Economic Policy Review Advisory Board

Federal Reserve Bank of New York April 2000 April Economic Volume 6 Number 1 Volume Policy Review Fiscal Policy in an Era of Surpluses: Economic and Financial Implications Proceedings of a Conference Sponsored by the Federal Reserve Bank of New York FEDERAL RESERVE BANK OF NEW YORK ECONOMIC POLICY REVIEW ADVISORY BOARD EDITOR Andrew Abel Richard J. Herring Wharton, University of Pennsylvania Wharton, University of Pennsylvania Paul B. Bennett Ben Bernanke Robert J. Hodrick Princeton University Columbia University ASSOCIATE EDITORS Timothy Bollerslev R. Glenn Hubbard Duke University Columbia University Linda S. Goldberg Charles Calomiris Christopher M. James Kenneth N. Kuttner Columbia University University of Florida, Gainesville Hamid Mehran Stephen G. Cecchetti Kose John Philip E. Strahan Ohio State University New York University Richard Clarida Edward Kane Columbia University Boston College Francis X. Diebold Deborah Lucas EDITORIAL STAF F New York University Northwestern University Valerie LaPorte Franklin Edwards Richard Lyons Columbia University University of California, Berkeley Mike De Mott Henry S. Farber Frederic S. Mishkin Princeton University Columbia University PRODUCTION STAFF Mark Flannery Maurice Obstfeld Carol Perlmutter University of Florida, Gainesville University of California, Berkeley Mark Gertler Raghuram G. Rajan David Rosenberg New York University University of Chicago Jane Urry Gary Gorton Kenneth Rogoff Wharton, University of Pennsylvania Princeton University James D. Hamilton Christopher Sims University of California, San Diego Ya le Un iver si ty Bruce E. Hansen Kenneth D. West University of Wisconsin University of Wisconsin John Heaton Stephen Zeldes Northwestern University Columbia University The ECONOMIC POLICY REVIEW is published by the Research and Market Analysis Group of the Federal Reserve Bank of New York. The views expressed in the articles are those of the individual authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. www.ny.frb.org/rmaghome Note to Our Readers: This special issue, devoted to the proceedings of the conference “Fiscal Policy in an Era of Surpluses: Economic and Financial Implications,” introduces a new cover and interior page design for the Economic Policy Review. Our aim is to give the publication a fresh look, with bolder color and more contemporary styling of text and graphics. The new design has two variants—one for conference volumes covering a single theme and another for a regular research issue containing articles on diverse economic and financial topics. The creation of a separate design for conference volumes is a reflection of the growing public interest in the conferences sponsored by the Federal Reserve Bank of New York. In recent years, Bank symposia have provided a valuable forum for the discussion of such important policy issues as income inequality, the economics of education reform, and the future of capital regulation. As part of the redesign, regular research issues of the Economic Policy Review will now preface each article with a helpful bullet-point summary of key arguments. The cover of these issues will also give greater prominence to the names of the authors and the titles of their articles—a nod to the considerable contribution that our economists are making to the literature in their fields. It is a particular pleasure for me to introduce the redesign of our publication at this time. This issue of the Economic Policy Review is the first of the year 2000 and the first to appear during my tenure as director of research. I hope that you will share my enthusiasm for the new look and features of the Review. Christine M. Cumming Executive Vice President and Director of Research Federal Reserve Bank of New York Economic Policy Review April 2000 Volume 6 Number 1 Contents Fiscal Policy in an Era of Surpluses: Economic and Financial Implications Proceedings of a Conference Sponsored by the Federal Reserve Bank of New York December 3, 1999 1 Opening Remarks William J. McDonough 3 Summary of Observations and Recommendations Richard Peach and Charles Steindel Session 1 9 Formation of Fiscal Policy: The Experience of the Past Twenty-Five Years Alan J. Auerbach 25 Commentary Barry Bosworth 29 Commentary C. Eugene Steuerle Session 2 35 The Automatic Fiscal Stabilizers: Quietly Doing Their Thing Darrel Cohen and Glenn Follette 69 Commentary Olivier Blanchard Distinguished Address 77 The Near-Term Outlook for Fiscal Policy Rudolph G. Penner Keynote Address 83 Fiscal Policy in an Era of Surpluses Gary Gensler Session 3 89 Enhancing the Liquidity of U.S. Treasury Securities in an Era of Surpluses Paul Bennett, Kenneth Garbade, and John Kambhu 121 Commentary Vaughn O’Regan 123 Commentary Charles H. Parkhurst Session 4 129 The Benchmark U.S. Treasury Market: Recent Performance and Possible Alternatives Michael J. Fleming 147 Commentary Lou Crandall 149 Commentary Thomas C. Glaessner 155 Commentary Stan Jonas William J. McDonough Opening Remarks