequently passed, albeit barely and without a single Republican vote,10 a deficit-reduction package somewhat larger than Clinton had originally proposed. Thus, the initial stages of Clintonomics turned out to be fiscal prudence without fiscal insurance. Just reduce the deficit, period.
Well, sort of. When you looked at the details, the five-year deficit reduction plan was heavily back-loaded to ease both the expected economic pain from reducing aggregate demand and the expected political pain of getting the plan through Congress. Specifically, the five-year deficit reduction targets for fiscal years 1994–1998 were
· 1994: −$39 billion
· 1995: −$54 billion
· 1996: −$92 billion
· 1997: −$140 billion
· 1998: −$148 billion
Even in the much smaller (than today) economy of 1993, $39 billion was not much—about 0.5 percent of nominal GDP.
Selling the Clinton Budget
But back to the credibility issue. During the 1980s and early 1990s, bond traders had seen, chewed over, and rejected as nonserious one deficit-reduction plan after another. They had come to believe that Rosy Scenario ran macroeconomic forecasting in the White House. We on the Clinton team were determined not to let that happen again. So, several features of the budget plan were specifically designed to make it highly credible.
First and perhaps foremost, Clinton’s first budget designated several sacred cows for ritual slaughter. Most prominently, Social Security benefits were reduced by making some of them taxable for upper-income (though not rich) individuals. Whoever thought a Democrat would advocate that?11 It was a real head-turner.
Second, the deficit-reduction plan included significant new revenues from both higher income taxes on the rich and a brand-new BTU tax, designed to raise revenue while reducing carbon emissions. The latter, a pet policy of Vice President Al Gore, was quickly eviscerated by Congress. The former survived, although its inclusion probably ensured that the overall plan would get zero Republican votes. Both of those tax proposals, however, demonstrated to the bond market that the new administration was willing to take political hits in order to bring the deficit down. The vigilantes, who remembered the political reception accorded the 1990 Bush tax hikes, liked that.
Third, the initial Clinton budget plan, covering five years, was remarkably free of the gimmicks and accounting subterfuges that the markets had come to expect but also detest after years of Reagan and Bush budgets. No blue smoke and mirrors for us. The document we produced looked (and was) sober and serious.
Fourth, the one “gimmick” that Clinton himself ordered (thereby ending a heated internal battle within the staff) actually cooked the books against him. Far from embracing Rosy Scenario as his forecaster, the new president directed the OMB to score the budget proposals by using the CBO’s more pessimistic economic forecast rather than his own administration’s more optimistic one.12 A less robust economy in the future naturally meant that tougher policies would be required to reach the $140 billion deficit-reduction target. Clinton understood that, but he insisted on using the CBO forecast anyway.
Selling deficit reduction to Carville’s feared bond market was one thing. Selling it to the public—and hence to the politicians whom Clinton wanted to vote for it—was quite another. For years, many Americans had shared an uneasy feeling that the federal budget deficit was too large. But precious few understood the benefits that could be expected to flow from smaller deficits.
In 1993 just as before and since, most mainstream economists would have told you a story that ran something like this: Smaller federal deficits should lead to lower real interest rates, which should in turn spur greater private investment spending. Since the larger capital stock spawned by higher investment is one of the mainsprings of worker productivity, which is in turn the central source of higher real wages, shrinking the budget deficit is an indirect way to boost real wages and living standards. That, not our Puritan heritage, is the main reason to seek lower deficits. Clinton’s economists told him precisely that.
But that is not how the president sold deficit reduction to the American public. For Clinton, deficit reduction, like everything else, was a jobs program—a vehicle for redeeming his campaign pledge to create eight million new jobs in four years. This message made most of us economists cringe. It was possible, of course, that lower deficits would so reduce interest rates that economic activity would actually be stimulated. But at the time that seemed like betting on a long shot.13 To stay on message without destroying our integrity, the Clinton CEA (consisting at the time of Laura Tyson and myself) insisted that we claim that the economy would create eight million jobs with our deficit reduction program, not because of our deficit reduction program. It was the truth though perhaps not quite the whole truth.
