Fiscal Imbalance: Problems, Solutions, and Implications A Summary of the 2005 Philadelphia Fed Policy Forum by Loretta J. Mester

iscal Imbalance: Problems, Solutions, and number of retirees is increasing. Implications” was the topic of our fifth Greenspan pointed out that cur- rently 3.25 workers contribute to the “F annual Philadelphia Fed Policy Forum Social Security system for each benefi- held on December 2, 2005. This event, ciary. By 2030, the number of benefi- ciaries will have doubled and the ratio sponsored by the Bank’s Research Department, brought of covered workers to beneficiaries will together economic scholars, policymakers, and market have fallen to 2. At the same time, spending per Medicare beneficiary economists to discuss and debate the implications of is expected to increase as the cost of fiscal imbalance for the U.S. economy. Our hope is that medical care rises. In fiscal year 2005, federal outlays for Social Security, the 2005 Policy Forum will serve as a catalyst for both Medicare, and Medicaid totaled about greater understanding and further research on the fiscal 8 percent of gross domestic product (GDP). Office of Management and challenges facing the U.S. economy. Budget projections suggest this share will rise to 9.5 percent by 2015 and to 13 percent by 2030. While productiv- ity growth can help alleviate some of the strain on the budget, it won’t be At the current pace of spending that budget imbalance is one of the the whole answer. Growing budget and revenue generation, the U.S. faces important challenges facing the U.S. deficits could drain resources from a worsening budget position over the economy over the medium and longer private investment and thereby hurt coming years. While the problems run, there is considerably less agree- the growth of living standards. with the Social Security program have ment on what should be done to meet As Greenspan noted, some of the garnered most of the headlines, financ- those challenges. parameters needed to scale the prob- ing health care and the Medicare Alan Greenspan, then Chairman lem are known. For example the size system poses the greatest challenge. of the Federal Reserve Board, opened of the adult population in 2030 is fairly The size of the problem, longer-term the conference. In his view, the defi- easy to estimate since most of that implications of fiscal imbalance, and cit-reducing actions necessary to stem population has already been born. But potential solutions were the focus of the worsening budget position will be other parameters, such as the amount the 2005 Philadelphia Fed Policy Fo- difficult to implement unless proce- of future medical spending, are very rum. While there is general agreement dural restraints on the budget-making difficult to estimate. Medical techno- process, like limits on discretionary logical innovations can improve the spending and the PAYGO require- quality of health care and lower the Loretta J. Mester ments, are restored. He said that cost of existing treatments, but they is a senior vice reinstating the structure in the Budget can also expand treatment possibilities president and and life expectancy, and both of these director of Enforcement Act of 1990 and coupling research at the it with provisions for dealing with can mean higher spending. Federal Reserve unexpected budget outcomes would be Greenspan said that he fears the Bank of beneficial. But it would not be enough U.S. may have already committed Philadelphia. This more resources to the baby boom- article is available to solve the problem. The fundamen- free of charge at tal issue is making choices among ers than it can deliver. If so, making www.philadelphiafed.org/econ/br/index.html. budget priorities, especially since the changes to those promises should come www.philadelphiafed.org Business Review Q3 2006 31 sooner rather than later – a theme theory of public goods or externalities. what people tend to think about is echoed by other speakers at the Policy Shiller listed several of the what other people think about (a kind Forum – so people can plan their work, concepts from behavioral economics of herding). There is also a wishful savings, and retirement spending ac- that are important to understanding thinking bias: People believe what they cordingly. Although he believes clos- how we think about the future. One want to believe. This makes people ing the budget gap depends on changes of these is hyperbolic discounting, tend to underestimate risk. Indeed, to both the spending and tax sides, which refers to the tendency to behave psychologists have hypothesized that he thinks that most of the change inconsistently over time: We tend to people have certain pathways in their should come on the outlay side, and be impulsive and put more value on brains to deal with risk, but they are he suspects that we may need to make today than tomorrow. Psychologists not suited to the modern world. For significant structural changes to U.S. are documenting that people think example, being in a crowded room retirement and health programs. Solv- about the present in concrete terms when a wild animal escapes would ing the Medicare problem is more dif- but the future in more abstract terms, cause your scared reflexes to engage, ficult than Social Security because of and this may underlie why people place but being told you are not saving the difficulties in estimating the trend more importance on the present than enough for the future doesn’t. The last in medical expenditures. Greenspan the future. Another concept is that of behavioral concept Shiller discussed concluded by saying that doing noth- framing. People may behave inconsis- was the instinct for people to believe ing to solve the budget imbalance tently, depending on how a situation those in authority: People have high could have severe consequences for the is described to them; they react to expectations for government authori- U.S. economy, but addressing the issue the names things are given and the ties and tend to believe them. in a timely and sound fashion could context. Psychological research has In Shiller’s view, we need to in- produce lasting benefits. also shown that some of the biggest corporate these concepts of behavioral errors people make are errors of atten- economics into our thinking about SOCIAL SECURITY AND MEDI- tion: Something else has caught their ways to solve the government budget CARE: SCALING THE PROBLEM attention, and they don’t get around problems, and he believes this is begin- AND PROPOSED SOLUTIONS* to thinking about saving. In addition, ning to happen. This approach need This session took up the problem of how to scale the fiscal deficit prob- lem and what can be done to solve it. Our first speaker, Robert Shiller, of Yale University, spoke on the underly- ing life-cycle issues involved in the Social Security and Medicare deficits. He expanded on many of Chairman Greenspan’s themes but from the perspective of behavioral economics. One of the fundamentals underlying the government budget deficit and the low personal saving rate is the problem people and society have in planning for the distant future. In Shiller’s view, these behavioral considerations justify government interventions in a broader set of circumstances than those sug- gested by the traditional economic

