Balance the Budget--but Tie It to the Business Cycle

Balance the Budget--but Tie It to the Business Cycle

Despite claims that Keynesian economics leads to a bloated government,  there is no automatic relationship between the size of government and Keynesian stabilization policies. Depending upon the mix of taxes and spending used to stimulate the economy during recessions and pay for the policies when times improve, the size of government can get larger, smaller, or stay the same.  For example, if every recession is attacked with an increase in government spending financed by increasing taxes when times get better, government spending will ratchet up in each recession and the government will grow over time. This is the spend-and-tax strategy that Democrats are often accused of pursuing.

Conversely, if tax cuts are used to stimulate the economy in recessions, and then spending is cut during booms to bring the budget back into balance, the successive spending cuts will reduce the size of government over time. This is, in essence, is the “starve the beast” strategy Republicans pursue:  Use recessions as an excuse to cut taxes and then use the resulting deficits to insist on cutbacks in spending.

But there is no need for the size of government to trend in either direction. In the examples above one of the two fiscal policy tools – taxes or spending – was used to stimulate the economy during recessions and the other to bring the budget into balance when times are better. But if the policy is simply reversed, if spending and tax cuts used alone or in combination to stimulate the economy are fully reversed when things improve, then the average size of government stays the same over time. Thus, under Keynesian stabilization policy it is a policy choice whether or not the government grows, shrinks, or stays the same size over time, and the choice depends critically upon the mix of tools we use.

One of the reasons Republicans object to Keynesian stabilization policy is the fear that the policies will be used to increase the size of government. They worry that most of the spending that is put into place will never go away, and proclamations such as the Administration’s “never let a serious crisis go to waste”  add to those fears. This is far from the only reason why Republicans oppose fiscal policy, of course. Some do not believe it works at all. But for many the worry that the end result will be larger government is a key element in their opposition to fiscal policy solutions. Democrats also worry that the tax cuts Republicans insist upon to stimulate the economy will persist far beyond the end of the recession.

Most of the time, the debate over using fiscal policy as a stabilization tool can be set aside. If the shocks to the economy are relatively mild, as they were during the Great Moderation from 1982-2007, then only one type of policy is needed. Since both sides of the debate generally agree that monetary policy is an effective stabilization tool, and since using both monetary and fiscal policy would be overkill, most of the time it is easier and more productive to agree to disagree on fiscal policy, ignore it, and concentrate on monetary policy.

However, one of the lessons of the Great Recession is that sometimes monetary policy alone isn’t enough to pull the economy out of the doldrums. When a severe recession hits the economy, a combination of monetary and fiscal policy is needed, and even that may not be enough to fully offset the problem.

Many Republicans who currently oppose fiscal policy solutions might be willing to at least give them a try if they could be guaranteed that when all is said and done, the government would be the same size as when it started. With such a guarantee in place, there wouldn’t be much harm in trying fiscal policy solutions.

But how can we ensure that recessions are not used by either side as an excuse to impose an ideological agenda regarding the role of government in the economy?

The key is to separate decisions about the size of government from stabilization policy. I am opposed – strongly – to any requirement that the federal budget be balanced on a continuous basis. As explained by Bruce Bartlett recently,  that makes fluctuations in the economy even worse. But I am starting to wonder if a requirement that the budget be balanced over the business cycle might not make fiscal policy more acceptable and hence easier to apply. If so, it would enhance our ability to stabilize the economy when large shocks hit the economy.

Under such a policy, the size of government would not be restricted. That would be up to Congress to decide just as now. Government could even be running a surplus or deficit when a recession hits. But variations around the size of government and the size of the surplus or deficit would have to balance over the business cycle. Taxes or spending could be changed as much as desired when a recession hits, but those policies would have to be offset once the economy improves. I would tie the specifics to the National Bureau of Economic Research (NBER) dates and the unemployment rate,  and then trigger surpluses once we are in a recovery and the unemployment crosses a predetermined threshold, but there are lots of ways to do this so the exact details aren’t essential. It’s the rule itself that is important.

If we could trust politicians to shave the peaks and fill the valleys on their own, such rules would be unnecessary. But we find it much easier to give things away–to run deficits when times are bad—than to do the much harder task of raising taxes or cutting spending when times improve. When the bills come due, there’s always an excuse to avoid making the hard choices (it will kill growth and jobs!). And the use of business cycles to promote long-run ideological agendas makes the problem even worse.

Forcing politicians to balance the budget over the business cycle is one way to overcome these tendencies and hopefully promote better stabilization policy. I am still wary of these types of rules – I’d much prefer that voters elect better politicians–but so far that hasn’t happened.