If monetary policy is deemed to be ineffective the government can switch to fiscal policy by doing two things:
Encourage private spending by cutting taxes
Boosting spending directly through government purchases
A fiscal stimulus as an increase in the budget deficit designed to boost aggregate demand. Here’s how it’s supposed to work in theory – when the growth rate of the economy falls below potential the government boosts AD by a deficit-financed increase in spending. And once the econ- omy recovers and tax revenues are high they run a budget surplus and use this to pay off the debt. Benevolent policymakers “smooth the cycle” by increasing debt during a downturn and paying it back in the boom.
At some point the stimulus must be paid for, and this will also reduce output. Consequently any initial benefit from a stimulus must be weighed up against the retrenchment that comes when it is withdrawn, and then paid for. Ultimately it is a matter of time horizons, and the relationship between borrowing and taxes. After all, borrowing is not really an alternative to taxes, it’s simply a way to defer them.
This suggests that the only reason we need to turn to fiscal policy is if monetary policy isn’t working. This may be because it loses its power at the ZLB, or it may be because it is not being implemented properly. But to some extent, while monetary policy determines the amount of total spending, fiscal policy only affects its composition. The main impact of fiscal policy comes from shifting spending from the future to the present. It is monetary policy that does the heavy lifting in the economy. The balance of spending between the public and private sector is a contentious issue because it gets to the heart of the argument about the optimal size of the state.
Economists tend to agree that an effective fiscal stimulus requires three characteristics.
It needs to begin while the economy is still in recession. Even Keynes agreed that the economy will self-correct “in the long run”, therefore the stimulus needs to kick in before this happens. If there’s a delay in implementation you may as well wait for the natural correction. So resource mobilization is key.
The Keynesian argument that boosting aggregate demand won’t simply lead to inflation assumes that there’s an output gap. Once the economy is back to its poten- tial a stimulus would be inflationary. Therefore not only should the stimulus kick in when the economy is still in recession, it needs to expire before the economy recovers. This is where the politics comes in. Politicians like an excuse to spend money, since they can direct it towards their supporters. But the supporters want permanent, not temporary, spending plans. Therefore there’s a danger that a stimulus is used as a vehicle to enact permanent spending commitments, and a stimulus is not supposed to increase long-term government debt.
The whole point is that the stimulus brings back on line the idle resources. If government projects use workers that would otherwise be employed in the pri- vate sector there’s no point (and if the government projects are less value-creating than private sector projects, it would make things even worse). If the resources aren’t idle, government spending “crowds out” private spending (the rise in G is offset by a fall in C or I). But it is difficult to only target idle resources; therefore the mar- ginal entrepreneur is now having to compete with the public sector.
In addition “idle” unemployment serves an important function in the economy – we need markets to adjust to changes in data. Even if there’s a shortfall in AD policymakers lack the signals to know what type of projects would create economic value. It’s easy to say “build more houses”, but there is also an obligation to know how many, what kind and where.
The fiscal multiplier is the ratio between a change in the budget deficit and a change in aggregate demand.
Estimates of the fiscal multiplier are controversial. But two points need to be made. Firstly, we cannot ignore the hidden costs of a fiscal stimulus. There’s a multiplier involved in private spending as well. Secondly, these are empirical assertions. We don’t know whether the multiplier is high or low. Policymakers are wrong to assume that any increase in government spending will kick start the economy, and economists are wrong to claim that any increase will automatically be offset by lower consumption.
Since the height of the Keynesian revolution in the 1970s there has been a sustained movement away from a mechanistic view of the economy to focusing more on expectations. One way to view the role of expectations is how policy changes affect confidence. Consider these examples:
When the US Treasury Secretary Henry Paulson prepared to speak to the press on 29 September 2008, his communications advisor Michele Davis said, “this is about market confidence. Don’t talk about mechanics.”
In March 2009 UK Chancellor Alistair Darling said he would take “whatever action is necessary” to deal with the ongoing financial crisis.
In May 2010 the President of the European Commission, José Manuel Barroso, said that the euro zone would do “whatever it takes” to save the euro.
The reason they did so – I assume – is because they believed it would reassure people that they had things under control. This is possible. But it’s also possible that it would scare people!
It is tempting to believe that because G is a component of GDP, increases in G (holding T stable) will boost GDP by definition. But this may only hold over the short term, with an implicit assumption that you already have a reasonably balanced budget. But what if the government has already been running a budget deficit, such that public debt levels are high and there are genuine fears that they may not be able to afford to pay it off? It’s conceivable that the boost to confidence caused by government stimulus is outweighed by the damage to confidence caused by even higher debt levels. In this situation it is possible that reductions in the budget deficit (i.e. a fiscal contraction, or austerity) can do more for growth. As the European Central Bank have said,
“a fiscal contraction may turn out to be expansionary if the expectation channel becomes sufficiently strong.”European Central Bank
Indeed it is possible that moving towards a more balanced budget can be better for growth than more debt, even in the short run.
Essentially this means that governments may choose to focus on prioritizing the confidence of the bond markets, rather than the confidence of domestic consumers and businesses. Having said this, it’s rarely a case of one or the other. It may be that the public are as concerned by the amount of borrowing (i.e. deferred taxation) as the bond markets are. Journalists like to pretend that “the markets” are separate from the public, but financial institutions are just intermediaries. In many cases it is the public who own the pension pots that have invested in government debt. What it comes down to is how people react, and this can be hard to predict.
In the same way that there are pros and cons to a fiscal stimulus, we should also look at the alternative – a fiscal contraction.
Following an analysis of six historical examples of fiscal contractions in the UK, a Policy Exchange report suggests that a successful fiscal contraction has the following general characteristics:
Although we are focusing on the impact of fiscal consolidation on the economy as a whole, it should also be recognized that reductions in government spending can have a negative (and sometimes a severely negative) impact on those who lose out. If an austerity package reduces disability allowance, for example, this is an important consequence to keep in mind. But such negative consequences of government spending cuts are a broader issue than austerity. Even if the overall amount of government spending was stable, governments can impose spending cuts on specific projects.
Keynes himself said that “the boom, not the slump, is the right time for austerity at the Treasury”, but if governments choose not to engage in austerity during the boom, the risk being forced into having to do it during the slump (quoted by DeLong, 2022, p. 511).
We can create two caricatures of how economists approach this issue:
Some say that the private sector take their cue from the government, and need to feel confident that there will be a recovery before they invest. Policy responses in a crisis calm markets and restore confidence.
Some say that government interventions create uncertainty. If investors want predictability, the threat of arbitrary and large- scale intervention may damage confidence.
We can define policy uncertainty as reductions in investors’ confidence caused by a lack of understanding as to how they will be affected by expected policy changes. According to the investor Lou Jiwei,
“right now we do not have the courage to invest in financial institutions because we do not know what problems they may have … If it [regulation] is changing every week, how can you expect me to have confidence?”Lou Jiwei
in January 2009 the UK government announced a five- point plan that was intended to deal with the ongoing financial crisis. But as the Bank of England’s Monetary Policy Committee pointed out, “it initially had little impact on market sentiment”. Their explanation was simple – “financial market participants were waiting for more detail on the plan.”