Part II. National economic policy.

13. Remember fiscal policy?

Pre-reading questions:

1. What fiscal policy instruments can you name?

2. What changes of fiscal policy are referred to as automatic stabilisers?

Task:

1. Read the article.

2. Make a précis and an annotation of the article.

How to use fiscal policy in a recession

THE standard objections to the use of fiscal policy—ie, changes in budget deficits or surpluses—to dampen the economic cycle take two main forms. First are economic arguments that fiscal policy will have less of an effect on the economy than its advocates suppose, or even no effect at all. Second are political arguments that, even if taking the right fiscal steps would help the economy, governments are incapable of designing the right measures or enacting them at the right time. The endless squabbling in Washington which takes place any time an economic-stimulus bill is proposed seems to confirm the truth of this second claim: so far as one can tell, by the time a bill emerges from Congress, it will almost certainly be both badly designed and too late. Evidently, activist fiscal policy is best left alone; monetary policy is a better counter-cyclical tool.

And so it is, usually. When it works, monetary policy is fine. But sometimes it does not work. Problems arise, especially, under the circumstances that most interested Keynes when he first developed his thinking on deficit spending as a cure for recession—that is, at times of low, or even negative, inflation.

Thinking about how to conduct macroeconomic policy under such circumstances used to be an academic, even unreal, exercise. For years, up to the 1990s, inflation was high. So nominal interest rates were also high, on average, over the course of the cycle, giving monetary policy plenty of room for manoeuvre. But when inflation and nominal rates are low, the scope for monetary relaxation is more limited—or at any rate, less obvious. Certain kinds of recession may also be less susceptible to lower interest rates. All this suggests that fiscal policy deserves another look.

Consider first the economic argument—the claim that fiscal stimulus is ineffective, because people adjust their behaviour to cancel it out. The strongest version of this idea is due to Robert Barro who developed a theory that, if governments cut taxes or increase spending, consumers will increase their saving (because they expect higher taxes in future) so as to offset the stimulus entirely. But although this remains an intriguing and influential insight—it spawned an enormous theoretical literature—there is little evidence that it is true.

A smooth idea

However, there is more to fiscal scepticism than Mr Barro. Too much public borrowing may raise long-term interest rates, offsetting the stimulus in a milder way. Such crowding out happens, the evidence shows, but only partially. Simple theory suggests another objection. People will prefer to smooth out their spending over time, rather than swing between famine and feast. So if the government enacts a once-off tax rebate, theory would lead one to expect that people would spread increased consumption over time, rather than go out and binge. In that case, a fiscal stimulus might be smoothed so much that it would have hardly any effect in the short term, when it is needed, but continue to boost spending later, when that may be the opposite of what is required.

In his article "Reviving Fiscal Policy" Laurence Seidman of the University of Delaware looked at recent evidence on the smoothing idea. The consensus is good news for fiscal policy: people do not smooth nearly as much as they “should”. The studies suggest a variety of reasons for this. Most consumers may be too uncertain about the future to plan much ahead. Or they may lack the wealth or borrowing capacity to make smoothing work, and are therefore accustomed to living paycheque by paycheque. In any event, the evidence is that consumption smoothing does not neutralise the stimulus effect of tax cuts.

One would expect public spending to have an even bigger initial stimulative effect than tax cuts (because in this case none of the initial stimulus is saved). But spending is highly vulnerable to delay. Planning and administering a big rise in spending, and organising political support for it, are likely to take far longer than is required to arrange a tax rebate. Temporary increases in, say, support for the unemployed make better sense, in this respect, than programmes of public works. In any case, if counter-cyclical fiscal policy is to work, speed is crucial.

To that end, Mr Seidman discusses ways in which counter-cyclical fiscal policy, at least in America, could be made more automatic, either by having Congress pre-approve tax rebates that could be triggered by economic data, or by setting up an independent board (in its relationship to Congress, rather like the Federal Reserve) with powers to make limited changes to tax rates in response to economic circumstances. It all seems very ambitious. Politicians, whose privileges are at stake, will not be keen. But there is no denying that, now and then, arrangements such as this would be nice to have ready.

At least governments should open their minds to the idea that the fiscal option needs to be restored. Automatic or independent fiscal-policy adjustment (on top of so-called automatic stabilisers that operate in any case) may be difficult to develop. But once a country has achieved a reasonably sound long-term fiscal position, its government should regard that as an asset that can be drawn upon. Surpluses are not an end in themselves. Budget balance on average, together with wide and well-timed fluctuations around the average according to circumstances, is clearly the policy to aim for.

From The Economist