Crisis: Should we worry too much about fiscal deficits?

Posted by Anis Chowdhury on 21 September 2009

Crisis: Should we worry too much about fiscal deficits?

Anis Chowdhury
Neil Hart
University of Western Sydney, Australia

Since the rise of neo-liberal economics in the early 1980s, budget deficit has become an unholy lexicon in policy discussion in both developed and developing countries. The performance of governments and their prospects for re-election (in mature democracies) now depends greatly on how well they are perceived as a “good” or “responsible” manager of finance, measured in terms of the size of fiscal surplus they preside over. For developing countries, attaining “sound” finance and “fiscal sustainability”, implying budget surplus or near zero budget deficits has become a condition for accessing loans from the International Monetary Fund (IMF).

However, it was not always like this. Fiscal policy played the lead role since the Great Depression of the 1930s and in maintaining full-employment in developed countries. Governments ran deficits when aggregate spending fell short of what was needed for employing all who wanted a job at a decent wage. It adjusted its expenditure downward when the aggregate spending tended to go beyond the productive capacity. Government budget repaired itself through the ups and downs of business cycles.[1] President Roosevelt in his 1936 budget speech noted, “deficit of today … is making possible the surplus of tomorrow.”

Governments played a major role in developing countries in building infrastructure, and in setting-up basic public services such as health-care and education. They 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. The only way they could build their newly decolonized countries was by running deficits, financed by printing money.[2] This was also the case when the US emerged as a new independent nation. Alexander Hamilton, Secretary of Treasury under President Washington, promoted the policy of incurring debts as a method of establishing sound credit.

The fall of fiscal policy from grace is the result of the ascendancy of conservative politics with the election of Margaret Thatcher in the UK and Ronald Reagan in the US. Conservative politics has a deep-rooted distrust of governments and favours rule-based government policies that constrains government’s discretionary spending power. The epitome of this is the "Gramm-Rudman-Hollings deficit control legislation" in the US and the EU’s Stability and Growth Pact and Article 104 of the EC (Maastricht) Treaty.[3]

Fortunately, the current crisis – as did the Great Depression – has proved that adhering to such strict rules would have meant asking the captain of a ship to hold firm the steering on a predetermined course in a turbulent sea. Governments and central banks (especially in the US) have shrugged off these binds and saved their economies and the world from a catastrophe.

The IMF and the World Bank, which insisted on “sound” fiscal policy in developing countries, have also seen the light and called for fiscal stimulus, especially by the leading industrialized countries and emerging countries, such as Brazil, China and India.

However, old practices die hard. There are already calls for winding back and worries about ballooning of deficits in the US and major EU countries.[4] The IMF is still sticking to deficit reductions as its conditionality of support for developing countries. Its policy advice still remains contractionary in nature. The old recipes of tight fiscal policies and single-digit inflation are still at the top of IMF’s conditions.[5]

Debate about the effectiveness of fiscal policy and concerns for debt sustainability is not new. Despite the immediate success of the New Deal programs, President Roosevelt quickly backed down and promised the nation that “a balanced budget [was] on the way”.[6] In 1938, he slashed government spending for fear of inflation, although unemployment shot up to 19%.

The doubt about fiscal policy was also observed in the early days within the Planning Commission of India. V.K.R.V. Rao argued that the Keynesian fiscal multiplier works only in nominal terms in developing countries.[7] That is, fiscal policy only generates inflation and no increase in output or employment. He based his argument on price inelasticity of supply, so that any increase in demand will only generate inflation – as if the economy is operating at full-employment.

A.K. Dasgupta believed that the problem was not due to supply rigidity caused by various structural problems in the commodity market, but due to subsistence real wage. [8] That is, the real wage in developing countries is already too low, and it cannot be lowered any more for fiscal policy to work for creating more employment. In other words, every time prices go up due to increased spending by the government, nominal wages need to be raised so that the real wage does not fall below the subsistence level. As a result, the employment level – determined by the real subsistence wage – remains unchanged, but at a higher price level.

The problem with the above analysis is that it ignores the productivity enhancing role of fiscal policy. Evsey Domar in the mid-1940s showed that economic growth is not neutral of the level and composition of government expenditure. He notes “that deficit financing may have some effect on income … has received a different treatment. Opponents of deficit financing often disregard it 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.”[9]

It means abandoning the narrow concept of “sound” finance measured by the debt/GDP ratio. Instead, the concept of “functional” finance, which evaluates government finance based on its impact, should be adopted.[10] From this perspective, a better measure of fiscal sustainability is the debt servicing ratio ([principal + interest payments]/GDP). This means debt will be sustainable if government expenditure is both productivity- and growth-enhancing.

In other words, governments still need to guard against unproductive expenditures, but not deficit per se. If the composition of government expenditure is right, then the level of deficit should not be a cause for concern.

[1] See Robert C. O. Matthews (1968). ‘Why Has Britain Had Full Employment Since the

War?’, Economic Journal.

[2] See Michael Kalecki (1976), Essays on Development Economics, Brighton: Harvester Press.

[3] The strict inflation targeting monetary policy framework is also the result of the distrust of the government. It is aimed to rule out government borrowing from the central bank to finance its deficits.

[4] Irony of the conservative politics is that they are not concerned about deficits going through the roof when the cause is external wars or beefing up law and order.

[5] See Nuria Molina (2009), “IMF emergency loans: Greater flexibility to overcome the crisis?”, Bretton Woods Project. Also see, Martin S. Edwards (2009), “The International Monetary Fund, Conditionality, and the World Economic Crisis: New Beginning or False Dawn?” http://pirate.shu.edu/~edwardmb/conditionalityreform.pdf

[6] See, Michael J. Sandel (1996) Democracy's Discontent: America in Search of a Public Philosophy, Harvard University Press.

[7] V.K.R.V. Rao (1952), “Investment, Income and the Multiplier in an Underdeveloped Economy”, Indian Economic Review, 1(1): 55-67.

[8]Amiya K. Dasgupta (1954), “Keynesian Economics and Under-Developed Countries”, Economic and Political Weekly, January 26.

[9] Evsey Domar (1944). The burden of the debt and the national income. American Economic Review, vol. 34, No. 4, pp. 798-827.

[10] “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.” Abba Lerner (1943, p. 39), “Functional finance and the federal debt” Social Research, vol. 10, No. 1, pp. 38-57; emphasis in original)