Fiscal Targeting: The First Steps
Keith Hall discusses fiscal targets and how we might implement them
This is an original piece for BP50 by Mercatus Distinguished Visiting Fellow Keith Hall.
Somewhere along the way, when interest rates were low, the U.S. lost its fear of excessive debt. We need that fear back. Current fiscal policy in the U.S. is clearly unsustainable, with public debt at extremely high levels and rising.
The Government Accountability Office (GAO), among many others, has offered some excellent advice: we need to formulate an effective fiscal plan where public debt is made stable or declining relative to the size of the economy. This almost certainly means that we must agree upon some well-designed fiscal rules, with realistic targets to control spending and revenues. Getting agreement on such a set of rules will be extremely challenging, especially in the current political climate. Therefore, the first steps should be baby-sized.
First, we need to acknowledge that we are on an unsustainable fiscal path. Though, that might very well be a major stride in itself, despite the frankly wide agreement on this by knowledgeable, responsible individuals and organizations working on public finance. Second, we must outline what sustainability looks like by setting some achievable, but nonetheless crucial, fiscal targets. We can then use them to begin tracking progress towards sustainability, and they can even be re-negotiated as future events unfold. Most importantly, however, is that this would provide a signal that Congress and the President do, in fact, take this issue seriously.
Policymakers are at least getting some good advice. Virtually every credible organization - within and outside of government - has described our current trajectory as unsustainable. Congress and the President should admit this publicly. For example, the most recent Financial Report of the United States Government (issued by the President’s own U.S. Department of Treasury) states plainly that “The current fiscal path is unsustainable.”1 The latest annual report on The Nation’s Fiscal Health (issued by Congress’ own Government Accountability Office) says in its opening sentence that the “federal government faces an unsustainable long-term fiscal future.”2 All recent directors of the Congressional Budget Office and chair of the Federal Reserve have also said similar things.3
Unfortunately, over the past 15 years, policymakers have steadily lost interest in the federal debt. They seemingly took what I considered - both then and now - to be bad advice. They were told that because interest rates were low then, they would always be low, and therefore, they could freely increase federal spending without consequence – violating some cardinal rules of prudent economic thinking.
Deficits were too high to begin with, and adding so much new borrowing to the debt would prevent this plan from working even in theory. The most cited advice about the implications of low interest rates was from Olivier Blanchard (2019) and Furman and Summers (2019). In his address as outgoing President of the American Economic Association, the former argued that interest rates were low and would always be low. Therefore, he argued, “public debt may have no fiscal cost” since the debt to GDP can decline using debt rollover alone. As a counterpoint, very shortly after his address, CBO (2019) noted that his debt rollover strategy couldn’t possibly work, unless deficits were completely gone (or at least very low). Of course, deficits at the time neared record highs. The advice from Furman and Summers agreed with Blanchard’s argument, and further pushed that policymakers should “lose their fear” of budget deficits, because there have been “long-term structural declines in interest rates.” Again, they were arguing that interest rates would always be low, so policymakers should go ahead and raise spending through increased borrowing.4 But the last time the rate of federal borrowing was low enough for their theoretical debt rollover to work was over fifteen years ago.5 Presumably, they believed that after spending at very high levels during the Great Recession and during the pandemic, we could easily return to running low deficits. This was entirely wishful thinking. During fiscal year 2023, we borrowed another $2 trillion - more than double that of the previous year - even while GDP grew a very strong 3.5%. So far, we have lacked the political will to become more fiscally responsible.
Of course, interest rates don’t have to stay low. Currently, the interest rate on newly issued federal debt has been surging, and is at its highest level since the Great Recession. This has been driven by the Federal Reserve efforts to tame inflation through raising the target federal funds rate. They now expect to hold the target interest rate high for several years. The average rate on existing federal debt will continue to rise for years, as the Department of Treasury replaces older, maturing securities with new ones at the higher rates. The expected interest cost of federal debt will be trillions of dollars higher as a result. Matching the surge in rates has meant a surge in the level of public debt and a record level of total interest payments.
The Great Recession was the first in many decades where we actively raised federal borrowing as a fiscal stimulus to supplement monetary policy. After holding debt roughly around 40% of GDP for decades, we borrowed trillions - doubling the level of debt in just five years. Low interest rates led us to believe that this was necessary because of the worry that monetary policy might not be enough. Despite this, we still had the most severe recession since World War II. Plus, this is where we seemingly lost our concern for debt and maintained new, very large deficits until the pandemic hit. Once again, we surged federal spending to stimulate the economy and borrowed trillions of dollars more to do this. And again, we had a recession even more severe than the last. From 2007 until now, federal debt went from $9 to $33 trillion. The net interest cost of $33 trillion in debt is extremely high, and will remain high whether interest rates decline or not. We are currently fortunate that a limited supply of safe global financial assets have kept U.S. assets in demand to finance public borrowing. According to the IMF, emerging market governments continue to have limited capacity to produce safe financial assets, which supports high demand for U.S. assets like treasury bonds. Foreign holdings are around 30 percent of total public debt. However, just as interest rates eventually rose from historically low levels, this global shortage of safe assets may not continue forever. If this ends, it might become immediately and extremely difficult to manage such a large public debt.
Ultimately, it is imperative that we reassess both mandatory and discretionary spending, plus tax policy. This reassessment should include a plan on how to address the coming insolvency of Medicare and Social Security. We’ve used fiscal rules before, but maybe not to the degree that we need them now. It will be hard decisions on some fiscal rules that get us to these targets. This might be achieved through the use of a dedicated bipartisan commission with target goals in mind.
Ideally, the target would be as ambitious as possible, while maintaining some kind of consensus. This would be a deliberate attempt to raise public confidence in their willingness (if not yet ability) to responsibly manage government finances.6 Once they have a public agreement on the existence of the problem and on some helpful targets, they could then begin to negotiate some well-designed fiscal rules to meet these targets.7 We would not be alone in setting such targets. For example, the UK has done just that with their Charter for Budget Responsibility.8 It provides a fiscal framework for managing their public debt and the setting of targets. Just as we should do, the Brits emphasize that their objective is to manage the debt, set reasonable and achievable fiscal targets, and establish routine budget reports from their Office for Budget Responsibility.
There are a number of options for how to set fiscal targets. They are most often set as ratios, such as debt/GDP or deficit/revenue (or some combination of these), or perhaps even “rolling targets,” as the UK sets out in their Charter for Budget Responsibility. They plan to update the target every year to be achieved in the following five years, according to their budget forecast. For example, their current target is to simply lower the debt-GDP ratio over the next five years, with a net borrowing limit of not to exceed 3% of GDP. Next year, this target will be revised for the following five years, and so forth. It is a commitment to plan on better fiscal management on a regular basis, that allows for changing circumstances that may affect future progress.
Again, all of this is easier said than done. Hence the focus on baby steps. A direct statement by both Congress and the White House acknowledging our unsustainability is comparatively easiest, but more important than it seems. Not only will it provide some clarity and reassurance to financial markets, it will also help open the door to serious mainstream deliberation over the debt. From this, we can move to the second step of formulating fiscal targets. As this involves hard decisions and conflicting political priorities, this will be more difficult and time-consuming, but I am confident that it is possible if debt-reduction is put center-stage in the discourse. Every difficult political undertaking involves patience and tenacity. We have to start somewhere.
Keith Hall is a distinguished visiting fellow at the Mercatus Center at George Mason University. Previously, Hall served as the the Director of the Congressional Budget Office and as Commissioner of the Bureau of Labor Statistics.