Jeffrey Frankel on Fiscal Policy, Macroprudential Regulation, Growth and Inequality
December 2015. GrowthPolicy staff member Devjani Roy interviewed Harvard Kennedy School Professor Jeffrey Frankel, focusing on several questions motivating the GrowthPolicy website. Below is an edited version of Professor Frankel’s comments.
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Key points and policy recommendations
1. Some developing countries, including commodity producers that always used to fall into the trap of pro-cyclical or destabilizing fiscal policy, after 2000 found a way around that through effective counter-cyclical fiscal policy, the star example being Chile.
2. Countries that have succeeded in achieving effective countercyclical fiscal policy tend to be countries that have achieved better quality of institutions, rule of law, freedom from corruption, and an efficient bureaucracy.
3. Successful economic policy integrates regulation of the financial markets, monetary policy, and fiscal policy.
1. Establish a counter-cyclical fiscal policy. In effect, the government sets fiscal targets in advance that are adjusted cyclically depending on boom or recession.
2. Effective counter-cyclical fiscal policy requires that policy makers are aware of the entire cycle, plan ahead, and establish policy with an eye to the ups-and-downs of the cycle.
In recent years, one of the things that has interested me is whether the U.S. and other countries, whether emerging market countries or Europe, follow pro-cyclical policies or countercyclical policies, in the case of fiscal policy.
There are some countries, especially developing countries, that, in the past, have had a pattern of making the business cycle worse. When the economy is booming, for example, commodity prices are booming. If they’re a commodity exporter, that’s when they feel like they’re rich and they can have access to lots of revenue and so they spend a lot of money. Then comes the downturn. Maybe the price of their exports goes back down and then they’re forced to cut back. So they end up exacerbating the business cycle, adding to the demand when the economy is already booming, and, then, adding to the crash and the recession when the economy goes down. I’ve been interested in why so many governments have fallen into that pattern in the past and in how some of them, after the 1990s, managed to escape from it. It’s a very general topic that applies to every part of the world.
If you recognize the whole cycle, you see that each boom is not the first time there has ever been a boom and each crash is not the first time there has ever been a crash. You’re aware of the whole cycle and that it’s worth planning ahead and setting policy with an eye to the cycle. That includes regulation of the financial markets. It includes monetary policy and it includes fiscal policy.
It used to be that developing countries, especially commodity-producing countries, had, what I will call, destabilizing fiscal policy that exacerbated the swings. When the economy was improving, that’s when they increased government spending. When the economy was crashing anyway, that’s when they decreased government spending. So, in effect, they added to the swings.
On the whole, our policy in the U.S. was countercyclical. During the periods of expansion, we would tend to run stronger budgets, even budget surpluses sometimes, and then when there was a recession, that’s when we would tend to increase spending or put taxes.
Some of my research looks at how that has changed since the turn of the century. Many developing countries, including commodity producers that always used to fall into this trap of pro-cyclical or destabilizing fiscal policy, many of them finally found a way around that.
Roughly a third of the developing countries in the past had had this problem and figured out a way after 2000 to solve it. The star example is Chile. For them, copper is a big export and a big source of government revenue. It used to be, though, when the copper price was high, they would spend more money and then when the copper price went down, they would be forced to cut back.
But after 2000, Chile reversed that pattern. During the boom from 2002 to 2008, when the copper price was high and economic growth was strong, they saved a lot of money. They paid down their debt and then when the recession hit, they had this cushion that they could spend. They got hit by an earthquake at about the same time they needed some spending. So fiscally speaking it worked out well.
Some of my research with coauthors has looked at countries that have succeeded in achieving countercyclical fiscal policy. They tend to be countries that have achieved better institutions. These are very general measures: the quality of institutions of a country, the rule of law, freedom from corruption, the efficiency of the bureaucracy, and so on. When you look at measures like that, both across countries and across time, you find that there’s a definite relationship. The countries that achieve better institutions are generally more likely to be the countries that have achieved countercyclical fiscal policy.
