III. U.S. POLITICS, WAR AND ECONOMIC POLICY

III. U.S. POLITICS, WAR AND ECONOMIC POLICY This month s feature article was written by Rudolph G. Penner, BCA s Washington Editor, and Senior Fellow at the Urban Institute, Washington D.C. Mr. Penner s key conclusions are: l l l The direct costs of a war against Iraq would not be large. The key uncertainty is the impact on oil prices. The results of next month s mid-term elections will have considerable impact on domestic and international policy. If the Democrats win the House, the ideology of the leadership of key committees will shift significantly to the left. Fiscal policy is in chaos. There could be an explosion in fiscal irresponsibility unless the new Congress re-establishes some budget rules. The U. S. political and policy outlook has seldom been so murky. Political analysts are unusually hesitant to forecast the election outcome and economic analysts seem incapable of forecasting next year s budget balance within hundreds of billions of dollars. Meanwhile, the Congress provided a huge dose of well-timed fiscal stimulus in 00, but is now operating without a fiscal compass. They have no budget rules or fiscal goals that can be identified. The only clear voices are possessed by the warriors Bush, Cheney and Rumsfeld. Whatever the merits of the case for attacking Iraq, the warriors have worn down the opposition, both here and abroad, and war seems likely. The Winds of War There has never been a significant war with as little effect on the national economy as that just fought in Afghanistan. The direct cost in fiscal 00 was estimated to be between $0 billion (Congressional Budget Office) and $5 billion (Pentagon), less than 0.% of GDP. The cost of waging war has plummeted as chip technology and lasers have enormously improved the accuracy of weapons and enhanced communications and navigational devices. Stealth technology has reduced the loss of aircraft as air defenses can be destroyed by unseen planes before an attack by conventional aircraft. The CBO recently estimated the cost of a three-month Iraqi War at less than $50 billion (below 0.5% of GDP). The Pentagon has made broadly similar estimates. Although there is considerable uncertainty as to exact The CBO estimates the monthly cost of two different scenarios and does not forecast the length of the war. For more details, see Letter to the Honorable Kent Conrad and John M. Spratt Jr. regarding the estimated costs of a potential conflict with Iraq, September 30, 00. Available at www.cbo.gov November 00

costs, it is very unlikely that war spending will have a very large impact on domestic demand, especially since a considerable portion of the money will be spent on fuel and other materials purchased abroad. There will be continued costs for an occupation force of $ to $4 billion per month, and a need for assistance as the country rebuilds. But in a country like Iraq with a GDP less than $0 billion, one billion dollars does a lot of rebuilding. The main economic risk to the U.S. obviously involves the effect of war on the price of oil. An enormous range of scenarios is possible. Optimists believe that lost Iraqi production will rapidly be replaced, there will not be disruptions elsewhere, and price increases will be limited to about $5 per barrel for three months. Pessimists discuss the possibility of the Iraqis having an enormous impact by contaminating Saudi oil fields with dirty bombs or biological and chemical weapons, although this seems a bit farfetched given their limited number of missiles. In Desert Storm and Afghanistan, the pessimists proved to be very wrong, whether discussing the military effectiveness of the opposition, the effect on the world economy, or the impact on political stability in the Moslem world. Of course, the pessimists may be right some day, but recent experience suggests going with the optimists. Might the war be cancelled? It is not clear whether President Bush s strategic approach to the debate over war was purposefully brilliant or an accidental triumph. His initial unilateralism made his most important critics argue that he must go to the UN and acquire some allies. He has now gone to the UN and he has acquired some allies. His critics do not know what to say next. They will probably think of other reasons not to act, but the main force of their arguments has been destroyed. Peace will prevail only in the unlikely instance that Saddam is killed or overthrown, or in the even unlikelier event, that he decides to disarm in a credible manner. The Mid-Term Elections The American people have seldom been as evenly divided politically. That was manifested in the almost equal popular votes of the two presidential candidates in 000, the one vote Democratic margin in the Senate, and the 5-49 percent split in favor of the Republicans in the House. The Cook Election Preview, one of the most sophisticated analyses available, identifies four highly vulnerable Democratic seats in the Senate. These include New Jersey, since made less vulnerable by Senator Robert Torricelli s withdrawal. The report identifies the same number of highly vulnerable seats on the Republican side, and four vulnerable seats on both sides of the aisle. The Senate election could not be closer, and it is little wonder that no one wants to make a forecast. In the House, the main effect of the redistricting inspired by the 000 census was to make incumbents even more secure than usual. Cook estimates that only 44 of 435 races are competitive. The Republicans have more vulnerable seats than the Democrats, but at the A Supplement to the National Journal, Fall 00. November 00 3

