Sunday, June 18, 2006

The Usefulness of Fiscal Policy

Brad Delong writes:
These days, except in exceptional circumstances--in a liquidity trap, when interest rates are already so low that the Fed can't or daren't lower them further, or when the fiscal expansion comes as a sudden surprise that the Fed does not have time to immediately offset--fiscal policy has next to no stimulative effect at all because the Federal Reserve takes steps to make sure that it does not. That's the big reason that claims in 1993 that the Clinton tax increases were going to send the economy into recession were wrong.
Suppose this proposition is true. The Fed always adjusts monetary policy so that aggregate demand is unaffected by fiscal policy. Then what does fiscal policy do?

(1) It changes the makeup of aggregate demand. Larger government deficits increase the supply of bonds, pushing up interest rates. Higher interest rates mean that fewer people want to invest. This is the "crowding-out" effect. Private investment is far more productive than government debt, so for this reason we shouldn't like deficits.

(2) The other macro effects of fiscal policy have to do with aggregate supply (not in the sense of changing G - T, but in the sense of changing marginal tax rates, subsidies, etc.) Lowering most marginal tax rates increases aggregate supply, so does funding research and development, decreasing unemployment benefits, etc.

(3) There are also the micro effects of individual government programs. These are the things that government spending and tax policy are ultimately meant to do like build infrastructure, redistribute income, provide defense, etc. This is a mixed bag: If these provide a public good or correct an externality they are good, if they regulate a competitive industry or subsidize farmers, they are bad.

These are the things that fiscal policy can do. The results for total budgetary policy are sort of ambiguous, but what about just a typical stimulus package of unfunded additional government spending? Deficits would increase, which is definitely bad. Aggregate supply would be unaffected. It is likely to decrease micro efficiency. So something like this is pretty unambiguously bad. (Of course it depends somewhat on the construction of the stimilus package, it could be worse or better.)

However, it seems politically impossible to ever argue that fiscal policy is impotent with respect to aggregate demand for this reason. We may all know that it's true, but it's hard to imagine that any Congressperson could use this against a bill. Suppose Senator A argues that deficits are just bad because the Fed will offset the stimulus. Senator B asks Ben Bernanke, who says that, no, in fact he doesn't stabilize output, only inflation. And since, in politics, what people say is more far important than what people actually do, Senator B wins.

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