Should Fiscal Policy Resemble Private Budgets?

Originally published at Project-Syndicate | Nov 3rd, 2023

The threat of a US government shutdown underscores the dilemma facing many countries trying to balance their budgets and stimulate economic growth. In the aftermath of the COVID-19 pandemic, a growing number of economists are questioning the notion that a balanced budget should take precedence over all other considerations.

NEW HAVEN – Every few months this year, the US government appears on the verge of shutting down. It happened in May, when congressional Republicans initially refused to raise the debt ceiling, and in September, when Congress managed to avert a last-minute shutdown by passing a stopgap bill to keep the federal government open until November 17.

In the event that Congress fails to reach an agreement to fund federal agencies by the next deadline, millions of government employees, including millions of military personnel, will be furloughed, disrupting critical public services.

While government shutdowns are a uniquely American phenomenon, the United States highlights the dilemmas facing fiscal policymakers today. It also sheds new light on the ongoing debate among economists over whether government budgets should be balanced, particularly in the aftermath of the COVID-19 pandemic.

Fiscal hawks often liken governments to private citizens or corporations. Just as insolvent private entities can be declared bankrupt and prohibited from doing business, the argument goes, governments must avoid accumulating large debts. While this view resonates with the general public and numerous economists, it is rather naive.

To be sure, public spending should be prudent, especially since governments do not operate according to the same competitive, profit-driven logic as private enterprises. But that does not mean that zero debt is ideal for a country’s welfare.

Those who believe that governments should avoid debt also often assert that deficit spending cannot effectively stimulate the economy. The so-called Ricardian equivalence, which David Ricardo himself deemed unrealistic, suggests that debt-financed spending will lead to a higher tax burden on future generations, so that present-day consumers, anticipating these future tax hikes, will become more cautious. But that is true only if the government is expected to raise taxes to balance the budget. Absent such expectations, the Ricardian equivalence concept crumbles.

The most radical (and compelling) argument against the balanced-budget doctrine was advanced by the Russian-born American economist Abba P. Lerner, who introduced the concept of “functional finance.” Much like John Maynard Keynes, Lerner believed that fiscal policy can and must be used to achieve full employment.

Public policies are designed to enhance the well-being of both the citizens and the state. When public debt is owned by domestic institutions and households, it can be viewed as an asset rather than a liability. Although a significant rise in public debt could result in increased foreign borrowing, domestic debt is merely a question of income distribution within the country.

With this in mind, Lerner proposed that the government could print money to cover its debts. Should this trigger inflation or negatively affect the balance of payments, it could jeopardize the country’s welfare. But if printing money does not cause such problems, the public deficit could serve as an effective tool to achieve full employment.

While not explicitly endorsing the concept of functional finance, Nobel laureate economist Paul Krugman champions its core tenets (albeit with slight hesitation). Given that states outlive individuals, he writes, they can refinance their debt or otherwise print money.

Over the past few years, as countries around the world have grappled with the effects of the COVID-19 pandemic and the war in Ukraine, our understanding of the age-old debate around public debt has evolved in two meaningful ways.

First, the pandemic underscored the limitations of maintaining a balanced budget. Unexpected events like wars, natural disasters, and public-health emergencies demand swift increases in public spending. If governments aimed to fund these outlays solely through taxation, they would need to impose much higher marginal tax rates, potentially reducing economic efficiency. Therefore, striving for a “primary balance” could be unwise. In fact, following the outbreak of COVID-19, the US and other governments adopted Robert Barro’s revenue-smoothing approach to managing public deficits.

Second, US President Joe Biden’s 2021 American Rescue Plan, with its hefty $1.9 trillion price tag, provided much-needed stimulus but also placed further strain on an economy already burdened by the Trump administration’s tax cuts for the rich. This helps explain why high inflation has been so persistent despite the Federal Reserve’s aggressive interest-rate hikes.

In his latest book, Fiscal Policy under Low Interest Rates, former IMF Chief Economist Olivier Blanchard argues that the world’s major economies can sustain reasonable deficits without risking bankruptcy, provided that the nominal interest rates on their public bonds remain low. Though this perspective is more conventional than the functional-finance approach, Blanchard also cites opinion polls suggesting that many US economists no longer believe that a balanced budget trumps all other considerations.

While this indicates a potential paradigm shift in economic thinking, the question remains: Should governments aim to balance their budgets despite the potential economic pitfalls? The past few years have certainly illuminated the serious consequences of not striking the right balance between fiscal discipline and fiscal expansion.

Koichi Hamada: Professor Emeritus at Yale University, was a special adviser to former Japanese Prime Minister Abe Shinzō.

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