moment, the Democrats are not doing well enough in the vulnerable seats to win a House majority. They may even lose a couple of seats. Nevertheless, things are so close that the final outcome is likely to be determined by random national and local events in the few days before the election. Pundits are even unwilling to say what type of events might be important because it is entirely unclear what the election is about. Democrats are fearful that it is about the war rather than about the economy. But there is little evidence that voters blame Bush and the Republicans for the economy, the stock market slide or corporate malfeasance. The Democrats have floundered in trying to come up with a coherent economic policy of their own. The majority of the party hates the Bush tax cut and would like to see it partially reversed. However, the leaders do not dare say this explicitly, because it would jeopardize the chances of those very vulnerable Democratic senators from states like Georgia and Louisiana who voted for the cut. Does it matter who wins? Because the two parties are likely to be so evenly balanced, gridlock will be the big winner regardless of which party gains formal control. Gridlock is very often beneficial economically. For example, it is likely to prevent the Congress from greatly overreacting in the area of corporate governance and accounting regulation. Such an overreaction was highly probable after the first round of legislation when an accounting oversight board was established, but some proposals were then quickly weakened. For example, the Congress was shocked to learn that many workers actually want to invest a substantial part of their pension saving in their employer s stock. An ill-considered proposal to severely limit such investment may have died anyway, but the overall gridlock helped to prevent any highly controversial proposal from rushing through in the emotional backlash to Enron. Gridlock can, however, also be quite harmful as in the four-month delay in providing protection for those insuring against damage by terrorists. Some say that has had a significant negative impact on building construction. With regard to more mundane tax and spending issues, the question becomes subtler. On the one hand, gridlock will be the dominant force and that will limit how much gets done. But to the extent that some things get through, the election outcome becomes more important. If the Democrats win the House, there will be a huge ideological shift in the composition of the leadership. For example, the Chairmanship of the Ways and Means Committee will go from Bill Thomas, whose voting record in 000 on economic issues was estimated as 6% liberal and 85% conservative by the National Journal, to Charles Rangel, estimated at 9% liberal and 8% conservative. The Chairmanship of Appropriations will go from Bill Young, 33% liberal and 66% conservative to David Obey, 85% liberal and % conservative. The Energy and Commerce Committee will go from Billy Tauzin, 5% liberal and 83% conservative, to John Dingell, 70% liberal and 9% conservative. One could go on and on, but the basic point is that 4 November 00

the ideological differences in the leadership of the two parties is far greater than the differences among rank and file members. This is important because the Chairmen have considerable control over what is put on the agenda and when items are raised. Scheduling can have a major impact on outcomes. The leadership also decides what and who to investigate. This can be a powerful weapon against an Administration. It is the common wisdom in Washington that President Bush is more likely to be re-elected if the Democrats win both Houses of Congress and give him a proper foil. That is not necessarily correct. It depends to some degree on how many members of the Administration get into trouble and how effective Congressional Committees are in attacking them. The ideological differences between the leaders and likely Chairmen in the Senate are not nearly as great as in the House; but control may be more important in the long run. It will have a profound effect on the ideological make-up of the judiciary for many years to come, and that will affect the results of cases involving economic issues. There was a time when the majority in the Senate gave the president great latitude in choosing judges, even when the president came from the opposing party. That is no longer the case. The process has become much more partisan with both Republicans and Democrats opposing candidates of different ideologies, even if the candidates are extremely well qualified. If the Democrats win the Senate, the end result will be either a very large number of vacancies in the judiciary which can limit the effectiveness of the court system, or the nomination of ciphers who have neither written nor said much of interest. They are also likely to be mediocre. The control of the Senate will also affect the ideology of people appointed to the Administration and to independent commissions, although the president will be given somewhat more scope in making such nominations. As in the House, the leadership of the Senate will determine the agenda and schedule and what and who gets investigated. Control of the Congress will also be important to the areas of trade policy and tort reform. The Democrats are clearly more protective of trial lawyers. They are also more protective of domestic industry. That may seem strange after President Bush s steel decision, but that move was justified as a means of getting Congressional approval to negotiate trade treaties that would not subsequently be amended. As an aside, Bush has learned that protectionism is not a cheap way to win political favor. Steel-using industries have howled about resulting steel price increases, and Bush s attempts to mollify them have antagonized steel unions and producers. It has been a lose-lose proposition. Democrats support more expensive variants of prescription drug programs under Medicare than do Republicans. It is not clear that they can get anything through with such an evenly balanced Congress, but if they do succeed, it will be the most important addition to entitlement spending in decades not initially, but because costs grow so rapidly in the long run. In recent years, the two parties have switched places with regard to their at- November 00 5

