Tuesday, February 26, 2013

Dear Money...

     Should the government spend more money to stimulate the economy? Should the government spend less and let the private sector be the stimulus? The debate in the US rages back and forth.

     And then I found this article. Its from my macroeconomic class [so it may refer to "last chapter"], but I think it provides some good points against increasing government spending.

     Feel free to debate it.
(from Gwartney & Stroup Macroeconomics 5th Edition)

Fiscal Policy 

What do we mean by the term fiscal? Merriam-Webster says that it comes from the Latin word fiscus, which means “basket” or “treasury.” It has come to mean anything pertaining to government financial matters. This can include government taxation, spending, and borrowing. All three of these areas of fiscal policy will affect the economy. Basically, changes in the government’s budget affect the overall economy. How so?

When the government spends more than it receives as revenue, there is a budget deficit. Assuming a constant money supply, the deficit is funded by borrowing. Typically, the US Treasury borrows by offering bonds.

When government revenues exceed government spending, there is a budget surplus. The surplus will reduce the government’s debt burden.

What causes the government’s budget to change? General changes in the economy affect both taxes and spending. Also, there may be intentional changes in government spending or taxation. This is called discretionary fiscal policy.

Last week we began our discussion of attempts to correct economic instability. This week our focus will be on attempts to use fiscal policy to affect the economy. You have already been introduced to Keynesian theory In general. Keynesian theory led the government away from the desire to balance the budget. Why would we want to balance the budget when we could simply change our spending habits to fix the economy?

The Keynesian view of fiscal policy is that the government can influence the economy by changing its budget. When we are in a recessionary period, a Keynesian would suggest that we should either increase government spending or reduce taxes. In other words, running deficits will help move us towards potential output and full employment. If inflation is becoming a problem, a Keynesian would suggest that reducing government spending or increasing taxes would put downward pressure on prices. So, running a surplus should help curb inflation.

If we have the tools to make it so, why isn’t our economic world perfect?

Crowding Out: reality sets in and spoils our noble ambitions…

This sounds like a nice simple idea, but there is a significant problem associated with borrowing to finance a government deficit. Do you remember our discussion a couple of weeks ago about how resource markets are interrelated with the overall market for goods and services? Government borrowing affects the demand for loanable funds. When the government needs to borrow funds to cover a deficit, it increases the overall demand for loanable funds. Other things constant, this pushes the price of loanable funds (the interest rate) upward. The higher interest rates will dissuade private spending. This scenario is referred to as crowding out. Thus the increased borrowing of the government crowds out the private sector from borrowing and spending. This makes the deficit-running fiscal policy less effective.

There is even more to this situation. Remember that higher interest rates will draw interest from foreigners who want to invest in dollar-denominated financial assets, thus making the US dollar relatively more valuable (appreciating against other currencies) and leading to a decline in net exports. (It will be more expensive to purchase goods with dollars.) So, the crowding out effect pretty much wipes out the intended effect of the policy. Whew! And we just thought we could run a little deficit and fix the economy… Oh boy, what a mess we have gotten ourselves into!

But wait, it appears there may be even more going on…

What if people realize that someone is going to have to pay for that new government spending? After all, we are no dummies. The New Classical view of fiscal policy argues that people will anticipate having to pay more future taxes due to current government spending and borrowing. This awareness will cause them to save more and spend less. The reduction in spending caused by increased savings will offset the deficit’s affect on the interest rate as well. Thus, the fiscal policy is really of no use. 

Even more discouraging news for those who would perfect the market via fiscal policy…

Do you remember how President G.W. Bush sent out checks to help stimulate the economy? Did you notice the time lag between reading about his intentions in the news and actually holding a check in your hand? That time lag is also a classic problem with discretionary fiscal policy. In fact, if it takes too long for a fiscal policy to actually be carried through, the result may be all wrong.

It should also be noted that there are some automatic fiscal stabilizers already in place. Unemployment compensation, corporate tax profit, and progressive income taxes work in opposition to the direction of the economy. When national output and income rise, unemployment compensation declines, corporate tax revenues increase and progressive tax revenues increases. On the other hand, when national output and income decline, unemployment compensation expenditures increase, corporate tax revenues decline and progressive tax revenues decline. So, these items tend to increase the budget deficit automatically during times of recessions and increase the surplus (or decrease the deficit) during expansions.

Could things get worse?

If you thought that you could fix the economy by implementing fiscal policies, I am sorry to disappoint you, but I must add this one last downside to the whole concept. I could sum it up in one word – politics. Politicians are motivated, as everyone else, by self-interest. For that reason, they will be much more likely to vote for expansionary policies than restrictionary policies. Politicians who vote for more spending are generally more popular than those who vote for restricting spending. This naturally makes deficit spending more likely, even when inflation is high.

Let’s sum it all up.

Here is the modern-day wisdom regarding fiscal policy:

· Timing is difficult and critical.

· Automatic stabilizers tend to move us towards potential output and full employment.

· Fiscal policy is not really that productive.

· All the demand-side policies we have discussed thus far will have differing results based upon all sorts of variables.

So, as time has passed, the potency of fiscal policy has come into question. Please be sure to pause a moment to review actual government budget figures which are presented in Exhibit 8. You may continue the graph in your own mind to include the massive spending of the recent years and imagine what sort of long-term effects may emerge from the current administration’s policies.