Some countries have a past history of poor governance that you have to get around. What should they do to achieve good institutions? I think it helps to be specific.
Very specifically, what is it that Chile did? What Chile did which I like is adopt a law that has three features. One is the government has to set a target for the budget. The second is that the target is cyclically adjusted so that if you have a boom that’s temporary, then you have to save some of the money and if you have a recession that’s temporary, then you can spend some of the money. I’m talking both about the price of copper and the growth rate. For Chile, those two are highly correlated. But if they move separately, then they’re both relevant. So a lot of countries do those first two things. Have a target and have it be cyclically adjusted. The third thing that Chile did, which I think was pretty unusual, is they delegated to an independent committee the responsibility for saying when an increase in GDP was temporary versus permanent and when an increase in the price of copper was temporary versus permanent. In my view, that is the key missing ingredient.
I’ve done statistical tests across countries. Almost all countries in their budget forecasts tend to think that when there’s a boom, it’s going to go on forever and therefore they can spend more money. One country where that pattern was broken, where the forecasts have been unbiased, is Chile. It is one country where just because there’s a boom today, it doesn’t necessarily mean they forecast it will go on forever. Those forecasts feed directly into the budget. That’s why Chile, after the turn of the century, was able to achieve countercyclical fiscal policy. I think that’s an example of lessons that countries like the United States or European countries could learn from emerging market countries.
Key points and policy recommendations
1. Although the specifics of financial instruments and technology have changed, there is much to learn from the past.
2. Leading up to the 2008 financial crisis, casting the statistical net wider in terms of number of years of housing market data examined would have been helpful.
3. As with fiscal policy, sound macro-prudential regulation includes avoiding pro-cyclical measures.
1. Instead of looking only at recent events, market participants, regulators, and homebuyers should examine past patterns in financial markets.
2. Financial crises in emerging market economies hold useful lessons for the U.S. and should be studied closely.
3. The boom-bust cycle has always been with us. Financial models should include data going back a hundred years, as economic historians tend to do, instead of focusing myopically on the recent past.
There have been financial crises for centuries. Many of principles and lessons should have been familiar from the experience of emerging market countries in the past, say in Latin America back in the 1980s and the East Asian crisis in the late 1990s. The history held useful lessons that the United States and Europe should have paid more attention to—from the key lesson that financial markets have frictions and don’t always work perfectly to how to deal with a crisis when it happens.
More and more economic researchers are now, painstakingly, putting into their financial and macroeconomic models financial market imperfections that weren’t there before but were quite common in the models of emerging market countries.
There is so much to learn from the past. A lot of these patterns have repeated themselves over and over again, from the excessive optimism and excessive borrowing in the boom phase to the panic in the crash phase. The specifics of the instruments have changed and obviously the technology has changed. But the basic pattern has gone on for a very long time. One of the causes of the most recent global financial crisis, more generally, is the feeling that the past doesn’t have lessons for us, that everything is so new, that only what happens within the last ten minutes matters because everything else is irrelevant.
My colleagues Carmen Reinhardt and Ken Rogoff wrote a famous book called This Time It’s Different (Footnote 1). The title says it all: in each boom, people think that past history doesn’t really apply to them. But the boom-bust cycle has always been with us and always will be. Both market participants and regulators would do better to be aware of those cycles. Certainly home-buyers should not get carried away with whatever has been the most recent trend in prices.
Consider the pricing formulas that were being used before the global financial crisis for pricing options, mortgage-backed securities, emerging market debt, or junk bonds. Those who used these pricing formulas generally took statistical estimates based on the last four, five, or ten years of data, thinking that nothing that came before that was relevant. As a result they were lulled into thinking that there wasn’t much risk out there. If they had cast the net wider, say, 100 years of data or more, as some of the economic historians do, they would have seen that there was more risk than they thought. What looked like a trend was probably really a cycle. Some “black swans” were knowable.