* Many of the presentations reviewed here are available on our website at www.philadelphiafed.org/econ/conf/ forum2005/ program.html. Robert Shiller, Yale University (left), and Peter Diamond, Massachusetts Institute of Technology.

32 Q3 2006 Business Review www.philadelphiafed.org not imply a “big government” solution. choices regarding health care.) Shiller be cut by about 25 percent to match People are in a better position to know thinks this should give government revenues. Using a 75-year horizon, the what they need and should be al- and private initiatives motivation to unfunded portion of promised benefits lowed to express it, but they will make help people deal with these compli- is 1.8 percent of taxable payrolls as of mistakes that have to be dealt with. cated issues, and he pointed to a few January 1, 2005. Comparing this to He concluded his talk by discussing examples of private initiatives. the current Social Security payroll tax some of the potential solutions to the The “save more tomorrow” plan of of 12.4 percent shows that there is a Social Security and health-care prob- Richard Thaler and Shlomo Benartzi problem, but it is not an enormous one lems. Shiller has been critical of the offers employees the choice to funnel when compared with the Medicare Bush Social Security plan, although future pay raises automatically into problem. he acknowledges it had some creative a savings account. People have a Certain groups rely more on Social elements. In particular, Shiller thinks tendency not to save for today, since Security for a larger part of their retire- the life-cycle part of the plan was ment income than other groups. For unique in that it would automatically example, a fifth of the elderly get all put people who chose the account plan While poverty among of their income from Social Security, into a life-cycle portfolio at the age of the elderly has fallen, and two-thirds get 50 percent or more. 47. Having this as a default option is Particularly vulnerable groups include in accord with some of the recent prin- it is still at fairly high long-career low earners, widows and ciples of behavioral economics – i.e., levels, especially widowers with low benefits, disabled you cannot expect people to make among divorced workers, and surviving children. active choices. On the other hand, he While poverty among the elderly has also criticizes the Bush plan, likening women. fallen, it is still at fairly high levels, it to a “margin loan” whereby people especially among divorced women. could borrow against their Social Se- it means taking away some of today’s In Diamond’s view, Social Security curity benefits and put the money into spending. But they are willing to is a part of addressing the country’s stock portfolios. For people already sign up to save more tomorrow, and poverty issue. saving with a diversified portfolio, it is the plan has been shown to increase Diamond was critical of the Bush not of much use. For people who are savings. Firms are also beginning to Social Security plan and some of the not saving, the plan is risky, since the change their 401K plans so that the others on the table. Diamond agreed stock market is volatile. default is that the employee is in the with Shiller that to the extent that Shiller said that the Medicare plan rather than out of it – a simple people’s private retirement plans are Part D prescription and health savings change that takes into account human moving from defined benefit to defined accounts have had some implemen- behavior. Shiller views this as a time contribution, with some investment in tation problems that can be viewed of experimentation in which our way the stock market, he doesn’t see the through a behavioral economics lens. of thinking about basic economic individual accounts in the Bush plan The prescription plans afford people problems is changing. Our solutions as being that valuable. Moreover, the so many options that it is a daunting to the savings and health-spending private accounts would exhaust the task to make an optimal choice. In problem can be more creative, since trust fund about a decade earlier than Shiller’s view, there is a creative idea they will be based on new discoveries under the current program. Some behind the health savings accounts, about the ways people make decisions. of the other plans actually go in the namely, insure people for catastrophic Peter Diamond, of the Massachu- wrong direction and make the 75-year events but have them manage a budget setts Institute of Technology, contin- Social Security trust fund shortfall to cover their other health spending. ued the discussion with a summary larger rather than smaller. Provi- Unfortunately, not many people have of the size of the Social Security and sions such as price indexing, which signed up for these plans, suggesting Medicare deficit problems and a cri- in Diamond’s view is a misnomer for they don’t know how to prepare for tique of proposed solutions. Accord- real-wage deflating, and raising the health risks. (Later Forum speakers ing to the 2005 Annual Report of the age at which full benefits start result in pointed out that consumers may not Trustees of Social Security, the Social large reductions in benefits. Regarding have the information they need on Security trust fund will be exhausted Medicare, the issue in Diamond’s view prices and quality to make optimal in 2041. At that point, benefits would is how to combine universal coverage