Clinton saw things differently, however, and with far greater political sensibility. The issue of the day in early 1993 was not real wages; it was jobs. America had been struggling with a sluggish “jobless recovery” for almost two years, and the public wanted their new president to do something about it. The intellectual argument leading from lower deficits to higher real wages, though logically tidy, was abstract, hard to follow, and out of touch with what the people wanted most at the time: more jobs. Had we tried to sell deficit reduction on those grounds, the effort would probably have failed.
Bill Clinton, the master politician, understood that and insisted that we sell deficit reduction as a way to create jobs, not as a way to boost real wages. (“Don’t ever say our program could cost jobs in the short run,” he warned us [Woodward 1994, 124].) History will record him right on both counts. The deficit-reduction program made it through Congress, though barely. And interest rates dropped like a stone, which helped jump-start the economy and throw the great American jobs machine into high gear. Clinton was amply rewarded for his perspicacity and risk taking. Total job creation during Bush’s four years had been only 2.6 million. During Clinton’s first term that total rose to above 11.6 million, greatly exceeding his pledge of 8 million jobs.
With this fine record to run on, Clinton smashed Republican Bob Dole in the 1996 election, winning the electoral college vote by a margin of 379 to 159. And that Clinton’s job approval rating remained high right through the end of his presidency, despite the Monica Lewinsky scandal, was due in no small part to the economic success. The American people were rewarded with another 11.6 million net new jobs in Clinton’s second term. The unemployment rate fell to its lowest level in a generation.
So, was Clinton wrong to sell deficit reduction as a job creator? Would anyone have been better off if instead he had tried to sell deficit reduction as the route to more investment and higher real wages (the economists’ answer) and the package had failed in Congress? Clearly not. This seems to be a case in which some arguably misleading rhetoric produced stellar substantive results whether judged on economic or political criteria.
Revisionist Thinking on Fiscal Policy
It did do some intellectual harm though. The fact that the Clinton boom began shortly after Congress passed a deficit-reduction package gave rise to some revisionist thinking—some of it serious, much of it muddled—on even the sign of the fiscal policy multiplier. Among politicians and media types, the notion that raising taxes or cutting spending, or both, would expand (rather than contract) the economy took hold rapidly and uncritically, with seemingly little thought about the mechanisms by which this was supposed to happen.
Quicker than you could say “Robert Rubin,” the idea that reducing the budget deficit was the way to grow the economy—even in the short run—came to dominate thinking in Washington, in the media, and even in the financial markets (where many people had degrees in economics). Such thinking was, of course, profoundly anti-Keynesian. Maybe it wasn’t thinking at all. But it still had a strong following in Congress years later when President Barack Obama tried to get a large fiscal stimulus bill through Congress in 2009 (more on this in chapter 15).
How could such thinking have been right? How could raising taxes or cutting spending increase output and create jobs, which requires a negative fiscal multiplier? I wondered about that a lot during the early Clinton years and after. The argument that Rubin and other deficit hawks made was that if nothing was done to curb the deficit, something terrible might happen. If reducing the deficit decreased the probability of that implied catastrophe and if that catastrophe would kill many jobs, you could argue that deficit reduction was a (net) job creator in a probabilistic sense. Clinton, Rubin, and others did precisely that.
But what was the feared catastrophe? In some nations, it could be a currency crisis in which capital flees the country, the exchange rate plummets, interest rates soar, and everything heads south. That indeed has happened in a number of times and places. But it seemed an implausible scenario for the United States of America in 1993—or now for that matter. Alternatively, “it” could mean that investors start thinking that the government might default on its enormous debt, interest rates would spike, and the country would fall into recession. Default by the U.S. Treasury? On debt denominated in U.S. dollars? How could that happen? A weaker version, I suppose, might envision not a default but rather a mass movement by investors away from U.S. government debt as foreign portfolios got saturated with treasuries, an interest rate spike, and a recession. Well, maybe. But that seems a weak reed to stand on.
Are there better arguments? In the academic world, some earlier theorizing by Stephen Turnovsky and Marcus Miller (1984) and by Olivier Blanchard (1984) was dusted off to explain how a credible reduction in expected future budget deficits could increase aggregate demand today. Their basic idea was that convincing investors that the national debt will be lower in the future would reduce long-term interest rates today, thereby stimulating current demand. Their models did not claim, however, that a reduction in the current budget deficit would be expansionary today, that is, that the fiscal multiplier was negative. Still, the Turnovsky-Miller-Blanchard analysis offered a theoretically coherent explanation of the Clinton boom that was decidedly superior to the many incoherent ones.
