Ed Dolan's Econ Blog

A Fiscal Program for Rand Paul: He Wants to Balance the Budget. Here’s How He Should Do It

“As President,” says candidate Rand Paul, “I will work to authorize common sense solutions that will solve our nation’s fiscal crisis.” He has floated a broad proposal for a constitutional amendment that would require the federal government to balance its budget. Soon he will need to start filling in the specifics. Here are some ideas that would combine common sense and fiscal prudence while remaining true to Paul’s libertarian principles.

Toward a Libertarian Fiscal Policy

Rand Paul is no anarcho-capitalist. He sees a legitimate, but limited, role for government in national defense, law enforcement, the justice system, and certain other areas. As Ralph Benko notes in a recent Forbes article, that places him in the classical liberal wing of the libertarian movement. With the option of zero government off the table, the remaining minimal state must raise revenue and spend it. A libertarian of classical liberal inclinations cannot get along without some kind of fiscal policy, so what should it look like?

The first principle should be, “Do no harm.” In a medical context, that precept will be familiar to a physician like Senator Paul.  In economics, “do no harm” means a policy of fiscal neutrality—one of managing both the revenue and spending sides of the budget in a way that disrupts the functioning of the market economy as little as possible.

Unfortunately, many past Republican proposals for budget balancing do not meet the standard of fiscal neutrality. Take, for example, the balanced budget amendment proposed not long ago by Utah Senators Orin Hatch and Mike Lee. As I discussed in an earlier post, that proposal, and others that would require  the federal budget to be exactly balanced each year, would be the opposite of neutral.

Because tax revenue falls when the economy contracts, a rule like Hatch-Lee would mandate sharp cuts in spending or increases in taxes each time the economy entered a recession. Those measures would deepen the slump and prolong the recovery. Even worse, from a libertarian perspective, they would provide little or no restraint on spending when tax revenues rose in good times. Lobbyists would descend on Washington like locusts, full of ideas on how to spend the surplus. In short, requiring strict annual balance for the current budget is anything but common sense.

A Better Rule

If Paul wants a rule that balances the budget, there is a better alternative. Its target would not be the balance of the current budget, but rather that of the structural or cyclically adjusted budget. Such a policy would set a fixed target for the surplus or deficit as it would look if the economy were at its potential real output, that is, if it were operating along a trend consistent with healthy long-term growth and full employment. A structural budget target would be truly neutral. It would not require procyclical tax increases or spending cuts during recessions. At the same time, it would automatically restrain politicians’ impulse to indulge the lobbyists when the economy was booming. Chile is one example of a country that mandates structural budget balance. Its fiscal policy rules are one of the reasons that country has had the most stable and prosperous economy in Latin America in recent years.

Some variants are possible within the broad notion of a structural budget target:

  • If you want to run the government debt down to zero, you can aim for an exact annual balance of the structural budget. Over time, that will get you to zero debt and keep you there.
  • If you want to stabilize the level of debt at some positive percentage of GDP, you can set your budget target at a slight deficit for the structural debt. (See below for why a libertarian might want to maintain a positive level of government debt.)
  • The exact structural balance needed to maintain a given ratio of debt to GDP depends on several variables, including the target debt ratio, rate of real economic growth, the rate of inflation, and interest rates on government borrowing. This earlier post and this slideshow explain the technicalities.

There are two common objections to a structural budget target.

One is that such a policy is too complicated. Voters, say these critics, want something they can understand. A rule that insists that the government can only spend what it takes in each year is easier to explain. Politicians may know that an annual balanced budget is impractical, even destructive, yet, feeling that no such policy is ever likely to become law, they pretend to support it to show voters where their hearts lie.

The other objection is that a structural budget target is too simplistic. A better idea, these other critics say, would be to set a flexible target for the structural budget. The target would be met on average over the business cycle but would allow for discretionary fiscal stimulus during downturns, offset by equal discretionary surpluses during booms. Advocates of this approach point to Sweden as a country that has successfully implemented such a policy. Under that policy, Sweden’s national debt has fallen from 75 percent of GDP to 25 percent over the past 20 years while prudent countercyclical policy has supported healthy growth.