www.philadelphiafed.org Business Review Q3 2006 33 that equals debt held by the public tudes. But it also could be that capital plus the present value of all future markets believe the government is outlays minus the present value of going to solve the problem mainly by all future revenues, and a genera- cutting benefits rather than raising tional imbalance component that taxes. Smetters thinks this is a some- measures the proportion of the fiscal what irrational view, given the aging imbalance due to spending by past of the median voter. He ended on an and current generations relative to optimistic note by pointing out that 50 what they have paid into the system. percent of U.S. households don’t hold Different reform proposals for Social any equities either directly or indirectly Security will have different effects in employer-sponsored defined contri- on the generational imbalance, bution plans. Thus, the component of depending on how they affect taxes the Bush plan that puts people into a and benefits now and in the future. life-cycle portfolio plan automatically Under the assumptions made by the by default is an important innovation Office of Management and Budget, in Smetters’ view. He is less concerned the Department of the Treasury, and than Shiller and Diamond that people Kent Smetters, Wharton School, the Council of Economic Advisers, will make wrong choices. University of Pennsylvania Smetters estimates that the total fiscal The Policy Forum’s keynote imbalance in Social Security in 2004 luncheon speaker was Katherine with quality and cost containment. was $8 trillion. Past and living genera- Baicker, a member of the Council of Diamond said that without universal tions have gotten about $9.5 trillion Economic Advisers, who spoke about coverage, cost containment would more from Social Security than they the important fiscal challenges the have some unintended consequences. paid into it, and under current law, U.S. faces over the coming years on The final speaker in the first ses- future generations will pay $1.5 trillion both the spending and revenue sides of sion, Kent Smetters, of the Wharton more into the program than they will the federal balance sheet and her views School, University of Pennsylvania, get out of it, for a net total imbalance of what steps should be taken to meet addressed some of the measurement of $8 trillion. Medicare has a much those challenges. Baicker pointed out issues in budget accounting, arguing larger imbalance of $61 trillion, with that while over the last 40 years spend- that the traditional budget approach $24 trillion due to past and living gen- ing and revenues have been relatively worked fine when government erations and $37 trillion due to future stable, there have been important programs were more of a bricks and generations. The rest of the federal changes in the composition of both mortar type; it works less well for pro- government is in a surplus. Thus, the that will help determine future stabil- grams with long-term liabilities, such total fiscal imbalance was $63 trillion ity if nothing is done to entitlement as Medicare and Social Security. The in 2004, and it is growing significantly programs, the largest of which are So- federal budget substantially underes- each year. This represents 18 percent cial Security, Medicare, and Medicaid. timates the government’s liabilities by of all future payrolls and is a very large Without changes in those entitlement ignoring long-term liabilities. It tracks problem. For example, Social Security programs, Baicker says that a decade them separately, off budget. So the and Medicare benefits would have to from now, government spending as a budget gives an incomplete picture of be cut by over half to close the imbal- share of GDP will begin to rise swiftly, the country’s fiscal imbalance. The ance. Alternatively, the combined with potentially dire consequences for traditional budget accounting also employer-employee payroll tax would the U.S. economy. makes it hard to evaluate the impact of have to rise from 15.3 percent to over On the expenditure side, federal program reforms. If the benefit of the 32 percent and the payroll tax ceiling spending as a fraction of GDP since reform is off budget but the cost is on would have to be removed. 1962 has been relatively stable at about budget, the reform will look like it in- Given these dire numbers, why 20.4 percent, but the share of GDP creases the fiscal imbalance. Smetters haven’t the capital markets reacted? devoted to entitlement spending has proposes a new budgetary framework Smetters says it could be behavioral, tripled, while the share of spending that includes two integrated compo- along the lines Shiller discussed; that going to defense and other government nents: a fiscal imbalance component is, they don’t understand the magni- spending, such as highways, educa-

