Why worry about fiscal deficits?

Why worry about fiscal deficits?

 

With the counter-revolution against Keynesian and

development economics in the early 1980s, budget deficits

have become taboo although fiscal deficits have played a

leading role since the Great Depression of the 1930s in

maintaining full-employment in developed countries.

Deficits and surpluses were adjusted counter-cyclically

through business cycles.1 In his 1936 budget speech,

President Roosevelt noted, “the deficit of today … is

making possible the surplus of tomorrow.” Therefore,

governments should not feel that “there is anything

especially good or bad about [budget surpluses or deficits];

[they] should merely concentrate on keeping the total rate

of spending neither too small nor too great, in this way

preventing both unemployment and inflation.”2

Governments have played a major role in developing

countries, in building infrastructure and providing basic

public services such as health-care and education. They

often did not have the resources or recourse to large scale

foreign aid, as war-torn Europe had, with the Marshall

Plan, to rebuild their economies. Thus, the only way they

could develop their newly decolonized countries was by

running deficits, financed essentially by printing money.3

This was also the case when the US emerged as a

newly independent nation. Alexander Hamilton, the first

1 R. C. O. Matthews (1968). ‘Why Has Britain Had Full

Employment Since the War?’ Economic Journal.

2 Abba Lerner (1943). “Functional finance and the federal debt”

Social Research, 10(1): 38-57

3 Michael Kalecki (1976), Essays on Development Economics,

Brighton: Harvester Press. However, some early development

economists, e.g. V.K.R.V. Rao and A.K. Dasgupta, were

sceptical about the effectiveness of fiscal policy in creating job.

They believed Keynesian fiscal activism would create inflation,

but they offered different reasons for such an outcome. See

V.K.R.V. Rao (1952). “Investment, Income and the Multiplier in

an Underdeveloped Economy” Indian Economic Review, 1(1): 55-

67. Amiya K. Dasgupta (1954). “Keynesian Economics and

Under-Developed Countries”. Economic and Political Weekly,

January 26.

US Treasury Secretary under President Washington,

incurred debt as a way of establishing “sound credit”.4

The fall of fiscal policy from grace followed the

ascendancy of market-fundamentalist conservative politics

after the election of Margaret Thatcher in the UK and

Ronald Reagan in the US. Their distrust of governments

has favored rule-based policies that have constrained

discretionary government spending, including the Gramm-

Rudman-Hollings deficit control legislation in the US and

the EU’s Stability and Growth Pact.

The current crisis, like the Great Depression, has

shown the fallacy of adhering to such strict rules.

Governments and central banks (e.g. in the US) have

shrugged off these fetters. And instead of insisting on

“sound” fiscal policy, many developing countries have also

introduced fiscal stimuli. However, with the “green shoots”

of recovery since mid-2009, there have been dire warnings

about ballooning deficits, especially by financial lobbies,

and renewed calls to cut reflationary spending to avoid

inflation. Meanwhile, the IMF insists on deficit reduction

in developing countries. Hence, its fiscal policy advice

remains basically contractionary in the medium term.5

Such debates about fiscal policy are not new. For

example, for re-election in 1937, President Roosevelt

4 This was mainly financed by printing money. Hamilton

established a national mint, and introduced tariffs for

temporarily protecting new firms to foster the development of

competitive national industries. These measures placed the credit

of the federal government on a firm foundation, giving it all the

revenues it needed.

5 See Mark Weisbrot, Rebecca Ray, Jake Johnston, Jose Antonio

Cordero and Juan Antonio Montecino (2009). “IMF-Supported

Macroeconomic Policies and the World Recession: A Look at

Forty-one Borrowing Countries”. CEPR, October, Washington,

DC. Although the IMF has challenged the CEPR findings, the

IMF’s own definition of “pro-cyclicality” and methodology for

determining program effects are too narrow. In an economic

slowdown, fiscal deficits normally grow as revenues decline and

social spending increases; some of these may be institutionalized

as automatic stabilizers. Note that discretionary changes in

spending or tax measures may be pro- or counter-cyclical.