titude toward macro fiscal policy. The Republicans used to be austere and therefore, politically masochistic. Since Reagan, they have become the goodtimes party proposing tax cuts for all occasions. Democrats have emphasized balancing the budget and want Bush to balance the budget outside Social Security, although they have not told him how to do it. Some Democratic leaders have even made the far-out argument that the Bush tax cut was deflationary because it increased the deficit and raised interest rates. If the Democrats win, the overall budget may be larger but more restrained. I doubt, however, that they would go so far as to reverse some of the Bush tax cut. They would probably look to raise taxes through closing loopholes and other base broadening measures. Fiscal Policy Two problems dominate recent fiscal policy. First, we are incapable of projecting budget totals. Forecast errors have always been embarrassingly large, but in recent years, they have been gargantuan compared to historical averages. In the 9 months between January 00 and August 00, the CBO projection of the 00 budget balance changed by well over $300 billion because of technical and economic forecasting errors. That is almost three times larger than the normal historical average. The second problem is that the modicum of discipline imposed by the Congressional budget process has disintegrated. The result is an extremely loose fiscal policy as taxes have been cut substantially while spending has CHART III- Shifting Fiscal Fortunes % of GDP 3 FEDERAL RECEIPTS FEDERAL OUTLAYS % of GDP 3 0 0 9 9 8 8 BCA Research 00 990 99 994 996 998 000 00 6 November 00

CHART III- Record Fiscal Stimulus in 00 % of GDP FISCAL THRUST* % of GDP POLICY STIMULATIVE 0 0 - - POLICY CONTRACTIONARY - - BCA Research 00 960 965 970 975 980 985 990 995 000 *ANNUAL CHANGE IN STANDARDIZED BUDGET BALANCE AS A PERCENTAGE OF POTENTIAL GDP surged, largely for reasons that have nothing to do with homeland security or the war in Afghanistan. Most of the forecasting problems occurred on the revenue side of the budget. The ratio of revenues to GDP has collapsed (Chart III-). The unanticipated portion of the revenue reduction was much greater than the decline resulting from the tax cut of 00 together with the additions to depreciation allowances in the stimulus package. In combination, the legislated and the unanticipated revenue declines were the equivalent of a huge tax cut as revenues fell more than at any other time since 946. When put together with a surge in discretionary spending, the end result was the largest fiscal stimulus (by some measures) in more than 40 years of data maintained by CBO. The change in the standardized budget deficit of.4% of potential GDP between FY 00 and FY 00 set a record, supplanting the.9% change in 983 (Chart III-). The actual budget balance changed by.7% of GDP. That is only slightly below the record change since 960 of 3% percent in 975. The economic impact of these dramatic changes in fiscal policy is somewhat unclear, because the reason for the unanticipated revenue shortfall is unclear. Some of the shortfall undoubtedly involves a collapse in capital gains realizations, and some may reflect a disproportionate fall in the incomes of the very rich. These portions of the unanticipated tax cut probably did not have the same expansive multiplier effect of a normal, broad-based tax cut; November 00 7

but they had some effect, and along with the legislated tax cuts and spending increases, they undoubtedly made the recession considerably less severe than it would have been otherwise. The breakdown in the Congressional budget process contributed to the fortuitous stimulus, but it bodes ill for the longer run. The process that has been in place since 974 requires the Congress to develop an overall budget plan called a budget resolution early in the year, setting targets for aggregate spending, revenues and the budget balance. The process was given teeth by the Budget Enforcement Act (BEA) of 990. It legislated caps on discretionary spending and a pay-as-you-go rule that prevented tax and entitlement policy from increasing the deficit. The deficit effects of any changes in policy had to be neutralized by other changes in tax and entitlement policy. These rules played an important role in bringing about budget surpluses in the late 990s. Once a surplus emerged in 998, however, discipline went out the window. The Congress was not able to pass a budget resolution in 999, and it began first to exploit loopholes in the rules of the BEA and then to ignore the rules altogether. No budget resolution was passed for 003, and the rules of the BEA were allowed to expire at the end of last month. The disorder has intensified. Not a single appropriation bill has been passed for 003, even though we have entered the new fiscal year. 6 5 4 3 4 0 - CHART III-3 The Spending Taps are Open % % ANNUAL REAL RATES OF GROWTH: NONDEFENSE DISCRETIONARY SPENDING % % DEFENSE DISCRETIONARY SPENDING 990-998 998-00 BCA Research 00 One might excuse some extravagance when the first surplus emerged in almost thirty years. Profligacy was further encouraged by large upward revisions in surplus projections over the subsequent two years. But one does not see much evidence of a return to austerity as deficits have re-emerged, and budget projections have been getting more pessimistic at a rapid rate. The lack of discipline is illustrated by the changing attitude toward discretionary spending. Between 990 and 998, real non-defense discretionary spending grew at.3% a year. Between 998 and 00, it grew at an annual rate of 6.% (Chart III-3). If spending related to September is removed, the rate of growth would still have averaged more than 6 5 4 3 4 0-8 November 00

