It is politics that explains why, according to the Congressional Budget Office, the federal government will likely run a deficit every year from now until 2038. It is politics that explains why President Obama and Congress have been unable to agree on the reforms of taxation and entitlements that are so manifestly needed. And it is politics that explains why, before too long, Washington insiders will be back to the usual brinkmanship over government funding and borrowing.
Most economists would agree that the politicization of monetary policy has undesirable consequences, like pre-election rate cuts and high inflation. Hence independent central banks. Yet there is no chance whatever of legislatures giving up control of the budgetary process to independent fiscal technocrats. So are there any alternatives? The obvious one is to enact budgets for longer than a single year.
This idea is not without precedent. A recent example of a multiyear budget comes from Israel, where one of us served as finance minister. The biennial budget approved in July 2009 (for the years 2009-10) was the first two-year budget in Israel’s history, and it was followed by biennial budgets for 2011-12 and 2013-14. Although Israel is going back to annual budgets in 2015, other democracies that have experimented with two-year budgets include Hungary and Spain. And a number of other states — including Austria, Canada and Slovenia — have moved toward rolling budgets, presenting two annual budgets at a time.
The idea has American precedents. In 1940, 44 states enacted biennial budgets. Today, however, only 20 do. And, while the idea of two- or three-year federal budgets has been floated many times in Washington, it has never made it to the statute books.
The principal arguments against multiyear budgets are, a) that they reduce the flexibility of fiscal policy in the event of sudden macroeconomic changes, b) that they rely on forecasts up to 30 months ahead, which are even less dependable than those for the next 12-18 months and, c) that, precisely for these reasons, two-year budgets would end up being revised after a year anyway.
Moreover, any legislature that reduces the frequency with which it tugs the purse strings loses power to the executive. That’s why Bismarck insisted on a seven-year military budget, to reduce the democratically elected Reichstag’s power over an army dominated by the Prussian aristocracy.
Yet longer-term budgets have important advantages. They reduce uncertainty for the ministries, agencies and private companies that depend on government funds. Public investment in infrastructure is a good example; so are defense contracts. In each case, long-term engagements need to be made with contractors and the results take years to materialize. But the danger always exists of unexpected budget cuts that terminate unfinished projects at high cost to all concerned.
A more subtle advantage of longer-term budgets derives from the argument of the Nobel laureates Finn Kydland and Edward Prescott that rules are often preferable to discretion in the realm of economic policy. A good example is investment in fixed assets. A short-sighted government might be tempted to set low taxes on business to encourage investment, but then raise them on installed capital after the fact. But investors who suspected such “time inconsistency” would simply not invest. Thus, a rule that bound a government from raising the tax rate on past investments would lead to higher investment.
Today, there is reason to believe that many Americans, contemplating the vast liabilities of the federal government, expect higher taxes and lower post-retirement entitlements. The rational response is to reduce consumption.
One of the main defects of the 2009 stimulus bill was that it was not accompanied by any credible plan to restore the federal budget to balance within, say, 10 years. If people had been more confident about future policy, they might have been more ready to spend rather than simply save their stimulus-generated dollars. While a direct causal link has yet to be established, in Israel the implementation of biennial budgets amid the global crisis was followed by an impressive 36 percent increase in fixed investment in the years 2010-12.
Longer-term budgets also have political advantages. Passing a budget in the United States, as in Israel, involves prolonged talks between the executive and legislative branches. True, this process is at the heart of democracy. Nothing connects a congressman to his constituents more than a vote on a tax hike or a spending cut. But does the horse-trading need to happen on an annual basis?
With annual budgets, much of the year is devoted to budget preparation. No sooner is the process over than it has to begin again. This treadmill leaves little time for ambitious structural reforms, or for legislators to scrutinize how public money is actually spent. In what other arena does budgeting so completely dominate implementation?
Economics is a world of double standards. For nearly two decades, the World Bank and the International Monetary Fund have recommended that developing countries adopt Medium Term Expenditure Frameworks. Yet this is not expected of developed economies, even though it is the United States, Japan and European countries that have the world’s biggest public debts.
America’s fiscal problems will not be solved without some bipartisan agreement. Biennial budgets might just be the place to start. After all, this is an idea that was supported not just by Ronald Reagan and both Bushes, but also by Bill Clinton, Al Gore (leader in 1993 of the National Performance Review) and the current Treasury secretary, Jacob Lew.
Moreover, Israel’s experience has been a great advertisement. Not only did it enjoy an impressively rapid recovery from the financial crisis under the system of biennial budgets; more remarkably, when directors-general of Israel’s government ministries were polled in 2010, not one of them favored returning to what one called “the Dark Ages and the madness of the single-year budget.”
Niall Ferguson is Laurence A. Tisch Professor of History at Harvard University. Yuval Steinitz is the Israeli intelligence minister and a former finance minister.