34 Q3 2006 Business Review www.philadelphiafed.org tion, and national parks, has fallen. In workers to prices would be 1962, entitlement spending was pri- an important step toward marily Social Security, and it was 2.5 permanent solvency. percent of GDP and 13 percent of the To control the cost of federal budget. Medicare and Medic- government-financed health aid were introduced in the 1960s, and care, Baicker said we need to in 2005, the three programs together address the costs of health accounted for 8 percent of GDP and care in the private sector made up 40 percent of the federal as well. In her view, much budget (not including the substantial of the spending on health contributions to Medicaid made by the care – both publicly and states). privately financed – is not The revenue side of the federal being efficiently allocated. budget also shows stability, with total To alleviate this, she said it federal revenues averaging 18.2 percent is most important to create of GDP since 1962. Payroll taxes, incentives for high-value which are used to fund Social Secu- care. For example, Baicker Katherine Baicker, Council of Economic Advisers rity and Medicare, have doubled over said that the current tax the period, from about 3 percent of code subsidizes employer- GDP to a bit over 6 percent. Personal provided health insurance relative to increase competitiveness in these income tax collections have been other forms of compensation and to markets, leading to lower prices and relatively stable, while excise tax and individually purchased health insur- improved quality. At the same time, corporate income tax collections have ance. This leads to insurance coverage Baicker acknowledged in the question declined. Comparing the revenue of routine and predictable health-care and answer period that several difficul- and expenditure sides shows that the expenditures rather than paying for ties would need to be solved before federal government has been running those out-of-pocket and insuring moving to what she calls “consumer- a deficit of about 2.2 percent of GDP a year. In 2005, the deficit was some- The stability of the fiscal situation in the U.S. what higher at 2.6 percent of GDP. But Baicker pointed out that over the past 40 years is in jeopardy, since the stability of the fiscal situation in the first part of the baby boomers will reach the U.S. over the past 40 years is in jeopardy, since the first part of the retirement age in 2008. baby boomers will reach retirement age in 2008. Over the next 40 years, the against catastrophic and unexpected driven health care.” One of these is a costs of the three entitlement programs expenditures. Baicker says capping the lack of transparency. For example, it will rise from about 8 percent of GDP employer exclusion of health insur- is difficult to decipher the pricing of today to over 15 percent of GDP in ance premiums is one step that could services from the bills you receive from 2045. This trend suggests that without be taken to increase the sensitivity of health-care providers and to obtain in- a change in the programs, either taxes the use of health care to its cost. She formation on the quality of providers. must increase substantially or spend- is also in favor of expanding health Without price and quality information, ing outside of entitlements must be savings accounts, which allow people rational health-care decisions are se- nearly eliminated – both poor choices to pay for health care with pre-tax verely hampered (even aside from the in Baicker’s view. Baicker agreed dollars as long as their health insur- behavioral aspects of decision-making with the earlier speakers that solving ance policy includes a sufficiently high Shiller spoke about). the Medicare/Medicaid problem was deductible and catastrophic coverage. Our second session turned to two more challenging than solving Social She believes steps like these would budget experts for their views on the Security, because she was optimistic help ensure that health-care resources current budget deficit and prognosis. that the President’s plan of progressive were allocated to uses with higher Doug Holtz-Eakin, then director of indexing of benefits of higher-earning value, and she thinks this could also the Congressional Budget Office, said

