Charles Steindel

Richard Peach

English

Research Papers in Economics

FRBNY Economic Policy Review / April 2000 1
Summary of Observations 
and Recommendations
enefiting from sustained economic growth and low
 inflation, the country’s fiscal outlook has undergone a 
remarkable reversal. The trend toward large and growing 
budget deficits has given way to two straight years of budget 
surpluses and projections for a continued rise in surpluses over 
the next decade. Yet this solid fiscal performance poses 
challenges for the financial markets, which have had to adjust 
to the diminishing supply of new Treasury securities resulting 
from the surpluses.
To offer insight into these developments, the Federal 
Reserve Bank of New York hosted “Fiscal Policy in an Era of 
Surpluses: Economic and Financial Implications.” The 
December conference focused on the forces behind the recent 
trends in federal receipts and outlays, the federal budget’s effect 
on the overall economy, and the financial market consequences 
of the shrinking stock of U.S. Treasury securities. More than 
100 academics, policymakers, and market participants 
attended the day’s discussions.
Factors Contributing to 
the Improved Fiscal Situation
The first of the day’s sessions focused on the economic forces 
and policy developments that have led to the nation’s dramatic 
fiscal improvement over the past several years. Alan Auerbach 
provided a broad overview of the key economic trends shaping 
the federal budget over the past quarter-century and the main 
currents in fiscal policy, which to a large extent were reactions 
to those trends. For example, he explained that the across-the-
board reductions of marginal tax rates and the indexing of the 
tax code in 1981 were mainly a response to the inflation-
induced “bracket creep” of the 1970s, which pushed federal tax 
receipts as a percentage of GDP to very high levels. More 
recently, tax policy has been strongly influenced by the 
pronounced increase in the share of income going to those in 
higher tax brackets. Accordingly, efforts to boost tax revenues 
in 1990 and 1993 were directed primarily at these taxpayers. 
With regard to outlays, Auerbach emphasized that the 
composition of federal spending has changed significantly over 
the past twenty-five years, with outright purchases of defense 
and nondefense goods and services yielding in importance to 
entitlement spending—particularly in the form of Social 
Security, Medicare, and Medicaid payments. Although defense 
and nondefense discretionary outlays as a percentage of GDP 
have fallen greatly over the period, Auerbach speculated that 
this trend was unlikely to persist. Indeed, he suggested that the 
trend could start to reverse itself, particularly now that the 
unified budget balance is in surplus. Auerbach stressed that the 
growing importance of entitlements—combined with 
demographic projections of a steep decline in the ratio of 
taxpayers to beneficiaries—makes the current unified budget 
surplus a poor indicator of the country’s long-term fiscal 
position. Furthermore, over a longer time horizon, the federal 
budget will remain seriously in deficit, and recent policy 
proposals could exacerbate that situation considerably.
 In the ensuing panel discussion, Barry Bosworth built on 
the themes of Auerbach’s paper. He noted that over the past 
twenty-five years, fiscal policy’s role in short-run economic 
stabilization has nearly disappeared because of an inability to 
Richard Peach and Charles Steindel
B2 Summary of Observations and Recommendations
reach political agreement on how to eliminate persistent 
deficits. Consistent with that development, legislative changes 
have played a relatively minor role in the improvement in the 
federal fiscal balance over the past several years. Bosworth 
suggested that much of the improvement can instead be traced 
to the rapid growth of individual income tax receipts resulting 
from the shift in the distribution of income and from 
substantial capital-gains realizations. Yet he acknowledged the 
potential for deficits in the long run, particularly given the fact 
that entitlements for the elderly claim a growing share of the 
federal budget. He proposed that entitlement programs be 
budgeted and funded according to principles that differ from 
those applied to day-to-day government operations. Eugene 
Steuerle reiterated Auerbach’s concerns about the emergence 
of future deficits as well as Bosworth’s concerns about 
entitlement funding. He observed that the current surplus 
might be seen as “the eye of the storm” between two periods of 
chronic large deficits.
The Budget and the Macroeconomy
In the second session, the focus shifted to the federal budget’s 
effect on the performance of the macroeconomy. Darrel Cohen 
and Glenn Follette offered a theoretical and empirical analysis 
of how the federal tax code and expenditure policy work to 
stabilize the economy automatically. Cohen and Follette began 
by presenting new theoretical findings using the modern two-
period, representative agent model. They showed that, even in 
the case of forward-looking consumers, automatic stabilizers 
in the form of progressive income taxes and income-support 
programs should reduce the volatility of consumption by 
providing insurance against income uncertainty. In the 
empirical part of their paper, Cohen and Follette outlined the 
results of experiments involving the FRB/US econometric 
model—results suggesting that the automatic stabilizers play a 
real, but surprisingly modest, role in reducing the impact of 
demand shocks on the economy. Moreover, their FRB/US 
model experiments indicated that automatic stabilizers have 
virtually no effect on supply shocks, such as changes in oil 