Alas, the United States seems to lack the political maturity and self-discipline needed to underpin any such policy. Sweden’s budget rules have enjoyed support across the political spectrum. They have been honored consistently through major changes in government. Senator Paul has seen the political disarray in Washington from the inside. He is perhaps right to distrust our government’s ability to handle the degree of discretion permitted by a Swedish-style budget rule.

The Golden Rule

Many supporters of a balanced budget argue that the government should maintain the same kind of budget discipline that a household or business does. As Rep. Roger Williams (R-Texas) puts it,

Every business, every family and every person in America eventually has to balance a budget. I’m a small business owner—I have owned and operated my business for 41 years, and I balance my budget every day. The government should be no different.

I agree, and so, I think, does Senator Paul. However, it is important to note that balanced budget amendment proposals like Hatch-Lee would lock in a very different kind of fiscal management from that which financial advisors recommend for a household or business.

The difference is that Hatch-Lee and similar proposals typically forbid government borrowing for any purpose short of all-out war. Prudent households and firms, however, regularly borrow to finance capital expenditures. No one considers it reckless for young family to take out a mortgage to buy a home, provided their income will support the monthly payments. We consider it admirable, not foolish, for a young person to go into debt to pay for medical school. Farmers borrow to buy tractors and corporations sell bonds to build new plants. Conservatives applaud the resulting growth of jobs and output. Yet the federal government is not supposed to borrow a dime, not even to fix the nation’s crumbling infrastructure or to build an aircraft carrier with a forty-year service life.

Senator Paul notes that forty-six states have constitutional provisions that require a balanced budget. “I have long been a proponent of adopting the same principle for the Federal Government,” he says in the spending and debt section of his Presidential website. Presumably, he is well aware that state constitutional requirements do allow borrowing for capital projects. As the National Conference of State Legislatures explains,

State balanced budget requirements in practice refer to operating budgets and not to capital budgets. Operating budgets include annual expenditures—such items as salaries and wages, aid to local governments, health and welfare benefits, and other expenditures that are repeated from year to year. State capital expenditure, mainly for land, highways, and buildings, is largely financed by debt.

Economists refer to this approach as the golden rule of fiscal policy. Gordon Brown was a particularly vigorous champion of the golden rule when he was Britain’s Chancellor of the Exchequer. At his urging, Parliament wrote it into law as the Code for Fiscal Stability. Under the golden rule, government budget policy really does come to resemble prudent management of a household budget: Borrow for a house or college, but don’t run up credit card debt to buy liquor or take out a second mortgage to go on a cruise.

By the way, forty-seven states also have rainy day funds. As the Tax Policy Center tells us, their purpose is to set aside excess revenue accumulated during periods of prosperity for use in times of unexpected revenue shortfall or budget deficit. Those funds help states avoid procyclical spending cuts in downturns and help prevent transient surpluses from being squandered during better times. Although the mechanics differ, their effect is much the same as a structural budget rule that averages surpluses and deficits over the business cycle.

The bottom line

Rand Paul is right to think that the United States has a fiscal crisis. Since the beginning of the century, the budget policy of the Federal Government has gone from bad to worse, as I have lamented before. I support Senator Paul’s determination to do something about our budget mess. Here is a checklist of things to keep in mind as he fills in the details of his fiscal program:

  • Fiscal policy should be based on the principle of budget neutrality. It should require management of both taxes and spending in a way that disrupts the functioning of the market economy as little as possible.
  • The common sense rule for fiscal neutrality is to target not the annual budget, but the structural budget. Deficits that develop as tax revenue falls during a recession should be offset by surpluses during economic expansions. Procyclical tax increases or spending cuts during downturns should be avoided, as should extravagant spending that adds to overheating during upturns.
  • Like the budget guidelines of individual states, the federal government should follow the golden rule of fiscal policy. The operating budget should be balanced on a structural basis over the business cycle. Fiscal rules should permit borrowing to finance long-lived capital expenditures provided that the resulting debt is kept at a sustainable level in relation to GDP and sufficient revenues are available to service it.