www.philadelphiafed.org Business Review Q3 2006 35 he viewed the U.S. fiscal situation to – such as incorporating an average something needed to be done about be the single most important economic level of funds in anticipation of natural it. There wasn’t bipartisan agreement policy challenge we face if the cur- disasters that recur repeatedly like about what should be done, but rules rent programs are not reformed. In hurricanes, wild fires, and droughts were put in place to control spend- his view, adhering to the promises – Holtz-Eakin said this is not the key ing, control entitlement spending, to spend as under current law will and control tax cuts, and the strong fundamentally impair the economic economy operated to reduce the deficit success of the U.S. It will result in a Doug Holtz-Eakin and turn it into a surplus. Rivlin said larger federal government, higher tax this time we do not have consensus rates, and more reliance on mandates said he viewed the that there is a problem, even though and regulations to achieve policy aims U.S. fiscal situation the future budget imbalance is very rather than on the budgetary process. large as spending on Social Security, In the CBO’s summer update to be the single most and especially on Medicare and Med- to the budget outlook, the federal important economic icaid, increases rapidly. Echoing the budget was projected to move back to policy challenge we earlier Policy Forum speakers, Rivlin baseline trends and become better in believes the Social Security problem is balance over the next five years. But face if the current manageable; Medicare and Medicaid there were several risks to that projec- programs are not are far larger problems. She thinks per tion, for example, the path of defense capita health spending, both nationally spending and possible changes to the reformed. and in these programs, will continue alternative minimum tax. Moreover, to rise 2.5 percent faster than GDP as the hurricanes, which occurred after to solving our budget problems. Rath- it has over the last four decades; she that update, affected the budget in er, the key is addressing the long-term is skeptical of the Medicare trustees’ three ways. They changed the cost cost of our mandatory spending prob- assumption that it will decelerate to 1 of ongoing programs, but not by large lems. It is important that the relatively percent faster than GDP growth and amounts. They led to direct appropria- benign near-term budget outlook not eventually to the same pace as GDP tions for relief and recovery, but the seduce us into ignoring the long-term growth. spending associated with those gener- problems. In Holtz-Eakin’s view, policy Under Rivlin’s assumption, there ally takes place over time. They might decisions rather than the course of the is no tax rate that will bring back fiscal also lead to permanent changes in the economy are central to the long-term balance, and if the deficit problem isn’t law; for example, 12 pieces of legisla- budget outlook. tion with hurricane relief provisions Alice Rivlin, of the passed quickly. Holtz-Eakin explained Brookings Institution, that the spending and tax reconcili- continued the discussion by ation is now an important part of the pointing out that it has been budget process. For the first time in decades since the U.S. has eight years, Congress has used these seen as rapid a reduction procedures to cut spending in manda- in revenues as a percent of tory programs that are relevant to the GDP as has occurred in the long-term budget outlook. In Holtz- past five years. The CBO Eakin’s view the important thing is not projections are based on cur- the amounts but the fact that Congress rent law. Thus, they assume now understands that each year the the tax cuts of 2000, 2001, mandatory programs need to be on the and 2003 expire. If instead table and that the process of recon- they continue, the budget ciliation will be part and parcel of the imbalance is much worse. process of legislating. Rivlin said we experienced While he suggested there are some a similar situation in the things the government could do to 1990s. Back then there improve the formulation of the budget was bipartisan agreement that Alice Rivlin, Brookings Institution

