Fed chairman seeks stronger budget rules

With the economy continuing to improve, the deficit is more likely to decline than to increase in the year ahead.

Nonetheless, the prospects for the federal budget over the longer term remain troubling. As yet, concerns about the budget do not appear to have left a noticeable imprint on the financial markets.

In recent years, even as fiscal discipline has eroded, implied one-year forward Treasury rates at long horizons, which history suggests are sensitive to changes in the fiscal outlook, have held fairly steady. Various measures of long-term real interest rates have also remained at moderate levels over this period.

These developments, however, do not warrant complacency about the fiscal outlook. With the baby boomers starting to retire in a few years and health spending continuing to soar, our budget position will almost surely deteriorate substantially in coming years if current policies remain in place.

The enormous improvement of the federal budget balance in the second half of the 1990s and early in the current decade was due importantly to the rapid growth in labor productivity during that period, which led, both directly and indirectly, to a vast but, in retrospect, temporary increase in revenues.

The Budget Enforcement Act of 1990, and the later modifications and extensions of the act, almost surely contributed to the better budget outcomes as well, before the brief emergence of surpluses eroded the will to adhere to its deficit-containment rules. The key provisions of the BEA expired in 2002, and no replacement has been adopted.

Reinstatement of a structure like the BEA would signal a renewed commitment to fiscal restraint and would help restore discipline to the annual budgeting process. But it would be only a part of any meaningful endeavor to establish a framework for fiscal policy choices. The BEA was designed to constrain legislative actions on new initiatives.

It contained no provisions for dealing with unanticipated budgetary outcomes over time. It was also not designed to be the centerpiece for longer-run budget policy; importantly, the BEA did not set a clear objective toward which fiscal policy should aim. …

Four or five decades ago, such mechanisms were unnecessary, in part because much of the budget was determined on an annual basis. Indeed, in the 1960s, discretionary spending, which is subject to the annual appropriations process and thus comes under regular review by the Congress, accounted for about two-thirds of total outlays. That share dropped markedly in the 1970s and 1980s as spending on retirement, medical and other entitlement programs rose sharply. In the early 1990s, it fell below 40 percent, where it has remained over the past decade.

The rise in the share of expenditures that is not subject to annual review complicates the task of making fiscal policy by effectively necessitating an extension of the budget-planning horizon. In the 1960s and early 1970s, the president’s budgets provided information mainly for the upcoming fiscal year.

The 1974 legislation that established a new budget process and created the Congressional Budget Office required that CBO provide five-year budget projections. By the mid-1990s, CBO’s projection horizon had been pushed out to ten years.

Given the changing composition of outlays, these longer planning horizons and the associated budget projections were essential steps toward allowing the Congress to balance budget priorities sensibly. Among other things, this change has made the budget process more reliant on forecasting.

To be sure, forecasting has become more sophisticated as statistical techniques and economic models have evolved. But because of the increasing complexity of our markets, the inaccuracy of forecasts – especially those that go beyond the near term – is a large problem.

… Mechanisms, such as triggers, to bring the budget back into line if it goes off track should be considered, particularly measures that force a mid-course correction when estimated future costs for a program or tax provision exceed a specified threshold.

I do not mean to suggest that our budget problems will be solved simply by adopting a set of budget rules that restrain new legislation – even if those rules are augmented by effective mechanisms for making mid-course corrections. ...

In the context of an unprecedented increase in retirees, the need to make stark choices among budget priorities will again become pressing. ...

The significant improvement in the budget in the 1990s reflected persistent efforts on the part of this committee and others. If similar efforts are made now, they should assist in preparing our economy for the fiscal challenges that we will face in the years ahead.