am very happy to welcome you this morning to our of this bounty while financial markets learn to cope with a Iconference “Fiscal Policy in an Era of Surpluses: Economic rapidly shrinking supply of new issues of Treasury debt. and Financial Implications.” It is gratifying that so many In the less prosperous years of the late 1980s and early 1990s, distinguished scholars, policymakers, and market participants research interest in fiscal policy and the debt market centered have taken the time to attend at this very busy time of the on objectives such as containing the explosive growth of the year—and century! federal health care programs, ensuring the long-term viability Our topic today is federal fiscal policy and the market for of Social Security, identifying the optimal tax structure for U.S. Treasury debt. Only a few years ago, a conference such as long-term growth and well-being, and extracting information this would have been devoted to the problems associated with from the shape of the Treasury yield curve. Of course, these large deficits and mounting debt. As recently as fiscal year 1992, remain topics of vital interest. But to our mind, the dramatic the federal deficit was $290 billion—nearly 5 percent of GDP— improvement of our fiscal balance has shifted the spotlight to and the stock of debt held by the public was fast approaching the topics we will be dealing with today: 50 percent of GDP. The prospect of “deficits as far as the eye • First, how did we come to the very enviable situation in can see” kept policymakers searching for ways to slow the which we find ourselves? Has it been the result of growth of spending and increase the growth of receipts while brilliant policymaking, or simply good luck? This year, the financial markets struggled to absorb a stream of massive which marks the twenty-fifth anniversary of the new Treasury debt issues. Congressional Budget Act, is a good time to review how Over the past several years of surprisingly strong real growth the budget process has evolved over the past twenty-five and low inflation, our fiscal situation has improved years and to assess how well it has worked. dramatically. In the fiscal year just ended, federal receipts • How has the interaction between the budget and the exceeded outlays by $123 billion (0.8 percent of GDP). This economy changed? More specifically, how do we achievement came on the heels of a $70 billion surplus the measure the stance of fiscal policy? Years ago, we talked previous year, giving the country its first two consecutive about the full-employment balance as a guide to the surpluses since the late 1950s. Moreover, under consensus government’s effect on the economy. However, both the projections, surpluses will continue to rise over the next outlay and the receipt sides of the budget have changed decade. Accordingly, policymakers today debate the wisest use significantly over the years. Entitlement outlays have William J. McDonough is the president of the Federal Reserve Bank of New York. FRBNY Economic Policy Review / April 2000 1 grown as a share of the budget while discretionary The troubled state of financial markets last year following spending and net interest have declined. On the revenue the Asian crisis and the Russian default illustrates our concerns. side, payroll taxes and taxes on capital gains have grown Traditionally, financial crises have precipitated a flight to in importance. quality—credit spreads widen and Treasuries become the • How do we measure the full-employment balance when “market of last resort” as investors seek a safe haven. But a year a very large portion of federal spending consists of ago, Treasuries were scarce. Volumes in the Treasury market indexed entitlement payments and a significant portion thinned and bid-ask spreads ballooned. The price-discovery of revenues comes from taxes on capital gains? At a time process did not work well, and the uncertainty in the Treasury when we are more focused on the fundamentals market amplified the troubles in the rest of the financial required for sustainable long-run economic growth, is system. Certainly, I do not want to repeat that experience. the full-employment balance still the best measure of Of course, we can say that the best way to avoid repeating it fiscal impact? is to eliminate the underlying problems, which were not based We at the Federal Reserve have been studying how monetary in the U.S. government debt market. However, history has policy should be conducted to achieve and maintain a low- shown that episodes of this kind can and do happen. When inflation environment. We see a low-inflation environment as they do, the existence of a liquid market for default-free the central bank’s major contribution to sustainable long-run securities is extremely helpful in seeing us through them. economic growth. There are important parallel issues for fiscal Ironically, the issues we are addressing are, to a great extent, policy as well.

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