prices. Cohen and Follette also presented updated estimates of 
the responsiveness of various federal taxes and spending 
programs to fluctuations in total output.
Olivier Blanchard, commenting on the Cohen-Follette 
paper, noted that much economic theory disputes the 
effectiveness of automatic stabilizers. Although Blanchard 
expressed his own view that stabilizers do work, he questioned 
the evidence from large-scale econometric models such as 
FRB/US. These models, he suggested, are constructed in such a 
way that they will invariably show that the existence of a 
progressive income tax and income-support programs 
dampens output fluctuations. Blanchard then offered 
alternative evidence supporting the effectiveness of stabilizers. 
For instance, he explained that in international data, output 
volatility tends to vary inversely with government expenditures 
as a percentage of GDP. 
In an address to the conference, Rudolph Penner reviewed 
the passage of the fiscal year 2000 budget and presented his 
views on the near-term outlook for fiscal policy. He described 
the ongoing pressures to increase spending, which have led to a 
significant increase in discretionary spending for fiscal year 
2000, as well as some of the political forces potentially at work 
in the budget process over the next few years. Although he 
agreed that it is difficult to project the budget and Treasury 
debt supplies, Penner was optimistic that the next decade will 
see a continued reduction in Treasury debt as a share of GDP.
Treasury Market Liquidity
The afternoon sessions addressed the implications of a 
shrinking supply of Treasury debt for the Treasuries market in 
particular and for the financial markets in general. In his 
keynote address, Treasury Department Under Secretary Gary 
Gensler described the ongoing changes in the auction schedule 
for debt as well as the Treasury’s plans to repurchase existing 
debt and reopen issues. He acknowledged that Treasuries 
might lose their importance as financial market benchmarks 
and that other instruments might take over this role. 
The following session was devoted to the preservation of 
Treasury market liquidity in the face of the declining volumes 
of new issues. Paul Bennett, Kenneth Garbade, and John 
Kambhu explored ways in which liquidity might be enhanced. 
For example, they proposed increasing the homogeneity of 
stripped Treasury coupon and principal components by 
allowing any stripped instruments of the proper maturity to 
reconstitute any issue. Bennett, Garbade, and Kambhu also 
recommended issuing 104-week Treasury bills and allowing 
market participants to create new stripped instruments by 
exchanging with the Treasury coupons or principal payments 
of similar maturities. 
Vaughn O’Regan, drawing on his experience with similar 
innovations in Canadian debt management, mentioned the 
potential hurdles that these proposals could face. Charles 
Parkhurst cited some peculiarities in the current market for 
STRIPS that suggest that further expansion of the STRIPS FRBNY Economic Policy Review / April 2000 3
program may not enhance Treasury market liquidity greatly. 
However, Parkhurst did support the idea of a 104-week bill.
The Treasury Market’s 
Benchmark Status
In the closing session, the participants considered the Treasury 
market’s benchmark role. Michael Fleming examined the 
implications of the market’s recent performance for the use of 
Treasury securities as a pricing and hedging tool. He observed 
that some of the attributes that have made the Treasury market 
a useful benchmark were weakened by the financial crisis of 
1998 and have not yet fully recovered. Fleming also spoke 
about the possibility that federal agency debt issues, corporate 
debt issues, and interest-rate swaps would ultimately displace 
Treasuries as benchmarks.
In the panel discussion, Lou Crandall noted that the 
Treasury market lost its benchmark status on the short end of 
the yield curve some time ago because of the unpredictable 
supply of issues and the fact that the credit risk inherent in 
Treasuries differs markedly from the credit risk of the 
instruments hedged with Treasuries. For these same reasons, 
Crandall expected that Treasury coupons would eventually lose 
their benchmark status and be replaced by interest-rate swaps. 
Voicing a differing opinion, Thomas Glaessner contended that 
the Treasury market has in fact retained many of the important 
features of a benchmark market and that any deterioration in 
its benchmark role would consequently be slow. Moreover, 
Glaessner noted that a number of the alternatives to Treasuries 
lack some of the major attributes desirable in a benchmark 
security. Adding to the debate, Stan Jonas argued that swaps 
would eventually take over the benchmark role. He emphasized 
that Treasuries’ lack of credit risk is only a relatively minor 
advantage; during financial crises, other sources of risk—such 
as a lack of liquidity—can be far more important.
The views expressed in this summary are those of the authors and do not necessarily reflect the position of the Federal Reserve 
Bank of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty, express or 
implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of any 
information contained in documents produced and provided by the Federal Reserve Bank of New York in any form or 
manner whatsoever.

Fiscal policy in an era of surpluses: economic and financial implications - summary of observations and recommendations

http://www.newyorkfed.org/research/epr/00v06n1/0004peac.pdf

Fiscal policy in an era of surpluses: economic and financial implications - summary of observations and recommendations

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics