Should fiscal policy always be counter-cyclical?

I am sitting at Melbourne airport today reading IMF working papers and typing this blog. You might speculate on what sort of life that is. Par for the course. The IMF recently released a new working paper – Is Fiscal Policy Procyclical in Developing Oil-Producing Countries? – which though reasonable in the context of the paradigm that the IMF works within (that is, that governments are revenue-constrained and bond markets are crucial to their functioning) – provides a classic example of why most of mainstream macroeconomics needs to be abandoned and replaced by an understanding of Modern Monetary Theory (MMT). The errors of logic and assumption that the paper makes permeates through the entire public debate and if the public only knew the real story the politics would change instantly and dramatically.

I was thinking this morning about the cut, cap and balance crew. When you visit their home page you get assaulted by a popup form entitled SIGN THE PLEDGE. However, I would r pledge to urge my Senators and Member of the House of Representatives to oppose any debt limit increase unless all three of the following conditions have been met:

The pledge is that you sign their petition agreeing that “substantial cuts in spending” and “enforceable spending caps” and balanced budgets are sensible. I have said this before but repetition is my style after all – I think they should offer an UNEMPLOYMENT PLEDGE as a demonstration of their confidence and credibility.

The wording should be something like:

I pledge to urge my Senators and Member of the House of Representatives who oppose any debt limit increase and want to cut net public spending to:

– to immediately resign from their paid employment;

– to donate all their superannuation fund entitlements to a credible charity;

– to liquidate all personal wealth and donate it to a credible charity;

– to refrain from any paid consultancies etc for the rest of their lives.

if the unemployment rate rises in the coming two years.

I also agree as a show of solidarity to do the same thing.

If that pledge was binding what do you think the politicians would do? Answer: the elected officials would be falling over themselves to propose and introduce a Job Guarantee as the exemplar of the government commitment to the security of all Americans.

It would be just like the sudden surge in consciousness in Britain at the moment about media abuse and how shocked they all are to discover it and how they will not waste a second dealing with it. I should add that I thought the theatre in London overnight (my time) with the octogenarian on the verge of falling asleep most of the time and his scion doing the “despite being hands on I didn’t know a thing” double act was hysterical. The standard of questioning from the conservative politicians was pathetic.

The only problem with my idea is that I do not believe in annoying (coercive) pop-ups forcing themselves on one while browsing the Internet. I am surprised the CCB lot who claim to espouse the virtues of individual freedom and the rights of individuals would actually use such coercion. Just goes to show.

Anyway, that provides the segue into the discussion (brief) about pro-cyclical fiscal policy.

The IMF paper is an empirical examination of the cyclical nature of fiscal policy. It suggests that oil-producing nations, faced with increasing oil price volatility in recent years, have endured major impacts on their “fiscal balances” such that “(e)ven a small fall in prices … may lead to a substantial increase in financing needs, as the exports of these countries are not diversified and oil revenue accounts for a large portion of total revenue”.

The basic proposition is that governments are forced to “react to oil price volatility by conducting procyclical fiscal policies”. Why? When revenue falls they run out of money and have to cut spending.

Reporting the extant literature, the paper notes that:

… that procyclical fiscal policies have harmful implications for developing countries. When governments cut expenditure in response to a fall in oil revenue, the poor get hurt because of the weak safety net, and long-term growth is hampered as governments cut capital expenditure and withdraw resources from productive projects.

So you get the impression that pro-cyclical fiscal policy is not a good thing and should be avoided by governments and that only counter-cyclical fiscal policy should be entertained. The problem is that the term – pro-cyclical – is very loaded and presumes a starting point of neutrality as being optimal. Despite all the claims to the contrary there is no sound basis in any credible economic theory that establishes that a balanced budget on average is a sensible strategy.

This discussion builds onto a number of points I have been concentrating on this week in the blogs – Propose a solution to a non-problem and make the real problem worse and Cut, cap and demolish – about the nature of budget deficits.

One gets the impression from the conservative press that budget deficits are somehow evil constructs that reflect the wayward whims of the ruling party in government. Clearly, wayward politicians can have an impact on the deficit outcome. But they exercise most control of the outcome when they actually use their net spending to ensure growth in output and employment is maximised.

This is no small point. There is a bias in the amount of control the polity can have on the budget outcome. Under conditions of fiscal austerity, the politicians actually cede more control to the market than usual because they not only cut the discretionary net spending component but also impel the automatic stabilisers to work against them (as output and hence tax revenue falls and welfare spending rises).

