12.6 Practical problems with discretionary fiscal policy  (Page 4/14)

Political realties and discretionary fiscal policy

A final problem for discretionary fiscal policy arises out of the difficulties of explaining to politicians how countercyclical fiscal policy that runs against the tide of the business cycle should work. Politicians often have a gut-level belief that when the economy and tax revenues slow down, it is time to hunker down, pinch pennies, and trim expenses. Countercyclical policy, however, says that when the economy has slowed down, it is time for the government to go on a spree, raising spending, and cutting taxes. This offsets the drop in the economy in the other sectors. Conversely, when economic times are good and tax revenues are rolling in, politicians often feel that it is time for tax cuts and new spending. But countercyclical policy says that this economic boom should be an appropriate time for keeping taxes high and restraining spending.

Politicians tend to prefer expansionary fiscal policy over contractionary policy. There is rarely a shortage of proposals for tax cuts and spending increases, especially during recessions. However, politicians are less willing to hear the message that in good economic times, they should propose tax increases and spending limits. In the economic upswing of the late 1990s and early 2000s, for example, the U.S. GDP grew rapidly. Estimates from respected government economic forecasters like the nonpartisan Congressional Budget Office and the Office of Management and Budget stated that the GDP was above potential GDP, and that unemployment rates were unsustainably low. However, no mainstream politician took the lead in saying that the booming economic times might be an appropriate time for spending cuts or tax increases.

Discretionary fiscal policy: summing up

Expansionary fiscal policy can help to end recessions and contractionary fiscal policy can help to reduce inflation. Given the uncertainties over interest rate effects, time lags, temporary and permanent policies, and unpredictable political behavior, many economists and knowledgeable policymakers had concluded by the mid-1990s that discretionary fiscal policy was a blunt instrument, more like a club than a scalpel. It might still make sense to use it in extreme economic situations, like an especially deep or long recession. For less extreme situations, it was often preferable to let fiscal policy work through the automatic stabilizers and focus on monetary policy to steer short-term countercyclical efforts.

Key concepts and summary

Because fiscal policy affects the quantity of money that the government borrows in financial capital markets, it not only affects aggregate demand—it can also affect interest rates. If an expansionary fiscal policy also causes higher interest rates, then firms and households are discouraged from borrowing and spending, reducing aggregate demand in a situation called crowding out. Given the uncertainties over interest rate effects, time lags (implementation lag, legislative lag, and recognition lag), temporary and permanent policies, and unpredictable political behavior, many economists and knowledgeable policymakers have concluded that discretionary fiscal policy is a blunt instrument and better used only in extreme situations.

References

Leduc, Sylvain, and Daniel Wilson. Federal Reserve Bank of San Francisco: Working Paper Series. “Are State Governments Roadblocks to Federal Stimulus? Evidence from Highway Grants in the 2009 Recovery Act. (Working Paper 2013-16).” Last modified July 2013. http://www.frbsf.org/economic-research/files/wp2013-16.pdf.

Lucking, Brian, and Daniel Wilson. “FRBSF Economic Letter-Fiscal Headwinds: Is the Other Shoe About to Drop?” Federal Reserve Bank of San Francisco . Last modified June 3, 2013. http://www.frbsf.org/economic-research/publications/economic-letter/2013/june/fiscal-headwinds-federal-budget-policy/.

Recovery.gov. “Track the Money.” http://www.recovery.gov/Pages/default.aspx.

Bastagli, Francesca, David Coady, and Sanjeev Gupta. International Monetary Fund. “IMF Staff Discussion Note: Income Inequality and Fiscal Policy.” Last modified June 28, 2012. http://www.imf.org/external/pubs/ft/sdn/2012/sdn1208.pdf.