Saturday, December 29, 2012

E. Cary Brown on Recent Fiscal Policy

While E. Cary Brown died in 2007, any intelligent commentary on fiscal policy should consider his 1956 paper - Fiscal Policy in the Thirties, which reminds us that the actual deficit may be rising even if fiscal policy has turned contractionary. Evan Soltas (with hat tip to Paul Krugman) follows in the tradition of Cary Brown:
The right way to evaluate the U.S.'s current fiscal condition is not to look at at its budget deficit, which fluctuates sharply due to economic conditions. Rather, it is to calculate the structural budget deficit, the difference between government spending and revenues when the economy is normal. (More technically, it is when the "output gap," the difference between actual and long-run potential economic output, is zero.) … For fiscal year 2012, the annual structural deficit was $325 billion, or 2.1 percent of GDP. (See the first graph accompanying this post.)
This graph is instructive for other reasons. It not only shows that the reason why the deficit has exploded in the last 5 years is the recession and not fiscal stimulus. It also shows that last two significant episodes of fiscal stimulus were the Reagan years and the reign of George W. Bush. The fiscal stimulus of the Reagan years was entirely unnecessary as it was the actions of the Federal Reserve that drove the economy during those years. And the Federal Reserve tended in insure that this fiscal stimulus crowded-out investment, which led to less long-term growth. And we were told the 1981 tax cuts were supposed to be pro-growth. Greg Mankiw in his first edition of Macroeconomics not only refer to this Laffer crowd as “cranks and charlatans but also describe how the reduction in national savings from this ill-advised fiscal stimulus increased real interest rates and crowded-out investment. Interestingly, Mankiw defended the Bush43 tax cuts as needed to offset the weak economy during the period of time. Of course, Bush43’s other economic advisors (e.g., Glenn Hubbard and Lawrence Lindsey) claimed the tax cuts were designed to increase national savings rather than reduce it. We could also argue whether we needed assistance from fiscal stimulus at the time since the Federal Reserve was capable to lower interest rates even more than it did. But even if Mankiw was right with his Keynesian defense of the 2001 tax cut, there was never any excuse of making it a 10-year tax cut since its expiration might occur just when the economy did not need fiscal restraint – which is precisely where we are right now with that fiscal cliff.

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