5%. Defense discretionary spending plummeted between 990 and 998 at a rate of 3.8% because of the end of the Cold War. Between 998 and 00, it grew at 4.7%. As noted above, only a small portion of this change is because of the direct cost of the Afghan War. On the entitlement side, the most important event was the enactment of an obscenely expensive agricultural bill. However, as already noted, both parties promise extremely expensive prescription drug programs under Medicare. The cost of the House-passed bill is estimated to rise by 5% per year toward the end of the 0-year projection period. An extremely expensive military retirement bill is also being contemplated, though it may be restrained by the threat of a Presidential veto. Because of time lags between appropriations and outlays, appropriation actions of the past two years guarantee a rate of growth of discretionary spending in the next fiscal year considerably above the potential growth rate of the economy, even if appropriations for 003 grow slowly. But it is not clear that 003 appropriations will grow slowly. Thus, the range of uncertainty for discretionary spending is between rapid growth of outlays and extremely rapid growth of outlays. If $50 billion were added for an Iraqi War in 003, then nominal outlay growth could considerably exceed 0%. Entitlement spending will be bolstered by soaring health costs; but mercifully, falling interest rates will limit the growth of debt servicing costs. Presumably, taxes will not be cut next year unless the economy gets very bad, and hopefully there will not be a further unanticipated drop in the ratio of revenues to GDP. It is impossible to be very precise, but the situation points to further fiscal stimulus next year, albeit much smaller than the huge surge occurring in 00. In the next few years, the fiscal health of the nation will be crucially determined by the growth of revenues. That, in turn, will be determined more by economic and technical forces than by changes in legislation. Revenue forecasters are at sea, because they do not understand what happened last year. Obviously, a decline in realized capital gains is responsible for some of the shortfall, but it must be a relatively small portion. Total capital gains tax receipts were only expected to be about $5 billion in 00, and only about half were expected to come from equity investments. The total revenue shortfall was closer to $300 billion. The shortfall may be better explained by a decline in the incomes of taxpayers in the top tax brackets. They may have been hurt more by the recession than ordinary taxpayers. A key question is whether much of this decline is associated with a decline in the regular income and bonuses associated with the stock market or due to entirely different factors. The CBO is just now getting its first look at tax returns from 00, but at this point, the data are fraught with errors. It will be well into next year before reliable data are available. In August, the CBO projected a current policy deficit of $45 billion with revenues of $,96 trillion for 003. Given the uncertainty, the revenue estimate could very easily be off $50 billion in one direction or another. It is not at all inconceivable that we could November 00 9

have profligate Congressional spending behavior and quite a healthy deficit outlook, or a surprising return to prudence and quite an alarming outlook. In the longer run, policy changes will have a more important cumulative effect than economic forecasting and technical changes. It will be important to see whether the Congress shows any interest in restoring a more rational budget process when they return next January. At the moment, there is no mechanism for adding up the spending decisions of various committees and no functioning mechanism for relating the spending and revenue sides of the budget. Without such processes, the Congress will not be able to get the budget under control even if they want to. Conclusions American political discussions are dominated by the probable war with Iraq. But wars have a dramatically smaller impact on spending than they used to. If war does not have a major impact on the price of oil, and does not go badly, it may barely be noticed economically. The election may be what Charlie Cook calls a Seinfeld election about nothing, but it is still important which party ends up controlling the Congress. It will have a significant cumulative impact on domestic and international economic policy, and on the ideology of judicial and Administration appointments. Fiscal policy is in chaos. Budget outcomes cannot be forecast because of huge uncertainty regarding revenues, and the Congress no longer has a fiscal strategy or even a process for developing one. If the new Congress arriving in January does not show any interest in developing a process, the effect could be an explosion in fiscal irresponsibility. One year ago, budget projections were still sufficiently rosy that it seemed implausible that we would observe sustained increases in the debt- GDP ratio before 00 when the baby boomers start retiring. Now such increases seem quite possible. Rudolph Penner Washington Editor 30 November 00