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I. Fiscal Policy
A. “Discretionary Fiscal Policy” refers to changes in G (government spending) or
T (taxes) that result from a vote in Congress or an Executive order. These
decisions target specific goals such as increasing employment or maintaining
stable prices.
B. “Automatic Stabilizers” are non-discretionary, built in adjustments to taxes
and G that require no voting or new legislation. These changes in fiscal
policy that automatically respond to fluctuations in economic activity can take
the form of higher income tax rates in a boom and higher unemployment/ food
stamps/ welfare (transfer) payments in a recession. While these policies help
to stabilize income and employment, they are not significant enough to
completely prevent periods of unemployment in recessions or inflation.
C. “Compensatory Fiscal Policy” was what Keynes advocated. It can take the
form of discretionary or non-discretionary policy, but what is key is that it
compensates for the economy being in a situation with unemployment or
inflation. This type of fiscal policy is used to restore Full-Employment GDP
(starting in a recession). The use of Compensatory policy is to maintain price
stability (in a boom). When fiscal policy is used in this counter-cyclical way,
it is also called “functional finance.”
II. Deficit Finance
A. If G exceeds T (as it usually does in the US), the amount of G-T= deficit.
If T exceeds G, T-G= surplus. A deficit is recorded for every year (calculated by
the difference between the yearly outflows in gov’t spending and the yearly
inflows of taxes) and rarely a surplus is recorded some years. Total all past
deficits, minus all past surpluses, and the result is the national debt.
B. Concerns about the deficits and the related debt include:
i. Magnitude (size) of deficits and the debt have grown significantly in
recent decades. Furthermore, with the baby boomer generation
earning wages through recent decades, Social Security ran a surplus.
When this demographic “swell” of citizens in a certain age group
retires, the Social Security fund will be in a deficit. This is why many
economists feel SS should be “off budget” because including the
surplus of the SS fund makes the overall deficit seem not as severe.
ii. The fraction of the total Federal Budget devoted to interest on the debt
is gradually increasing. This is problematic because, while existing
programs and new spending can be reduced in attempts to balance the
Federal Budget, interest payments are non-discretionary.
iii. Deficit timing is also a concern. In the past, deficits were used to pull
the economy out of severe overcapacity (depression) or for urgent
national security needs (WWII) but more recently deficits have existed
while the economy was at or near full-employment. This is potentially
inflationary (D-P inflation)
iv. The “Crowding Out” is the reduction in private spending (C and/or I)
that results from deficits pushing up interest rates. The reason deficits
increase interest rates can be shown in the market for loanable funds;
demand increases (shifts right) by the amount government decides to
increase the deficit. This shift increases the interest rate. Mostly this
impacts Investment Spending negatively (recall that there are
important reasons C will remain stable in the face of changing interest
rates, while I is extremely volatile).
1. We know i.r. inversely relates to I, so if this spending
by firms was graphed, with I measured in dollars on the
horizontal axis and the i.r. on the vertical, I will be
downward-sloping. So increasing the i.r. will first
impact I through a change in the quantity of dollars
invested, or movement along the curve.
2. Then, the nature of the deficit spending must be
considered. If the deficit spending goes to those who
will spend it as C (Consumption spending) then there is
some burden placed on future generations because I has
been “crowded out.” This type of spending includes
transfer payments to individuals and hiring or pay raises
for public employees. If, however, the deficit spending
itself is an investment in the future, future generations
will have additional productive capital to increase their
real output.
3. At first, the increase in i.r. inversely affected I, but the
government spending will either provide jobs (for
projects like dams, power facilities, roads) or put more
money in the hands of consumers through transfer
payments or salaries to government workers. In either
case, there is more money to be spent on C, leading
firms to increase investment spending. This is
represented by a shift to the right of the Investment
spending line, causing the original level of I to be
restored at the new, higher i.r.
4. In reality, this “employment effect of government
expenditure” may more than, less than, or equally offset
the crowding-out effect.
C. Unfounded Concerns, or myths, about deficits and the debt
i. Debt Myth 1: the size of the debt will bankrupt the nation
1. Revenue can be raised. Government has the Constitutional
authority to raise taxes, which are the main revenue source for
government. Individuals and firms can go bankrupt, but the
government is not vulnerable to bankruptcy.
