Eakinomics: Balanced Budget Amendment to the Constitution

When I finished my Ph.D. program (aka the place where they drum all the common sense out of you) in 1985, I would have sided with the vast majority of economists that a constitutional balanced budget requirement was a terrible, no-good, awful idea. Yesterday, I testified in favor of a balanced budget amendment (BBA) at the House Judiciary Committee (ironically, seated next to my Ph.D. professor Alan Blinder who testified against the BBA). What happened?

The short version is that a BBA is the single worst idea except leaving the budget up to Congress and the president. We’ve seen how that panned out.

The longer version contains four major arguments. First, the U.S. has an unsustainable fiscal outlook. I won’t belabor this; the simple fact is that projected spending increasingly diverges from projected revenue as far as the eye can see, and debt rises increasingly rapidly. Second, left unchanged, the fiscal position of the United States will have consequences that range from bad to disastrous. It will be bad that over the next decade interest expenses will become the 3rd largest federal program, exceeding everything but Social Security and Medicare spending. This will limit budgetary flexibility and make the federal government the greatest source of systemic financial risk. It will be worse that the U.S. has entered the range of debt accumulation that is associated with a growth penalty, and that rising debt will crowd out investments that raise productivity and the standard of living. It will be disastrous if the U.S. experiences a genuine sovereign debt crisis a la Greece or Portugal.

Interest rates would spike and Congress would be forced to jam through damaging tax hikes and austerity spending cuts. The foundation of the global financial system — U.S. Treasuries — would be impaired and spread the damage. If 10-year Treasuries jumped 1000 basis points, today’s prevailing mortgage rate of 3.96 percent would jump to 13.96 percent. For the sake of comparison, at today’s rates, monthly interest and principal payments on a $250,000 home loan would amount to $1,188. At 13.96 percent, payments would jump to $2,954. Payments on a $20,000 car loan would amount to $443 per month. At 13.06 percent, payments would jump to $537. That amounts to $4,509 in extra payments just toward interest. And this is before the tax increases and spending cuts crush the economy. Obviously, the U.S. should not even flirt with this possibility.

Third, the evidence is in that the Congress and the Executive simply cannot consistently constrain themselves to put the budget on a sustainable trajectory. There is no document that the House, Senate and White House agree upon that reconciles annual levels of mandatory spending, discretionary spending, and revenues. Instead, these are set independently. Instead of having a fiscal policy, the U.S. has fiscal outcomes — usually bad outcomes.

Periodically, there are attempts to impose discipline, but Congress regularly reneges on things like the Budget Control Act, or pay-as-you-go rules, or others. Instead, what is needed is a “fiscal rule” that governs the process. In the U.S. system, that means a constitutional provision. Other countries — the Netherlands and Sweden, for example — have successfully adopted fiscal rules.

Finally, what should we look for in a fiscal rule? It should work; that is, it should help solve the problem of a threatening debt. (A fiscal rule like PAYGO at best stops further deterioration of the fiscal outlook and does not help to solve the problem.) There should be be a direct link between policymaker actions and the fiscal rule outcome, as there is with tax and spending choices. Finally, the fiscal rule should be transparent so that the public and policymakers alike have a clear understanding of how it works. This is a strike against a rule like the ratio of debt-to-GDP. (The public may not fully grasp the concept of federal debt in the hands of the public, and understandably does not understand how GDP is produced and measured.) Without transparency and understanding, public support for the fiscal rule will be too weak for it to survive.

A BBA is a simple, transparent, workable fiscal rule that targets the threat that is the projected debt. It is time to give it a try.