36 Q3 2006 Business Review www.philadelphiafed.org solved, interest expenditures will rise especially for diseases like to over 20 percent of GDP by 2050, so cancer where the innova- borrowing is not a sustainable option tions are unlikely to lead either. to expanded treatment, According to Rivlin, to solve the since these diseases already budget imbalance problem, we need to always get treated at some slow the rise in health-care spending stage. There are political in the federal budget. And we need obstacles that would need to do that in a way that will slow the to be overcome. In Rivlin’s per capita spending on health care not view, these include the only by the government but also by the power of insurers, phar- private sector, because otherwise it is maceutical companies, just shifting the expenditures. Rivlin and providers, who have pointed out that the U.S. has a very been fairly negative on expensive health-care system com- change. Rivlin concluded pared with other countries; while the by pointing out that the U.S. Richard Fisher, President, Federal Reserve Bank of Dallas rates of growth in per capita spending is not alone in this problem, are similar in developing countries, which she says is a problem our level of spending is higher. While of prosperity. In the U.S. and in other tion. He believes it is very important there have been cost-saving innova- successful economies people are living to consider how the forces of globaliza- tions in providing health care, these longer and better, and part of that liv- tion affect U.S. fiscal deficits. Glo- innovations also tend to increase ing better is better medical care. balization means a nation’s economic demand for the service. But there are potential is no longer defined by its ways to increase cost effectiveness. geographic boundaries. In a global For example, the practice of medicine economy, goods, services, capital, and continues to be paper-based; improve- In a global economy, labor can migrate to where they can be ments in information systems could goods, services, most efficiently used and where there probably reduce costs and might also capital, and labor can are fewest obstacles to putting them result in fewer treatment errors. to efficient use. So countries need Because the Medicare system is an migrate to where they to compete for these resources. In almost universal system for the over-65 can be most efficiently Fisher’s view, businesses have come to population, it holds the potential for grips with globalization, and global- learning about which treatments are used and where there ization has helped discipline central cost-effective – provided its data can are fewest obstacles bankers around the world to focus on be analyzed. The next issue would to putting them to keeping inflation low. Fisher believes be what to do with this information. that globalization is also exerting some Rivlin pointed out that one strategy efficient use. discipline on fiscal policymakers, and was suggested by Baicker: to give the U.S. is in better shape than most consumers the information and let of its competitors. One of the ways them make the choices through, for The Policy Forum’s final session globalization has a beneficial effect example, health savings accounts. took up the broader implications of on fiscal decision-making is via tax The other strategy is to change the fiscal imbalance for the macroecono- competition. Fisher pointed out that reimbursement system to reward ef- my. Richard Fisher, president of the average tax rates are falling in the fective medical care and not pay for Federal Reserve Bank of Dallas, agreed world’s most open economies. Also, to ineffective and excessive medical care that the magnitude of the projected the extent that young people can move – although Rivlin admitted we don’t budget deficits is of great concern to escape high Social Security taxes, know how to do that yet. She suggest- and said that, left unchecked, they it is more difficult to sustain a system ed a companion step is to use federal have the potential of harming U.S. based on intergenerational transfers. government research dollars to push economic prosperity and undermining In theory, globalization should ex- for innovations likely to be cost saving, the progress we have made on infla- ert a similar discipline on the spending