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G-24 Policy Brief No. 51 2

backed away from his New Deal and promised that “a

balanced budget [was] on the way”. In 1938, he slashed

government spending, citing inflationary fears, causing

unemployment to shoot up to 19%.

Evsey Domar (1944) noted “Opponents of deficit

financing often disregard ... completely, or imply, without

any proof, that income will not rise as fast as the debt…

There is something inherently odd about any economy

with a continuous stream of investment expenditures and a

stationary national income.”6

Understanding this means abandoning the narrow

concept of “sound” finance in favour of “functional”

finance, which evaluates government finance based on its

impact. According to Lerner (1943: 39), “The central idea

is that government fiscal policy, its spending and taxing, its

borrowing and repayment of loans, its issue of new money

and its withdrawal of money, shall all be undertaken with

an eye only to the results of these actions on the economy

and not to any established traditional doctrine about what

is sound or unsound.”

Therefore, debt is sustainable if government

expenditure is both growth- and productivity- enhancing.

The notion that government deficits will need to be

‘financed’ through higher taxes in the future is spurious as

revenues will rise in an expanding economy.

A lingering concern is the financing of the deficit. The

first recourse for governments is to borrow domestically,

raising the spectre of “crowding-out”, i.e. government

borrowings driving up interest rates and adversely affecting

private investment. This ignores the consequences (e.g. low

profitability, bankruptcies, etc.) of a depressed economy.

Government action is necessitated, in the first place, by

inadequate private spending causing the collapse of the

private sector.7

Moreover, the immediate financial implication of

expansionary fiscal policy action when the central bank

uses interest rates – in a world of ‘endogenous money’ – is

6 Evsey Domar (1944). “The Burden of the Debt and the

National Income”. American Economic Review, 34(4): 798-827.

7 For a review of the theoretical debate, see Philip Arestis and

Malcolm Sawyer (2004). “Fiscal Policy: A Potent Instrument”.

New School Economic Review, 1(1):15-21. Reviewing the empirical

literature on both developed and developing countries, one IMF

study concluded that fiscal multipliers have been overwhelmingly

positive. See Richard Hemming, Michael Kell and Selma

Mahfouz (2002). “The Effectiveness of Fiscal Policy in

Stimulating Economic Activity – A Review of the Literature”.

IMF Working Paper WP/02/208.

to add to the cash reserves of private sector banks in which

government checks are deposited. This, in turn, increases

(net) liquidity if the central bank does not implement

offsetting money market operations. Hence, the actual

central bank discount rate should decrease, exerting

downward pressures on retail interest rates. This should,

therefore, encourage – rather than crowd-out – private

investment.

In the absence of a well-developed capital market, the

option for most developing countries is borrowing from

the central bank, commonly referred to as printing money.

The opposition to this option stems from the presumed

link between printing money and inflation. This fear arises

from lack of appreciation of the root cause of the problem,

i.e. insufficient spending or inadequate demand.

Printing money in a depressed economy should not

cause inflation. The objective is to keep total spending

“neither greater nor less than that rate which at the current

prices would buy all the goods that is possible to

produce.”8 If expansionary fiscal policy achieves its

intended purpose of boosting output and employment,

increased money supply will match the increased demand

for money needed for a higher level of transactions.

Some inflationary pressure due to expansionary fiscal

policy is inevitable, but that does not depend on the mode

of financing the deficit. Instead, price rises are inevitable in

an expanding economy undergoing structural change.

There is no evidence of runaway inflation just because

some prices rise. Policy makers should ensure the

expansion of sectors desirable for long-term development.

In sum, fiscal policy should help maintain full

employment and achieve structural change. Fiscal deficits

do not lead to hyper-inflation if deficits serve to enhance

productive capacity.

___________________________________________________________________________________

Anis Chowdhury is Economic Affairs Officer in the Office of

the Under-Secretary-General in the United Nations

Department of Economic and Social Affairs. Currently on

leave from Professor of Economics, University of Western

Sydney, Australia.

Neil Hart is Senior Lecturer, School of Economics and

Finance, University of Western Sydney, Australia.

8 Abba Lerner, op cit. p. 39