Sunday, September 25, 2011

Fiscal policy in the states

Here is my much-delayed discussion of the outlook of fiscal policy in the states.

As demonstrated in A quick glance at the big picture the U.S. economy is functioning well below its potential. Unfortunately, there is little reason to believe that a recovery of consumer spending will return the economy to full employment. Additionally, traditional monetary policy, which can help bring about recoveries under the average recession is fairly impotent due the liquidity trap that prevails. While there may be potential for other interventions which can improve the situation, including significant write-downs of mortgage debt, the standard Keynesian approach is to undertake fiscal stimulus.

Most states have constitutional balanced budget frameworks, which mean that sources of revenue and total expenditures have to balance each year. Given the current economic climate, that means reduced revenues and hence budget cuts and/or tax increases. Major sources of revenues in the states tend to rely most heavily on property taxes, sales taxes and, to a lesser extent, income taxes. It is obvious from the discussion of housing prices in Consumer spending battered by housing market that the housing market has undergone a significant devaluation, which have caused from property taxes to decline with the same tax rates prevailing. Furthermore, incomes and spending are linked closely to changes in gross domestic product, so all the main sources of revenues have declined.  The states can approach this shortfall of revenue from one of two angles: raising taxes or cutting spending. Which one is worse? An equal cut in spending or taxes would not have an equal macroeconomic effect. Money taken in taxes could be used either for spending or savings, but government spending is, by definition, spending, so a cut in government spending of an equal amount of money clearly has a greater negative impact on aggregate demand than an increase in revenue, especially under the condition of a liquidity trap.

Could the states do something to increase aggregate demand and, hence, raise employment?  Yes, but it would require them to either go into debt (not run a balanced budget, which is only an option for certain states) or to increase both taxation and spending. Deficit-financed spending has a higher multiplier, but the balanced budget multiplier (Haavelmo Theorem) indicates that a balanced increase in taxes and spending can also yield higher aggregate demand.

Even if the states were to embrace the logic of the balanced budget multiplier and undertake both greater spending and taxation to drive aggregate demand, it is not likely that it would be undertaken on the scale necessary to bring about full employment in the U.S. economy. Even more important, half of the political establishment would be completely against it (the Republicans) and the other half would be afraid of its implications for political developments (the Democrats). Frankly, not enough people would buy into the concept to make it politically sustainable, which is very important, since a policy which brings the economy to full employment would have to be sustained long enough for the recovery of the housing market and/or the repayment of sufficient debt to bring personal finances to sustainable levels.

Fiscal policy is a difficult tool to use. First, there is the often-commented upon problem of timing. It is hard to know whether fiscal policy which is considered many months or even years in advance will be setting the right direction. Right now that principle is somewhat overturned because of the prevalence of a sustained depression of aggregate demand. Second, there is the tendency to misuse fiscal policy. It is often easier to increase spending at a greater rate when revenues are rising rapidly, when that is likely the time for austerity. Currently, there is a widespread problem of embracing austerity while much of the world economy is in a depression. Third, there are political elements to fiscal policy. People create ideas about how the government should spend money and how it should tax and they become rules of thumb which are sometimes embraced with too much enthusiasm, even when it is no longer appropriate. The balanced budget has become a politically desirable idea, but it is currently being used to undermine long-term fiscal soundness by short-term budget thinking. It is hard not to be concerned and somewhat pessimistic in the current political environment.

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