www.philadelphiafed.org Business Review Q3 2006 37 side, but Fisher says we have yet to see Fisher. In Barro’s view, in the last 25 of California at Berkeley, formulated such deficit-reduction pressures. None- years there has been a major triumph his talk around the policy changes we theless, when investors are considering in terms of central banks around the should expect in response to the fiscal where to allocate their capital, it is world achieving low and stable rates situation we face and the economic the relative position of one country vs. of inflation. He said he is not certain effects we should expect as people an- another that matters. In Fisher’s view why monetary policy has worked as ticipate these policies. He agreed with the U.S. has been able to finance its well as it has in the U.S. and abroad. earlier speakers that we face a rising spending via foreign capital because His analysis indicates that Fed policy imbalance that gets much larger with we are doing better in terms of fiscal under former Chairman Greenspan every year something isn’t done to solve policy compared with other coun- could be characterized as a reaction it. Auerbach said the problems policy- tries. Fisher provided some numbers: function, with the federal funds rate makers need to address (in order of im- According to OECD data, public-sec- reacting to the inflation rate and the portance) are health-care spending and tor spending (including federal, state, real economy as embodied in employ- the federal contributions to Medicare and local government spending) was ment growth and the unemployment and Medicaid; general revenue taxes, projected to be 3.7 percent of GDP rate. The analysis suggests that the i.e., taxes not associated with entitle- in the U.S. in 2005, compared with Fed does not respond to changes in ment programs and not payroll taxes; 6.5 percent in Japan, 4.3 percent in real GDP that are due to productiv- and Social Security. In Auerbach’s Italy, and 3.9 percent in Germany. He ity growth. The Fed’s policy is also view, most discussions of the macro- thinks that the demographic chal- characterized by gradualism: It moves economic effects of fiscal imbalance lenges regarding Social Security and interest rates gradually. Barro said it have focused mainly on the effect of Medicare in the U.S. are not as severe was not clear that the Fed’s reacting current fiscal policy on the economy. as those facing Japan and Germany. to the real economy and gradualism These would include possible crowding But while the U.S. may be bet- are beneficial. Nonetheless, in Barro’s out of private investment by govern- ter off than other countries, Fisher view the Fed’s triumph over high infla- ment spending, higher interest rates, believes following “least-bad” policy tion is a remarkable achievement. and current account deficits. There is risky, since it is never clear whether Alan Auerbach, of the University has been little discussion of the effects our advantages will last, especially if a rising deficit erodes U.S. economic performance. He believes that to se- (left to right): Tony Santomero, former President, Federal Reserve Bank of Philadelphia; cure our advantages we should put our Robert Barro, Harvard University; Alan Auerbach, University of California at Berkeley; and Doug Holtz-Eakin, former Director, Congressional Budget Office. fiscal house in order before our competitors put theirs in order. Fisher pointed out that monetary policy- makers cannot be indiffer- ent to the thrust of fiscal policy because poor fiscal policies create pressure for poor monetary policies, e.g., monetizing the debt and fueling inflation. But he emphasized that the solution to the U.S. fiscal imbalance rests with fiscal policymakers and not the central bank. Robert Barro, of Harvard University, took up the theme of monetary policy touched on by