Let me make it very concrete. There was a huge housing boom in the United States and a few other countries such as the U.K. It was said, well, even if the housing market cools off, the housing prices are not going to actually go down in nominal terms because “that has never happened before.” The worst that happens is they stop rising for a while.
A lot of calculations were made based on that. People said that in their lifetimes, in their countries, they had not observed housing prices go down in nominal terms, in dollar terms. But the fact is that it shouldn’t have been so much of a surprise when prices did go down after 2006. If they had looked further back, it happened in previous periods in U.S. history: It had also happened during the Great Depression in the 1930s. It had happened in our memory in other countries as well. In Japan, the housing prices went down in the 1990s. People just thought that that wasn’t relevant. They weren’t casting the net wide enough.
The image of the Black Swan (Footnote 2) is often used to make the point that something like this is couldn’t have been imagined. I like to say that a better use of the metaphor is, rather, the point that it could have been predicted as a possibility — not a high probability, but as a possibility — if you had looked more widely across time and across countries, if you had looked at other periods of history and looked at other countries.
I have written about very specific innovations – specific policies and institutions — that have been tried as an experiment by some smaller countries, some of them less developed, some of them not. Some of the innovations worked out quite well and we could all learn from them. Earlier I gave one example, the fiscal institutions in Chile [see above]. But there are other examples.
Another example is what we call macro-prudential regulation of financial markets. We, in the United States, have apparently learned nothing from the financial crisis about mortgage lending. We still encourage households to go too deeply into debt during a housing boom. There are countries, some of them in Asia, that have countercyclical macro-prudential policies. These are regulations such as the rule says that in order to buy a house, there’s a limit on how big a loan you can take out. There has been some success in having that vary with the business cycle. The regulators tighten up when bhousing prices are going very high and you have a credit-fueled boom in the housing market, which history shows is especially dangerous.
A country like Korea has had some success tightening up the requirements, limiting how much of a loan people can take out to buy a house, And then when there’s a downturn, if the housing prices do go down, that’s the time to loosen up on the loans. Whereas we in the U.S. really have not learned that lesson at all.
Key points and recommendations
1. Americans have become excessively dependent on long-term debt: housing loans, auto debt, and student loans.
2. Although high debt levels were a main cause of the recent housing crash, the subprime mortgage crisis, and the global financial crisis, we are yet to learn our lessons about the dangers of unsustainably high debt.
1. Universal, high-quality preschool education increases economic growth and reduces inequality.
2. Increase spending on infrastructure: roads, bridges, and other kinds of transportation, communications, and energy infrastructure.
3. Raise financing for transportation infrastructure projects by increasing the gasoline tax.
4. A higher gasoline tax can be applied towards paying for highway maintenance and construction while being environmentally beneficial because it discourages driving and gas usage.
5. Reform the tax structure by reducing distortionary tax policies, such as those that encourage harmful activities such as pollution or excessive debt.
6. For the corporate tax system, cut the overall tax rate but make up the lost revenue by eliminating some wasteful exemptions, like the subsidies for fossil fuels.
7. Curtail the home interest mortgage deduction, which currently costs the government a lot of revenue but doesn’t benefit the poor.
8. The revenues could be applied towards policy measures benefitting low-income workers: for example, expanding their earned income tax credit or raising the threshold at which they have to start paying payroll taxes or social security taxes.
9. The attitude that the more housing Americans have access to, the better, is misguided policy if homeowners can’t pay back the debt.
10. Our housing regulations should require a more serious, higher minimum down payment.
11. Mortgage originators should be required to hold a certain percentage of the mortgages rather than selling them all off to someone else.
When we had the new Members of Congress here last December (Footnote 3), I had seven or eight broad policy recommendations that I think are basically good economics and that make sense from my viewpoint of increasing growth and reducing economic inequality.