2. Refinancing is available. New bonds can be issued to repay old
ones. By changing the life of the bonds (e.g. five-year issues
instead of one-year issues) the repayment schedule can be made
more favorable to existing economic conditions (like a shortfall in
government revenues). The deficit never must be fully repaid.
3. While increasing the supply of money (by actions of the Fed, or
simply printing more money) is potentially inflationary, it will
make the real debt shrink (remember that debtors benefit from
inflation). This is just another way the government could avoid
bankruptcy.
ii. Debt Myth 2: The debt will burden future generations
1. Every dollar of U.S. debt is a credit to a bondholder. Debt is a
liability to the government, owing the money, but an asset to
creditors. Further, 82% of the creditors holding U.S. bonds are
domestic citizens (or institutions). Therefore, if the debt was fully
repaid tomorrow, the effect on AD would be minimal and a wealth
would shift from taxpayers to the bondholders. Using key terms, it
is necessary here to distinguish “internal” from “external” debt.
2. The current generation carries much of the debt’s burden. If the
deficit buys military goods, then there is productive capacity being
used for that purpose, rather than to make more consumer goods.
The decreased goods and services enjoyed by the public is the
opportunity cost for building defense goods. It is true, however,
that to the extent it is capital goods that go unmade in favor of
defense spending, future generations will have the burden of
reduced future output.
D. Traditional Argument: Budget Deficits cause Trade Deficits
i. The sequence in which this causality unfolds:
1. Government has a deficit
2. The borrowing increases demand for loanable funds so the
interest rate increases.
3. As the crowding out of I occurs, foreign investors buy more US
securities of all types, with a return on investment based on the i.r.
plus other factors.
4. To buy US bonds and other dollar-denominated financial
instruments, the foreign investor has to buy dollars, exchanging
their currency to do so. Demand is increasing in the market for
dollars – this is called an appreciation in the dollar against other
currencies.
5. As purchasing dollars becomes more expensive, purchasing
American goods (our exports) declines since U.S. producers want
to be paid in dollars.
Imports increase as the currency exchange rate makes goods
produced abroad cheaper.
6. When exports fall as imports rise, the trade deficit is increasing.
ii. The alternative to the traditional view
1. Another view is that deficit spending will not lead to higher
interest rates.
2. It is founded on “Ricardian Equivalence,” which says deficit
spending has the same effects on the economy as tax increases.
The reasoning is that people will set aside money i.e. save at a
greater rate in response to deficits because they know it has to be
paid back in the future. Save more=spend less, so supply in the
market for loanable funds (also called the credit market) increases
in the same amount the demand initially increased when the
government demanded more loans in the form of bonds. The net
effect is no change in interest rates.
3. Economists with the traditional view can point to the last
twenty years as evidence that budget deficits existed along with
trade deficits.
E. Passive vs. Structural Deficits
1. Structural deficit refers to the portion of the deficit that would be there
even if the economy is at potential GDP. Passive deficit is the amount of the deficit that
is caused by the economy’s being below potential (in a recession).
2. Both can be viewed for their inverse, a surplus.
3. Adding the passive to the structural for the same year gives the actual
deficit (as shown in table 15-2)
III. Efforts toward Balancing the Federal Budget
A. In 1985, Congress passed the Graham Rudman Hollings Act, which required
a balanced budget by the year 1991. Two years later, the goal was extended to 1993.
However, in 1991 the recession and the massive bailout for bankrupt Savings and Loans,
the budget cuts required by the GRH Act were never made and the legislation was
abandoned.
B. In 1990, the Budget Enforcement Act was passed to decrease the deficit over
the next five years by 500 billion dollars. Not only would G be cut 260 billion over that
period but taxes increased.
i. Progressive taxes instituted were:
1. Increase in the income tax rate paid by those in the highest
income bracket.