In my view, these rules are fully consistent with Paul’s classical liberal brand of libertarianism, not to mention with common sense. Let’s hope that he sticks to his principles and does not, in the heat of the campaign, fall back on the cynical populism of past GOP budget proposals like Hatch-Lee.

Related posts:

Yes, the US Needs Fiscal Policy Rules, but Not Hatch-Lee

How Intelligent Budget Rules Help Chile Prosper

How Smart Fiscal Rules Keep Sweden’s Budget in Balance

What does it Mean for Fiscal Policy to be “Sustainable?” MMT and Other Perspectives

As We Move into Fiscal Chaos, Just How Bad is Our Fiscal Policy, Really?







18 Responses to “A Fiscal Program for Rand Paul: He Wants to Balance the Budget. Here’s How He Should Do It”

windrivenApril 16th, 2015 at 10:36 am

The Golden Rule is – or should be – a matter of common sense. That it isn't, at least in the halls of Congress, speaks volumes.

I am a recovering libertarian. It is an alluring philosophy in the sterile world of thought experiment where bright people behave honorably and pursue their interests rationally and ethically. The world we live in is ratherdifferent, sad to say. Where libertarians tout free markets and competition, reality finds rent seeking, information sequestration, and predatory marketing. Moreover, libertarianism supposes maximizing economic efficiency to be the sine qua non of a society.

This leads to idiocies like massive offshoring, essentially beggaring one's neighbors – especially those at the lower socio-economic end – and transferring huge loads of hard-won technological expertise for a few extra bucks of profit. The offshoring of jobs essentially transfers costs from the company (which is seeing an incremental decrease in labor costs) to society, which has to provide public support to displaced workers. Just because people are no longer working for, say, Delco doesn't mean they simply disappear. And the notion that these people will upgrade skills and move to more productive roles is betrayed by stagnation in real wages for all but the top decile since the '70s. The mean IQ is 100. Half the people are at or below that mark. Few of these will find meaningful work programming in C++ or running biochemical assays. The consequences of stripping people of their sense of contribution and participation are clear to anyone with a pulse and a brain.

Moreover, for businesses to sell, someone has to buy. When we strip our neighbors of the ability to consume, we consign them to living on public support – with all the social consequences that implies – and we shift our focus to exports to fuel growth. In 1960* exports accounted for about 5% of GDP, in 2014 it was 13.4%. There is, of course, nothing wrong with exports. But one must be aware that increasing reliance on exports reshapes the commercial landscape and moreover has geopolitical consequences both good and bad.


Also see

windrivenApril 16th, 2015 at 12:44 pm

It isn't that I object to either, Dr. Dolan. I object to imports that derive their value from cheap labor thereby shifting the capital/labor balance and increasing the social burden. I object to an economic model that focuses increasingly on export markets because the domestic market is too starved to consume robustly.

burkbraunApril 16th, 2015 at 12:57 pm

Golden Rule? What could be more wrong-headed? The federal government is not a household, and does not need to balance its books. It prints the money, for crying out loud. With a balanced budget, even in the long-term structural sense, where is the money going to come from for secular growth? The Fed doesn't make net money, but only borrows and lends. Banks make credit, but also keep the loans on their books, and are unstable to boot. High-power money comes from one place, and that is government spending. Whether it also issues bonds is a matter of indifference.. they do not "soak up" anything that would cause inflation. And where is inflation now? Nowhere to be seen. Thus, there is no fiscal mess at all, whatever the deficit is. This is all basic modern monetary economics, and I would urge you and other readers to get familiar with it, as it describes the monetary system far more accurately than other current models.
Best wishes..

windrivenApril 16th, 2015 at 2:32 pm

Thank you Randy Wray.

"And where is inflation now? Nowhere to be seen"

And neither we nor any other country has ever encountered inflation, right? Because we don't have it today does not mean that it isn't on the horizon and it doesn't mean that government overspending doesn't influence it.