38 Q3 2006 Business Review www.philadelphiafed.org of the necessary policy changes on the ments in the future. Means testing has markets. Until that uncertainty is economy. mixed effects on incentives to accumu- resolved, the equity premium should Given the size of the future fiscal late wealth. If you are so wealthy that be higher. At least, this should occur imbalance and the fact that federal you know you are going to be hit by when people realize the current fiscal taxes as a share of GDP are lower now the means test, you’ll have an incen- situation is not sustainable. A resolu- than at any time since the 1960s, an tive to accumulate even more wealth, tion of policy uncertainty would make eventual tax increase of 4 percent since your retirement and health-care us better off, and Auerbach suggested of GDP, through a combination of benefits have just been reduced. But that the costs of adjustment that we broadening the tax base and increasing if your wealth is near the level where know must come at some point would marginal tax rates, would not be im- benefits are phased out by the means be lower if we adopted more gradual plausible in Auerbach’s view. Econom- ic models suggest that higher future There was agreement that difficult policy tax burdens should induce people to increase effort today to be able to pay choices will have to be made and that the time future taxes and to save. Thus, we’d for making them is now, not later, if we want to expect higher labor-force participation, reduce the impact of the fiscal imbalance on higher employment, and higher private saving to pay for future taxes. The the U.S. economy. higher marginal tax rates might also encourage more work today if people test, you could have a strong incentive systemic plans to address the fiscal plan to retire earlier than otherwise as to save less so that you would qualify imbalance. However, Auerbach said a result of the tax change and decide for benefits. And since you are saving he was not encouraged by recent policy to work harder now to save enough to less, you’ll work less as well. actions. retire. However, higher marginal tax Auerbach pointed out two other rates would also induce lower private potential macroeconomic effects as the SUMMARY saving, since those savings would be economy adjusts to changes in fiscal The 2005 Policy Forum generated taxed at a higher rate. policy. Trade deficits will shrink and lively discussion among the program Auerbach doesn’t think much turn into trade surpluses in the future. speakers and audience on the chal- progress on the Social Security and As that occurs, the composition of lenges facing the U.S. in dealing Medicare problems will be made until U.S. GDP will change toward more with its increasing fiscal imbalance. there is a crisis. At that point, the trade-sensitive industries. Until we Although there was no agreement on problem will be too large to be solved know how the fiscal imbalance will be particular solutions, there was agree- by increased payroll taxes alone, but handled – how much taxes increase, ment that difficult policy choices will politically it will be nearly impossible to how much marginal tax rates increase, have to be made and that the time for make sizable benefit cuts for less afflu- how much the tax base broadens, how making them is now, not later, if we ent retirees. Thus, Auerbach believes much benefits are cut – there will be want to reduce the impact of the fiscal there will be means testing of entitle- substantial uncertainty in financial imbalance on the U.S. economy. BR

www.philadelphiafed.org Business Review Q3 2006 39 The Philadelphia Fed December 1, 2006 POLICY FORUM Economic Growth and Development:

We will hold our sixth annual Philadelphia Fed Policy Forum on Friday, December 1, 2006. This year’s topic is “Economic Growth and Development: Perspectives for Policymakers.” At right is the program. The Policy Forum brings together a group of distinguished economists and policymakers for a rousing discussion and debate of the issues. For further information, please contact us at [email protected].

PHOTO BY B. KRIST FOR GPTMC Photo by B. Krist for GPTMC

FEDERAL RESERVE BANK OF PHILADELPHIA December 1, 2006 The Philadelphia Fed Policy Forum The Philadelphia Fed Economic Growth and Development: Perspectives for Policymakers December 1, 2006 POLICY FORUM Federal Reserve Bank of Philadelphia, 6th and Arch Streets Economic Growth and Development: Continental Breakfast Opening Remarks Charles I. Plosser, Federal Reserve Bank of Philadelphia

Economic Growth and Development: An Overview of Issues and Evidence Moderator: Michael Dotsey, Federal Reserve Bank of Philadelphia

roberto Zagha, The World Bank Xavier Sala-i-Martin, Columbia University

Discussion and Audience Participation

Policy Responses: Trade and Foreign Aid Moderator: Kei-Mu Yi, Federal Reserve Bank of Philadelphia

elhanan Helpman, Harvard University William Easterly, New York University

Discussion and Audience Participation

Lunch

Financial Markets and Growth Moderator: Loretta J. Mester, Federal Reserve Bank of Philadelphia

Jeffrey M. Lacker, President, Federal Reserve Bank of Richmond robert M. Townsend, University of Chicago

Discussion and Audience Participation

Institutional Arrangements and Economic Growth and Development Moderator: George Alessandria, Federal Reserve Bank of Philadelphia

PHOTO BY B. KRIST FOR GPTMC Dani Rodrik, Kennedy School of Government, Harvard University ross Levine, Brown University Daron Acemoglu, Massachusetts Institute of Technology

Discussion and Audience Participation

Reception and Informal Discussion

FEDERAL RESERVE BANK www.philadelphiafed.org Business Review Q3 2006 41 OF PHILADELPHIA