2. Decrease in allowable deductions from taxable income
3. New luxury taxes of “10%…on certain high-priced items to the extent
that they exceed certain statutory limits. Effective January 1, 1991, the tax applies to the "first retail sale" of
luxury goods with a sales price above the following thresholds: automobiles $500,000; boats $100,000;
aircraft $25,000; and jewelry and furs exceeding $10,000. The tax was originally projected to provide
revenues of $9 billion over the next five years.” (CPA Journal Online 10-91)
ii. Regressive taxes instituted were
1. Increased Excise taxes (taxes on certain goods that many would
argue the government has an interest in decreasing their consumption) on Gas, tobacco
products, and alcohol.
3. Increased Payroll Taxes
The Act required new government spending to be accompanied by equal tax
increases. Similarly, tax cuts had to be accompanied by equal spending cuts.
While these steps helped reduce what would have been relatively more copious
deficits, the deficit still is projected to grow.
C. Proposals for Further Change
i. The proposal to add a balanced budget amendment to the Constitution
narrowly failed to pass the US Senate in 1995. Those in favor argued it
was the only way to reduce deficits significantly, while those opposed
argued that this would constrict the flexibility required for active fiscal
policy. It would prevent Compensatory Fiscal Policy:
Imagine that in the year 2010 AD shifts down and the economy is in a
recession. This could have been caused by a crash in the stock market,
which would reduce C. The balanced budget amendment would prevent
the government from making new spending to restore the economy at Y*
(Full-employment GDP). The only way it could increase G is if there was
an equal increase in T, which would reverse the positive intended effect on
Consumption. To make fiscal matters worse, falling incomes decreases
revenue from taxes.
ii. The “line-item veto” would enable the President to cut certain sections
out of newly passed legislation, as opposed to the standard all-or-nothing
veto. Sections could be eliminated to reduce increases in G or tax cuts
that often arrive packaged in bills resulting from compromises during the
legislative process. Line-item veto power existed briefly when Clinton
was president, but “Line-Item Veto Outlawed (June 25, 1998): In a 6–3
decision, justices rule Constitution prohibits president from rewriting
legislation by striking out single items of spending or specific tax breaks
passed by Congress” (Infoplease.com “Major decisions of the Supreme
Court”).
iii. “Privatization” is the migration of public services to business owners.
The operation of services like Amtrak, CalTrans, and the postal service
could be contracted to firms. Motivated by profits, it is argued that firms
will produce more efficiently than the government. While less obvious
bureaucratic functions and various defense requirements may be good
candidates for privatization, passenger rail services worldwide rely on
public funds and currently appear unable to make profits.
Also, government assets can be simply sold, such as oil reserves, public
land, and power plants.
iv. The proposal that government should reform the way the budget is
accounted is called “Current account – Capital account budgeting” and is
the procedure private firms must use. “Current revenues” (tax dollars
collected this year) could balance the “current expenditures” of salaries for
government workers and transfer payments (which pay for services or
benefits enjoyed this year). “Capital expenditures” which expand the
potential output for future generations, like building road, dams, bridges,
and power sources (i.e. infrastructure) could be financed by deficit
spending. This address the problem inherent in the current “cash-flow
accounting system”
IV. Another solution to layoffs (unemployment) in a recession, and the resulting lost
output: The share economy. Wages are partially tied to profits. A majority of worker
salaries would be stable, in economist Martin Weitzman’s proposal, while 15-20% would
be variable and directly tied to the profits of the firm. The result, Weitzman argues, is
that in recessions, when firms can not sell as much product, profits decrease, and the
variable (or “bonus”) portion of salaries will decrease. Layoffs will be reduced since
firms’ payroll expenditures – the input cost of labor – have decreased.
Major opposition to the two wage system would come from senior union leaders who
have enough seniority that the threat of layoff is not a risk, eliminating benefits for them
from the proposal while they still would face the cost of a variable paycheck.
Former U.S. Dept. of Labor Secretary Larry Summers also notes the fellow worker
problem that could arise. Any newly hired workers means more people with whom to
split the workers’ share of the profits through bonuses, making those with seniority likely
to resist new hiring and welcome layoffs of less efficient and newer hires so their own
share profit pie can grow. Also there could be an investment problem when stockholders
see there is another claimant to profits.