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Thursday, September 22, 2005

Using Fiscal Policy to Stabilize the Economy

As Janet Yellen points out, monetary policy is not an effective means of mitigating short-run fluctuations in the economy arising from events such as Katrina.  In general, if it can be implemented quickly and efficiently, fiscal policy (meaning changes in either spending or taxes) is a more effective means of dealing with such fluctuations, and with higher frequency fluctuations in GDP and employment more generally. To use fiscal policy to stabilize the economy however, you have to spend more or tax less in the bad times (increase the deficit) and then do the hard thing which is to raise taxes or cut spending in the good times (decrease the deficit).  To keep the budget in balance the good has to be matched somewhere by the bad.  If you cut taxes for this disaster, or this recession, or this war, and don’t raise them later, what do you do next time?  Cut again?  Okay, what about the time after that?  It won’t work forever.  The priming of the economy during the bad times must be matched by a slowdown during the good.  Borrow when income is low, pay it back when income is high. 

Furthermore, in stabilization policy, it’s also not possible in the long-run to use both government spending and taxation at opposite points in the business cycle.  That is, suppose you cut taxes during the bad times, then cut spending during the good times to pay it back.  That will work for a recession or two, a hurricane or two, but it won’t work forever because eventually there will be nothing left to cut out of government.  The opposite will not work forever either.  If you increase spending during the bad times then increase taxes during the good, the size of government will grow indefinitely over the long-run.  In more graphic form:

G↑ (rec) → T↑ (boom) →  G↑ (rec)→  T↑ (boom)  → G↑  (rec) → T↑ (boom)  →  bloated government

T↓ (rec) → G↓ (boom) →  T↓ (rec)→  G↓ (boom)  → T↓ (rec) → G↓ (boom)  →  no government

These two policies, or some combination of them (increase G and cut T in recessions, do the opposite in booms) are sustainable:

G↑ (rec) → G↓ (boom) →  G↑ (rec) →  G↓ (boom)  → G↑ (rec) → G↓ (boom)  →  sustainable size of government

T↓ (rec) → T↑ (boom) →  T↓ (rec) →  T↑ (boom)  → T↓ (rec) → T↑ (boom)  →  sustainable size of government

The Democrats are accused of adopting the first strategy and bloating the government.  The Republicans claim to adopt the second strategy to shrink government, but they’ve bloated government themselves (take the second line and change it to T↓ (rec) → G↑ (boom) → etc., a clearly unsustainable path).  Neither party seems willing or able to use either the third and/or the fourth lines as a means of stabilizing the economy.  We are seeing that now, and maybe even less stable budgetary variations.  The WSJ and other members of the GOP seems to advocate T↓ (rec)→ T↓ (boom) → etc. which, without cuts in G, cause deficits rise no matter how much they claim otherwise. 

There are, of course, lots and lots of variations on these basic chains of events, e.g. to adjust the size of government the first or second strategies can be adopted temporarily, and you hope lawmakers would put all their cards on the table as they do so whichever direction government size is to be adjusted.  But fiscal policy that is sustainable in the long-run, through recession after recession, natural disaster after natural disaster, war after war, has to adopt some combination of the third and fourth lines.  Simply cutting taxes whenever and wherever possible gets us into the predicament we are now in.  But those who try and adopt responsible budget practices face stiff opposition:

A GOP Tax Increase?, WSJ:  ...Markets have begun to get rattled in the last couple of days, both in fear of further damage in the Gulf region from Hurricane Rita, and in response to the bad ideas that are starting to flow fast and furious from Congress. These include ... a revival of the oil "windfall profits" tax. ... But the worst news is that a handful of GOP Senators think a tax increase is needed to pay for Katrina spending. ... some GOP Senators are suggesting that they should redo reconciliation and drop the capital gains and dividend tax cuts. ... We can understand why some Democrats would want Republicans to repudiate their own tax policies. But why Republicans would want to join in this act of masochism is a mystery. President Bush has ruled out tax increases to finance Katrina relief, but we hope someone in the White House is telling him what members of his own party are doing in the Senate. Katrina has already done enough damage, without the political class compounding it with policy blunders.

The political climate makes it unlikely, but some combination of the third and fourth lines during the recovery period is the best way out of our budget predicament.  There are certainly places government can be cut or made more efficient.  But cuts alone aren't enough and tax increases of one sort or another are also needed.

    Posted by on Thursday, September 22, 2005 at 02:25 AM in Budget Deficit, Economics, Policy, Politics, Taxes | Permalink  TrackBack (0)  Comments (13)

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