As a result, in general, fiscal austerity without very generous external conditions operating will be self-defeating in terms of the narrow aims of the government (to reduce the deficit and public debt) in addition to being very damaging in terms of the broader aims that governments should be held accountable for – maximising human potential and prosperity within the constraints imposed by our natural environment.

The very generous external conditions refer to strong private spending growth and/or favourable net exports. However, when fiscal austerity is being implemented these conditions are usually unfavourable which is the reason the deficits have risen in the first place. Certainly when a number of governments are pursuing fiscal austerity it is highly unlikely that growth will follow. Please read my blog – Cut, cap and demolish – for more discussion on this point.

The lesson is that “good” deficits are always better than “bad” deficits – the former which arise from the balance being overwhelmed by automatic stabilisers as private spending falls and governments resits using public spending to fill the gap in demand. Bad deficits are accompanied by persistently high unemployment and depressed output levels relative to potential.

Good deficits rather result when the government actively uses the flow of net public spending (that is, the deficit) to ensure that aggregate demand is sufficient to keep real output close or at potential and the labour market vibrant. Good deficits are the exemplar of sound and responsible fiscal management.

In that context, one should ask what a pro-cyclical budget position involves.

The IMF paper considers the “neoclassical” (which is synomous with neo-liberal in the broader non-technical context) and the “Keynesian” theories of fiscal policy. It says:

Both the neoclassical and Keynesian theories support the idea that effective fiscal policy should smooth the volatility of output during the business cycle. Barro’s (1973) “tax-smoothing” hypothesis of optimal fiscal policy suggests that, for a given path of government expenditure, tax rates should be held constant over the business cycle, and the budget surplus should move in a procyclical fashion. According to the Keynesian approach, however, if the economy is in recession, policy should increase government expenditure and lower taxes to help the economy out of the recession. During economic booms, the government should save the surpluses that emerge from the operation of automatic stabilizers and, if necessary, go further with discretionary tax increases or spending cuts. As a result, fiscal policies are expected to follow countercyclical patterns through automatic stabilizers and discretionary channels. In other words, one would expect a positive correlation between changes in output and changes in the fiscal balance or a negative correlation between changes in output and changes in government expenditure.

Which is a fairly good summary of where the mainstream is at. Note the Keynesian position is just part of the mainstream narrative – being a balance the budget on average over the whole business cycle. Note that the CCB gang of vandals is much more extreme than the standard neo-classical textbook approach based on “tax smoothing”. They want no deficits (except in war) and so are in denial of the business cycle.

To the CCB gang, the budget deficit has nothing to do with the business cycle which is a denial of basic knowledge about the interaction of the budget balance with the swings in economic activity. It is thus a anti-knowledge approach which in other terminology is referred to as religion or cult-worship or worse. For example, it is the same reverance to the cult that led men to don white hoods and set crosses on fire.

The so-called “Keynesian” approach is flawed in different ways. I would add that many so-called progressive economists advocate just this approach – deficit spend when times are bad but “pay it back” when times are good. Note the term – during booms “the government should save the surpluses”. This idea has not application in a fiat monetary system.

How can the issuer of the currency meaningfully save in that currency? Saving is non-consumption and is motivated by the presence of a financial constraint on spending such that to expand future consumption possibilities a person, household and/or firm has to foregoe some spending now and save. But a government that issues its own currency never has to do that.

Its spending capacity is not limited by its access to funds. Rather it is limited by what is available for sale in that currency (or via conversions into other currencies). Running a deficit in Period A doesn’t reduce (or expand) the capacity to run a deficit in Period B. Similarly, running a surplus in Period A doesn’t provide any extra funds which can be spent in Period B.

A surplus just destroys private purchasing power in Period A – it is lost for that Period. The purchasing power doesn’t go anywhere – it is just taken from the non-government sector bearing the surpluses.

Think about this in more detail.

The budget balance that is reported is made up of two components: (a) the discretionary component which reflects the governments decisions about spending and tax rates; and (b) the cyclical component – the automatic stabilisers which conceptually measure the impact of the departure from full capacity activity on tax revenues and spending at the current policy setting.

Please read my blog – Structural deficits and automatic stabilisers – for more discussion on this point.

