Amidst fears of a recession and a jittery stock market Bush has signaled that he is open to a larger fiscal stimulus package–i.e. larger deficits.
Jolted by global recession fears, the Federal Reserve slashed interest rates Tuesday, and President Bush and leaders of Congress joined in a rare show of cooperation in promising urgent action to pump up the economy with upwards of $150 billion in tax cuts and government spending.
One of my big problems with “fiscal stimulus” is that I see it as somewhat better than simple re-arranging the deck chairs on a sinking ship, and not much more. After all, how does a government run a deficit? By borrowing money. Now if that money could be used for productive purposes such as investment, or spent, then the impact of deficit spending is reduced. Further, there is the work of Robert J. Barro on deficit spending. Under certain assumptions, such as intergenerational altruism–i.e. you care about your kids, grandkids, etc., then any increase in the deficit is precisely offset by increased savings in the terms of government bonds, and there is no net increase in output. Of course, not everyone has kids, or in some cases they may prefer to spend their kids inheritance on themselves, so the strong conclusion above is mitigated somewhat.
Further, another problem with fiscal policy is the concept of time inconsistency. For example, a president might say, “We are on the brink of a recession, so we should increase government spending and run a deficit to avoid the recession and the pain they cause. Latter, when the economy recovers we’ll increase taxes to pay down the debt that was incurred. Since economic expansions are typically longer than contractions, the tax increase will be modest and we will be able to afford it.” Sounds eminently reasonable. Now imagine you have are that politician in the future and you are looking at the debt and the prospect of raising taxes. People don’t like higher taxes generally. Further, you have an election coming up. So, do you keep your promise you made earlier or do you renege and come up with a reason why raising taxes during an economic expansion is imprudent? Even if you are a benevolent dictator, by delaying paying back the debt1 social welfare can be enhanced, so even in that case of dictator there is an incentive to deviate from what was, earlier, perceived to be the optimal policy.
When you look at the last 50 years of how the government has handled its finances you see that deficits are pretty much a constant. Running a surplus is actually the exception to the rule. Factor in that politicians have even less incentive to work towards a balanced budget or paying down the debt and fiscal policy could become geared towards running permanent deficits which could end up having an adverse impact on growth if the debt gets to be large enough.
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1Note this does not mean not paying back the debt. Delaying could merely be paying the interest on the debt vs. paying the debt off. If the economy is growing this could be seen as a choice that enhances social welfare since you can avoid raising current taxes and the burden of the debt in the future diminishes as a ratio of GDP.