The first policy recommendation is education. Specifically, I would say universal, high-quality preschool education. It hits both of those goals, increasing the growth for the whole economy and doing it in a way that’s consistent with reducing inequality.
Something else that also should be possible to get a consensus on across the political spectrum is spending on infrastructure, including roads and bridges and other kinds of transportation, communications, and energy infrastructure.
I would suggest financing that by raising the gasoline tax. We have this crisis in the federal highway trust fund, that it keeps running out of money and Congress, in its cowardly way, keeps postponing the issue. But the obvious way to pay for highway maintenance and construction is gasoline taxes and that would be good for the environment because we’re discouraging driving and gas usage. I would make that tax higher than non-economists want to see because it’s good for the environment, and use the money for all kinds of infrastructure projects.
My third policy recommendation would be various steps to put Social Security on a sounder footing for the longer term. We do not have a budget deficit problem in the country today but there are big deficits looming ahead, particularly with the retirement of the Baby Boomers’ generation. Most of these recommendations are very unpopular politically.
I don’t like the dependence that Americans have gotten into over the long term on debt, whether it’s housing debt, auto debt, or student loans. It obviously was a big cause of the housing crash, the subprime mortgage crisis, and, therefore, the global financial crisis, and it’s as if we haven’t learned any lessons from this at all.
The politicians on the left and right, liberal, democrat, every single one of them, still think that the more housing, the better. It doesn’t matter in their thinking if American households have to get up to their eyeballs in debt and can’t pay it back. It’s still a good thing. They don’t phrase it in that way, but that’s the way they act. Our regulations don’t really require a serious minimum down payment. The mortgage originators should be required to hold a certain percentage of the mortgages rather than selling them all off to someone else.
I would curtail the tax deductibility on mortgage interest. What I’m saying is extremely unpopular politically but in terms of inefficient aspects of the tax code, that’s definitely one of them. You could use the tax revenue to cut other taxes or for other purposes, other to reduce the budget deficit.
On tax reform, I would like to reduce some distortionary tax policies, those that encourage harmful activities like pollution or excessive debt, and to raise a given amount of revenue in a less distortionary way. So for the corporate tax system, that would mean cutting the overall tax rate but making up the loss revenue by eliminating some wasteful exemptions, like the tax benefits for oil, for example.
In the case of the personal income tax, I already mentioned curtailing the home interest mortgage deduction, which costs a lot of revenue but doesn’t benefit the poor. It benefits the middle class and the upper middle class. You could use the revenue to do a lot of good things that would benefit lower-income workers, such as expanding their earned income tax credit or raising the threshold at which these workers have to start paying payroll taxes or social security taxes.
Key points and recommendations
1. Job growth in the future will be in the areas of services and health care.
2. In advanced industrial societies, the general pattern is a decline in agricultural and manufacturing jobs and a growth in services-related jobs.
Where the jobs will come from, it’s just so hard to say. There are thousands of sectors. But there are new jobs being created and destroyed all the time. So it’s just really hard to identify.
I will tell you what’s expanding. The field of healthcare has been an expanding area for jobs for a long time and it will continue to be so. A general pattern is that in advanced industrial societies, agricultural jobs have been going down forever and most of the growth areas are in services.
Over the last five years, manufacturing employment has actually gone up some in the US, which is remarkable. It’s definitely bucking a long-term trend. But if you want to know where most of the new jobs are, over time, it’s in services such as healthcare.
 Reinhart, Carmen M., and Kenneth Rogoff. This Time Is Different: Eight Centuries of Financial Folly. Princeton, NJ: Princeton University Press, 2009.
 Taleb describes rare but high-impact events that are seemingly impossible to predict but are rationalized as completely normal once they occur. Taleb, Nassim Nicholas. The Black Swan: The Impact of the Highly Improbable. New York: Random House, 2007.
 Frankel is mentioning the HKS Program for New Members of Congress, specifically, their visit on December 3, 2014.
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