Ed Dolan EdDolanApril 16th, 2015 at 2:41 pm

Sorry for the flip tone of my comment. Let me try a more serious answer, even though I still have to disagree with you.

I afraid I see enduring truth in the old idea that two countries both benefit when each trades by exporting goods in which it has a comparative advantage. Usually poor countries with abundant labor have a natural comparative advantage in labor-intensive goods.

It is true that not everyone in both countries necessarily gains from the trade. It is possible, for example, that low-skill workers in the high-income country will find their wages decreased by the trade, and that their loss of income is greater than the advantage to them of low-cost imported goods.

In that case we have this scorecard:

Winners: High skill workers and capital owners in the exporting country plus workers (and possibly also capital owners) in the low-income country.

Losers: Low skill workers in the high-income country..

If low-skill workers in the high-income country are the ones we care most about (I am not saying we should; just offering that for the sake of discussion), then the question is whether the best way to help them is by discouraging trade with low-wage countries, or whether there are other kinds of policies–education, training, income transfers, etc. that would give them more help at less cost to all of the parties that would lose from trade restrictions.

Ed Dolan EdDolanApril 16th, 2015 at 2:53 pm

Yes, I am familiar with MMT economics. A couple of years ago, I had a long exchange of posts with my Economonitor colleague L. Randall Wray about the meaning of "sustainability" of fiscal policy, and other related issues. They key post in the series is linked above (fourth in the list). I strongly recommend that you read it.

To make a long story short, what I argued in that post is that MMT is correct to say that a country with a sovereign currency cannot become insolvent as a result of excessive deficits of government debts. MMT is also correct that annually balanced budget rules are bad rules. However, it is a misinterpretation of MMT to claim that fiscal policy does not matter or that a government can never, regardless of context, have a deficit that is excessive. MMT or no, there is a place for intelligent policy fiscal policy rules.

windrivenApril 16th, 2015 at 3:11 pm

"Losers: Low skill workers in the high-income country.. "

And the taxpayers who inevitably support them. Just because they don't have jobs doesn't mean they're moving to Cuba.

"the question is whether the best way to help them is by discouraging trade with low-wage countries, or whether there are other kinds of policies–education, training, income transfers, etc."

But the context of the discussion was libertarianism and the possible policies of a self-described libertarian candidate. Libertarianism as I understand it is not generally welcoming of income transfers and so forth. And I see limited value in advanced education for a displaced blue collar worker with an IQ of 78. Their prospects as mechanical engineers are limited.

"I afraid I see enduring truth in the old idea that two countries both benefit when each trades by exporting goods in which it has a comparative advantage."

I do too, though much less so when labor cost is the "advantage." The high quality of French wines may well have stimulated better quality from American vintners. Siemens (German) industrial controls offer significant technology and force American competitors to up their game. What is the competitive advantage of cheap labor? We don't get access to that cheap labor without significant technology transfers (a cost that is generally socialized for private profit). And what competition does cheap labor stimulate? Automation, arguably. But automation is expensive except for products with very long projected sales lives. So what? More efficiently marginalizing the lower socio-economic stratum?

Economics is a tool and profit should not be, in my estimation, the ultimate focus human life. I do not want to live in a society where a significant fraction of the population lives on largesse whether governmental or private, where those people do not participate in the economic life of their community, where they form a population apart. The social pathologies that accompany that are not worth the price.

I guess that, in part, is why we have elections.

burkbraunApril 16th, 2015 at 4:40 pm

Thanks for your reply. I think the latter assertion, that there can be no excessive deficit, is false and a mis-caricature of MMT. The fair assertion is that the metric of proper or improper deficits is the inflation rate. If inflation is (too) low, then more deficit is indicated, and if inflation is too high, less is indicated. This would be a great assistance to the Fed, which can fight high inflation through its blunt interest rate instrument, but can't do much at all when it is too low. So I/we would suggest that the intelligent fiscal policy rules are best constrained by the macro situation, especially the inflation/unemployment balance, not by some zero-based long term budget balance, which I think would be quite damaging. Honestly, it is just Keynes all over again.

