Functional Finance vs. Balanced Budget rev.

Functional Finance vs. Balanced Budget
Functional Finance vs. Balanced Budgets

Should the budget be balanced at all times or only over the business cycle? Or is balancing the budget irrelevant? Each of these positions finds some disciples among politicians, economists, and the public at large. Let's examine the logic of whether balancing the budget really matters.

Balancing Budgets Annually

            Many people who want less government also favor continually balancing the budget for political reasons. Their rationale is that more of a laissez-faire approach will unchain market forces and stimulate economic growth, and a "balanced budget" amendment to the Constitution would limit the ability of Congress to spend, and reduce the economic role of government. Even if you favor tighter limits on government, however, you should recognize that a balanced-budget amendment might open a Pandora's box. We could find ourselves faced with Herbert Hoover's dilemma---curing deficits may worsen unemployment and stymie economic growth. If GDP began falling, tax revenues would fall. At the same time, rising unemployment would mandate more outlays for such transfer payments as unemployment compensation.

            Raising tax rates would shrink both Aggregate Supply and Aggregate Demand and could actually reduce tax revenues. Attempts to slash government spending might even shrink GDP so much that tax revenues would fall even more than any spending cuts, worsening the deficit. Few economists are convinced that fiscal policy has zero effect on National Income, and even fewer favor rigidly balanced budgets. Focus 1 describes a recent revival of an ancient argument that total government spending matters, but how the budget is financed is irrelevant.

Budget Balancing Over Business Cycles

            A more sophisticated view admits that annually balanced budgets may foster instability. This proposal is to balance the budget over the business cycle. Its advocates realize that we should not raise taxes or cut spending to cover cyclical deficits caused by recessions, or liquidate inflation-caused surpluses through tax cuts or hikes in spending. This group contends that cyclical deficits should be offset by surpluses collected during prosperity. Thus, over a complete business cycle, there would be no net growth in national debt.

            Keynesians have typically criticized this approach by arguing that prosperity may not last long enough or be strong enough to generate surpluses sufficient to offset deficits, especially if recessions tend to be either extended or especially severe. Our economy might equilibrate around a lower average level of income than might otherwise be sustainable.

Functional Finance

            Keynesian economists traditionally favored "activist" fiscal policies, arguing that we should try to balance the economy at full employment, and that balancing or not balancing the budget is irrelevant per se. In this view, injections (investment plus government spending plus exports) need to be set to equal withdrawals (saving plus taxes plus imports) at a high rate of capacity utilization. A budget mix that yields full employment is best; taxes and government outlays never need to balance precisely.[1]
The functional finance approach to the government budget emphasizes that taxes are only one way to finance government outlays. How best to pay for government depends on which policies are least costly under existing economic conditions.
           
            Taxation to cover new government spending is the least expansionary mode and is most appropriate when the economy is close to full employment. If the Treasury borrows to cover a deficit, the people who buy government bonds may reduce their spending. Investors also tend to be squeezed, because Treasury bonds absorb private saving and drive up interest rates. Nevertheless, bond financing is usually considered more expansionary than taxation as a way to finance government outlays.

            The most expansionary method of all is to create more monetary base to cover a deficit. But this path can be explosive. During 1991-1993, Yugoslavia (comprising only Montenegro and Serbia, after Bosnia and Croatia each declared independence in 1990) tried to finance almost all government spending via the printing press. The resulting hyperinflation mounted to 1,000,000 percent per month, threatening to eclipse the all-time record set by Hungary during 1945-1946.

Crowding Out

What the government gives it must first take away.                       John S. Coleman
Keynesians believe that increased government purchases can stimulate a depressed economy. New classical economists disagree, arguing that government spending tends to "crowd out" private economic activity. They point out that gross private saving (total output minus private consumption) is absorbed by government purchases regardless of whether government taxes (T), borrows (DB), or inflates the money supply (DMB). Nevertheless, how government is financed strongly affects the impact of government purchases. The FED is the government's banker and, with the Treasury, determines how deficits and surpluses are financed. This resolution is crucial in determining levels for prices, interest rates, trade balances, and National Income and Output.

            Crowding out and paying for government are closely related.
Crowding out is the idea that increases in government purchases inevitably cause reductions in private consumption or investment.[2]
Government outlays may crowd out private activities through (a) less leisure for workers, (b) reduced consumer purchasing power (caused by inflation or tax hikes), or (c) lower profits for investors (because of higher interest rates). Keep in mind, however, that it is possible that the goods government provides may be more valuable than the activity crowded out.


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[1] Abba P. Lerner, "Functional Finance and the Federal Debt," in Richard Fink and Jack High (eds.), A Nation in Debt: Economists Debate the Federal Budget Deficit, 1987.

[2] Early "crowding-out" hypotheses focused only on how government deficits drive interest rates up and, consequently, reduce investments. Our treatment follows a more recent convention that crowding out encompasses all reduction in private activities caused when government programs grow.