After the fabulous success of Clintonomics, few people stopped to ask whether the lessons of those glory years could be generalized. One exception was Janet Yellen and I in a small book published years later. Our conclusion was that “this is not a formula that can be repeated at will” (Blinder and Yellen 2001, 23). Why not? One obvious reason is that a fiscal announcement can precipitate a major bond market rally only if bond yields start high, as they did in 1993. Another is that fiscal policy must surprise the bond market pleasantly and in large magnitude. This consideration almost requires a prior period of fiscal irresponsibility and then an election that brings in new leadership, as also happened in 1993. Finally, as emphasized earlier, the proposed fiscal changes must be highly credible. Could all that happen again? Certainly. But we should not expect it to occur frequently.
Chapter Summary
The long road to repairing the damage done to the federal budget in 1981 began in 1982 with the repeal of some of the Reagan tax cuts. But progress stalled right there for more than a decade. In the 1980s, three senators (Gramm, Rudman, and Hollings) tried twice to legislate a solution—and eventually a balanced budget—by threatening Congress with mechanical sequestrations of appropriated funds if deficit targets weren’t met. But Congress called its own bluff each time, and both attempts failed.
The first successful steps toward genuine deficit reduction came under President George H. W. Bush in 1990. Despite a recession, he agreed with the Democratic majority in Congress to raise taxes and cut spending. By classroom definitions this was perverse, destabilizing fiscal policy. But the most important step taken in the 1990 budget agreement was to institute a pay-as-you-go requirement for any tax cuts or increases in entitlements, balancing the budget at the margin. PAYGO proved the naysayers wrong by working well until it was repealed in 2002 in order to allow President George W. Bush to bust the budget again. Thus, ironically, one of the good deeds of the father was repealed by the son.
PAYGO was in force when Bill Clinton came into office, and he bolstered it with a sizable five-year deficit-reduction package that included tax hikes, cuts in discretionary spending, and even some trims in entitlements. In Clinton’s memorable phrase the Democrats became “Eisenhower Republicans,” and a sharp bond market rally made it all work—amazingly well, in fact. Helped along by the Clinton boom of the late 1990s, the federal budget went from chronic large deficits to surpluses with amazing speed. Even Clinton’s anti-Keynesian prophecy that deficit reduction could create jobs seemed to come true.
These developments were good news for the American economy but bad news for believers in Keynesian fiscal policy. Under George H. W. Bush, the government opted for fiscal contraction during a recession. Under Bill Clinton, a fiscal contraction seemed to precipitate a boom. Was the fiscal multiplier actually negative? No. But quite a few Americans, including many members of Congress, came to think so.
Ideas have consequences. The thought of what would happen the next time the U.S. economy needed a boost from fiscal policy left many economists uneasy. They didn’t have to wait long.
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1. In those years the federal government’s fiscal year ran from July 1 to June 30. Thus, fiscal year 1975 spanned July 1, 1974, through June 30, 1975.
2. See, among other possible sources, Safire (1984).
3. See, for example, the satirical tone in Yang (1990).
4. “Higher” interest rates must be assessed against the long-term downward trend in interest rates discussed earlier.
5. Many references could be cited. Two are Evans (1987) and Kliesen (2002).
6. To be sure, public opinion polls typically found support for less government spending in the abstract. But when offered cuts in specific programs, respondents rejected almost all of them.
7. Previous presidents had something analogous to the National Economic Council. But Clinton’s clear intent was to elevate economics to the same status as national security, hence the name National Economic Council to give it parity with the National Security Council.
8. This is a major theme of Woodward (1994).
9. In a TV interview years later, Bush lamented that “I reappointed him and he disappointed me” (Greenspan 2007, 122).
10. Vice President Al Gore had to break a 50–50 tie in the Senate.
11. Confession: I made a small bet with another economist on the Clinton team that the president would not accept that recommendation. I lost.
12. Another confession: I was in charge of the administration’s five-year forecast, which while more optimistic than the CBO’s proved to be far too pessimistic. The economy did vastly better than we dared imagine. But no one ever criticized me for the terrible forecast!
13. The long shot came in. Long-term interest rates plummeted while the Clinton plan was being debated and enacted.