Ed Dolan EdDolanApril 16th, 2015 at 5:03 pm

Probably we are not as far apart as it might appear. Would it be fair to say that MMT advocates a sort of Taylor Rule approach to fiscal policy, loosen if unemployment is over target or deflation is threatening, tighten in the opposite situation?

burkbraunApril 16th, 2015 at 11:16 pm

Yes, Mr. Dolan, it would work like a rule of that sort, on the fiscal side. But note that in a deflationary environment, it would be (and is) vastly more effective than any kind of monetary policy. Also, there is a great deal of disagreement about what is a good or bad level of unemployment, so the settings there are to taste, really.

But this scheme is far, far away from your prescriptions above. We are:

– not in a fiscal crisis
– do not need federal balance on any time horizon, or any structural basis, indeed do not need to issue bonds.
– do not need budget neutrality
– the fed gov is not a household, or a non-sovereign monetary state like Maine, etc.
– to the fed goverment, capital expenditures are no different than any others- it is all spending, and its fiscal policy is our monetary and economic policy, at every instant in time.
– The federal government does not need to borrow from anyone, for anything. It can spend based on macroeconomic settings, combined with adjusting the tax rates on the other end to accomplish net monetary goals.

windrivenApril 17th, 2015 at 9:28 am

"It can spend based on macroeconomic settings, combined with adjusting the tax rates on the other end to accomplish net monetary goals"

And that;s the rub, isn't it? The politics of spending are rather different than the politics of taxation regardless of the economic model one embraces.

Ed Dolan EdDolanApril 17th, 2015 at 11:29 am

Fair enough. However, please don't automatically conflate my personal recommendations with Rand Paul's. What I am offering in this post is a set of suggestions of an if-then variety: If Rand Paul wants to balance the budget in a way consistent with his libertarian principles, then he would do better to propose a rule based on a structural target rather than an annual target. If you go back through my previous posts on budget policy (links at end of post) you will see that on the whole, they encompass a somewhat broader perspective than this post taken in isolation.

You may be right that we are not in a fiscal crisis at the present, as defined by the usual metrics of sustainability of the debt and deficit. However, I do believe that we have a crisis of fiscal policy. The fiscal policy coming out of Washington is completely incoherent. It follows no rational rules or principles, it is systematically procyclical, it combines gross overspending in some areas with underspending in others, and it raises tax revenue in a highly inefficient and distortionary manner.

As for your idea of spending to achieve a coherent set of macro- and microeconomic goals, and adjusting taxes as necessary, yes, I can understand the logic of that within the MMT perspective. The problem is we have no fiscal policy authority (comparable to the quasi-independent FOMC) that could implement such a policy. As long as that remains true, the MMT recommendation remains merely a theoretical curiosity.

burkbraunApril 17th, 2015 at 2:13 pm

Well, if it all makes so much sense, then calling it a theoretical curiosity seems uncalled-for. Even counter-productive

The thing is that we do have fiscal policy, but it is not very coherent. We managed to pass a significant stimulus after the 2008 crisis, which staved off much worse catastrophe. This was far more effective (if still not enough) than all the operation twists from the Fed. What is needed is not so much some super-independent fiscal entity, but the intellectual consensus that Keynes was right, and that fiscal policy is a key, even the key, macro-economic tool. And that is where you come in!

Best wishes, and I apologize if I took your prescriptions out of their GOP context.

MinJune 16th, 2015 at 9:40 am

Just a note on selling counter-cyclical policy to US voters. Most of them as children heard the story of the Seven Fat Years and Sever Lean Years. That is perhaps one thing that is behind the adoption of rainy day funds by the states. IMO the main obstacle to counter-cyclical policy is propaganda by politicians and pundits who cry that we can't afford it.

OC, the Federal gov't does not need a rainy day fund, as it is the source of the US dollar.