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Weekly Commentary by Dr. Scott Brown
Excessive Fiscal Tightening – A Major Worry
June 21 – June 25, 2010
Studies of past recessions show that downturns associated with financial crises tend to be more severe and longer-lasting, with gradual recoveries.
Simply put, it takes a long time to repair financial damage. The restoration of household, business, and banking balance sheets does not happen
overnight. Studies also point to a common error made in these recoveries – that is, policy is often tightened too soon. Chairman Bernanke is a student of
the Great Depression – so the Federal Reserve seems unlikely to make that mistake. However, there is a growing public mood to do “something” about
the federal budget deficit. State and local governments do not have the luxury of borrowing. Increased taxes and cuts in government services have
shaved a few percentage points off GDP growth in recent quarters and reduced nonfarm payrolls. In Europe, austerity has spread beyond the “problem”
countries and fiscal contractions are poised to weaken the recovery in 2011. While well intentioned, excessive fiscal tightening is bad economics.
In the U.S., there have been efforts over the years to enact legislation to require a balanced budget. At its worst, a hard budget balance would be
countercyclical, making recessions worse and booms more frothy. In a downturn, tax revenues normally fall, pushing the budget out of balance. To
return to balance, the government could raise taxes or cut spending, but these moves dampen growth even more. A balanced budget requirement could
be nullified during recessionary periods or in times of war, but that’s not as clear as it sounds. (For example, would Congress have to officially declare
war? What do we mean by a recessionary period?). It may make sense to work toward a balanced budget (or perhaps a small deficit) over the course of
the business cycle, running surpluses during booms and deficits during busts. That sounds easy, but there’s always a strong political incentive to spend
more or to cut taxes during an economic boom. That’s seen clearly at the state level.

2. Most state and local governments have stringent balanced budget requirements. States and cities are responding to the drop in tax revenues by raising
taxes, but mostly by cutting services. In most downturns, government provides some stability. However, in the current recession/recovery, state and
local governments have added to the downturn. Over the 12 months ending in May, state and local governments shed 172,000 payroll jobs (-0.9%).
State and local government subtracted 0.3% from GDP in 4Q09 and 0.5% in 1Q10.
The concept of Keynesian economics has been corrupted over the years by both the right and the left. In the 1960s, it was thought that fiscal policy
could be used to fine-tune the economy. We know now that this is impossible. Similarly, some have argued that any increase in deficit spending would
crowd out private borrowing and be countered by expectations of higher taxes in the year ahead. In general, that’s also wrong. What Keynesian
economics gives you is a recipe for countering a severe recession or depression. It’s not a magic bullet – strong growth will not return overnight.
However, it can prevent the downturn from becoming a lot worse. It’s not a permanent fix. Ultimately, economic growth must depend on the private
sector. However, it allows the private sector time to recover – and to date, that transition is playing out largely as expected.
The nearly $800 billion federal fiscal stimulus was made up of temporary tax cuts and increases in government spending. In the current environment tax
cuts do not give a lot of bang for the buck. That is, for each $1 of tax cuts in this kind of situation, you can expect less than a $1 of additional GDP
growth. That’s because tax cuts are more likely to be saved than spent. Last year’s stimulus checks to senior citizens were a waste. In contrast, $1 spent
on additional government spending (think of hiring someone to build a road or bridge) generates more than $1 in added GDP (since that person spends
most of his pay, which is someone else’s income, and so on). Private-sector estimates show that the stimulus has played an important part in supporting
economic growth in recent quarters. Some of the stimulus was carved out to extensions of unemployment benefits and aid to the states. Neither of these
provides much lift for overall economic growth, but they did prevent the downturn from becoming much more severe.
Still, deficit spending should not be taken lightly. It’s something you would want to do only rarely. There will be some added costs over the long term,
but these are very small – we’re talking a couple of tenths of a percent of GDP – and long-term interest rates remain relatively low (moreover, the sizes
of the government’s Treasury auctions are trending lower).
One major problem with the current deficit spending is that we already had a large structural deficit before the financial crisis. As the economy recovers
and temporary spending fades, the deficit will decline, but we’ll still be left with the structural deficit. The budget outlook 10 to 20 years down the road
is much more troublesome – and Medicare (not Social Security or discretionary government spending) is the major problem.
One issue in deficit spending is deciding how much is enough to carry us through. Removing fiscal stimulus too soon risks derailing the recovery. Anti-
deficit sentiment has already hampered a push for further stimulus to support job growth. Across the Atlantic, austerity moves threaten to dampen
European economic growth in 2011. Long term, deficit reduction is important, but short term, it’s just foolish.