By definition the automatic stabiliser component is counter-cyclical. Its contribution to the budget balance is expansionary when economic activity is in decline and vice versa. Note that the automatic stabiliser component does not have to be associated with a deficit or a rising deficit. It could be that net exports are very strong and private domestic saving is less than the external surplus and so the budget is in surplus. A decline in the external surplus or a rise in private domestic net saving could result in a smaller budget surplus via the automatic stabilisers.

This would lessen the fiscal drag (the drain on aggregate demand) coming from fiscal policy and would be an expansionary effect even though the overall fiscal position would remain contractionary.

Also by definition, the cyclical component is zero when the economy is at full employment. As I have noted previously the way economists actually estimate the cyclical component is not without controversy and this conflict arises from different notions that are held about what full employment actually constitutes. Generally, the mainstream economists (who pray at the altar of the NAIRU) assume full employment occurs at much higher levels of labour underutilisation than would a MMT proponent (such as myself).

Please read my blog – The dreaded NAIRU is still about! – for more discussion on this point.

MMT assumes that full employment is when there is zero hidden unemployment and underemployment and unemployment arising from frictions only (people moving between jobs). It considers that this state will only occur when there are sufficient jobs (and hours of work) to match the preferences of the labour force.

This suggests that the mainstream estimate of the cyclical component at any point in time will be lower than that made by a MMT proponent. Which means that the structural (non-cyclical – or discretionary) component of the budget will be more expansionary (less contractionary) at any point in time if computed by a mainstream economist compared to the estimates provided by MMT.

What this means is that when a mainstream economists considers the budget position to be pro-cyclical it may be that this is just an artifact of their flawed definition of full employment and that, in reality, the budget position is contractionary at a time when the cycle is improving.

But with that point made we can abstract from the differences in measuring the cyclical component (although it permeates the empirical work that the IMF paper performs and distorts their conclusions).

Concentrating on the discretionary component – should this be counter-cyclical? That is, should the government reduce its net spending (which could as noted mean increasing an already surplus stance) when non-government spending is rising? The answer is that it all depends.

If the economy was always at full employment (capacity) and every time non-government spending fell (either in levels or growth terms) the government net spending increased to fill the gap and ceded when non-government spending recovered then the answer is yes. This presumes that the “full employment public/private spending mix” is appropriate.

Counter-cyclical fiscal policy in this situation, however, does not mean (necessarily) that the government should run a surplus. Generally (for most nations) the government will have to provide continuous deficits to support aggregate demand in the face of external deficits (typical) and net private domestic saving. That was the position for most nations from the end of WW2 to the beginning of the neo-liberal era which began variously around the mid- to late 1970s.

In that context, a counter-cyclical stance (at full employment) would mean rising and falling deficits. Budget surpluses would be inappropriate in that context and damaging to the nation’s prosperity.

If the economy was not at full employment then the discretionary component of the budget position should not be counter-cyclical. But in this case there will be an asymmetry in what the government should do. If private spending is growing but there is unemployment (non-frictional) then public net spending should also be growing until the overall aggregate demand is restored to its full employment level. So it fiscal policy should be pro-cyclical in that situation.

However, when private spending is falling – public net spending should never be pro-cyclical. That conclusion is irrespective of whether the nation is at full employment or not. A pro-cyclical stance in this situation will worsen the state of the economy and compound the private spending decline.

This is one of the massive hypocrisies of the mainstream approach. They claim that pro-cyclical fiscal stances are bad but then just when they should be strongly counter-cyclical they advocated pro-cyclical fiscal austerity. And they don’t even blink a lid when they pontificate about this.

Conclusion

As you can see, once you understand what a deficit actually is and the role it should serve as part of a government’s charter to maximise employment and output as noted above then the question about the cyclicality of discretionary fiscal policy becomes more complicated.

Studies that suggest that pro-cyclical fiscal positions are examples of poor fiscal practice (the mainstream literature mostly) are thus erroneous and should be ignored (such as this IMF paper).

Moreover, economists who espouse some balanced budget rule over the course of the business cycle (meaning on average the budget will neutral) are typically misguided.

And as a corollary, the presumption that counter-cyclical fiscal policy means that the government should run surpluses when private spending is strong is similarly likely to be misguided.

None of these rules if applied are likely to result in an appropriate fiscal stance. Prudent fiscal design requires the government understand the state of the cycle and the state of the external and private domestic balances and their direction of change. Sometimes pro-cyclical discretionary fiscal policy will be the best and sometimes counter-cyclical policy positions will be best.

But fiscal austerity when private spending is weak and there is high unemployment is never indicated or sound.

My time is up – the announcements have called me!

That is enough for today!