What has fiscal policy been over the years and what have been its effects? Figure 33-5 shows fiscal policy in recent U.S. history. It shows the actual federal deficit and the cyclically adjusted deficit (what would have been at full employment), each as a percentage of GDP. The cyclical adjustment corrects for the automatic changes in government spending and taxing that result from changes in the GDP. As explained in Chapter 24, in bad times the government automatically spends more (for example, more unemployment benefits and welfare payments) and receives less (lower proceeds from income tax) and therefore runs a higher deficit than usual. This is not always on purpose. The cyclically adjusted deficit corrects for these automatic changes and shows what the deficit would have been without the cyclical deviations upwards or downwards. Here's the payoff: when the actual deficit exceeds the cyclically adjusted deficit, fiscal policy is expansionary; when the actual deficit is smaller than the cyclically adjusted deficit, fiscal policy is contractionary.
Can you conclude from the picture that in recent years the U.S. government has conducted a stabilizing discretionary fiscal policy?
Figure 33-5 The actual Federal budget deficit versus the cyclically adjusted deficit
Caption: The cyclical adjusted deficit is an approximation of what the deficit would have been if the economy had been operating at normal (or trend) levels. When the actual deficit exceeds the cyclically adjusted deficit discretionary fiscal policy is expansionary; a lower actual deficit indicates a contractionary fiscal policy. The bars represent recessions. So was the discretionary fiscal policy expansionary during recessions? The picture is inconclusive, feeding doubts about the efficacy of fiscal policies.
Start with the Kennedy administration (1961-63). During the 1961-62 recession, fiscal policy was expansionary, but only slightly so. Fiscal policy in the years immediately preceding the recession seemed to be even more expansionary. The graph casts doubt on the reputation of Kennedy as the "first Keynesian president". It's true that in 1963 he proposed cuts in personal and business taxes in defiance of the sentiment prevalent then that the government should stick to a balanced budget. But that was well after the recession. And Kennedy actually did not live to see his policy implemented. Only after his assassination in November 1963 was his successor, Lyndon Johnson, able to convince Congress to cut personal income taxes by 20 percent and business taxes by 10 percent. Whatever effect this may have had does not show up in Figure 33-5: the actual deficit moves more or less parallel to the cyclically adjusted deficit.
Justified or not, Keynesian economics experienced a heyday, briefly. Kennedy's endorsement of Keynesian policies was a major factor. On top of that the policy seemed successful as the unemployment rate dropped and economic growth picked up. Whether these developments were due to the Keynesian policies were debatable--Figure 33-5 gives some cause for doubt--but the appearance of success was sufficient to boost the reputation of Keynesian economics.
In the Johnson years, fiscal policy was contractionary, at least according to Figure 33-5. With the economy advancing at a healthy pace, the principle of functional finance called for a continuation of this contractionary fiscal policy. Instead, as Figure 33-5 shows, fiscal policy became slightly expansionary as the actual deficit jumped on top of the cyclically adjusted deficit. The deficit (measured as a percentage of GDP) kept going up, but not because wise policy experts were using it as an instrument. It went up because of the costs of the Vietnam war. Seeing that the economy was about to get overheated, Johnson's Keynesian advisors tried in vain to convince him to increase taxes. But Keynesian economics had run into political reality. Politicians had been ready to accept economic arguments to increase the deficit, but were unreceptive when the arguments pointed to the need to cut it.
The next discretionary fiscal action came in 1975, when President Ford decided to do something about the recession the economy was in at the time. He cut taxes temporarily, and Figure 33-5 shows that the actual deficit soared. Ford's action is most pronounced in the entire period that is depicted. The effect, however, is questionable. The action came late in the recession--due to the recognition and implementation lags. By the time the dangers of the recession had been realized and Congress and the experts had been persuaded that a tax cut was needed, the recession was almost over.
In the early 1980s the government deficit began its steep climb. As discussed in Chapter 30, the reason was Reagan's supply side economics, not at all Keynesian in intent. Reagan's policy was institutional because it aimed to improve incentives for work and saving by means of changes in the tax code, reducing taxes. The increase in the deficit was a side effect of the policy, but a big one. As a matter of fact, Reagan had predicted that his policy would lead to a balanced budget. He believed the more prosperous economy would result in larger tax collections even at the lower rates. He was wrong. His policy ended up working through a shift to the right in the aggregate demand curve--mainly because of increased consumption spending--, and not through a shift in the aggregate supply side. That makes it a demand-side or Keynesian policy, rather than the supply-side policy he had announced.
Figure 33-5 shows no further evidence of discretionary fiscal policy in the late 1980s and early 1990s, the actual and cyclically adjusted deficits moving more or less in unison. What deviations did occur were not intentional.
The historical record is less than encouraging for proponents of fiscal policy in the present day. When the government in history has implemented a fiscal stimulus, it did so usually too late, because of the decision and impact lags. When the principles of functional finance suggested it was time to cut deficits, politicians were unable to do so.
McCloskey: It seems clear enough. We should forget about fiscal policy altogether. It works neither in theory nor in practice.
Klamer: Not so fast. Even if "fine-tuning" of the economy by means of fiscal policy has proven to very difficult, fiscal policy will be effective when the economy is not doing very well in terms of unemployment and unused capacity. In such a situation, the crowding effect will be small and aggregate supply will hardly respond. History proves the point. When governments began to spend before WW II, economies improved. Reagan's deficits most probably helped to get the American economy going. In general, when the private spenders are uncertain about the future and hold back their spending, public spending can give the needed boost to the economy.
Paul: But what about the deficits that such expansionary policies produce? Aren't they bad for the economy?
Klamer: The fear for government deficits is greatly exaggerated. Let's see why that is.