April 19, 2014

The Economy’s Ailments and the Best Fiscal Policy Prescriptions

Throughout this painfully prolonged economic recovery, economic developments as they are reported have often been confusing. They seem to send mixed messages about the best courses of action for fiscal policy.

Sometimes we are told that more personal spending (consumption) would be good, and sometimes we are told we need to save more. Sometimes we are told that we need to reduce the government budget deficit, and sometimes we are told that continued deficit spending is needed to avoid a double-dip recession.

So what should we be doing with fiscal policy right now -- consolidating or stimulating?

The most recent economic news is that the economy’s overall growth rate has slowed and is falling short of expectations (2.2 percent annual growth rate of GDP for first quarter of 2012 compared with 3 percent in the prior quarter and 2.5 percent expected). Personal spending has slowed as well (0.3 percent monthly growth in March, down from 0.9 percent the prior month and below the 0.5 percent expected). Job gains have also weakened and are not keeping pace with the natural growth in the working-age population.

This news suggests that more private consumption spending, encouraged by continued stimulative, deficit-financed government spending and tax cuts, is needed to further expand economic activity and reduce unemployment.

When spending slows relative to income growth, that means saving rises. Is that a bad thing, or a good one? And what is the best that fiscal policy might offer as a prescription? To answer that we need to consider what the binding constraints on the level of economic activity (GDP) are, currently and in the future, and then consider how the structure and the financing of various fiscal policy options might free up those constraints.

In a recovering economy still below “full employment” level, the binding constraint is lack of demand for goods and services. Increasing the supply of productive resources won’t increase GDP if there is already excess supply, or idle capacity, in the economy. It will only increase unemployment. In such an economy, fiscal policy can increase GDP by stimulating consumption -- either through the government’s direct purchases of goods and services, or through tax cuts or transfer payments that indirectly increase private spending. Deficit spending can be effective at increasing demand and GDP immediately; how effective it is depends on how well targeted the policies are toward households and businesses most likely to spend additional funds on goods and services, and on how much the industries that produce those goods and services respond by hiring additional workers.

Sudden fiscal consolidation or deficit reduction, on the other hand, can jeopardize an economic recovery if it substantially reduces the net incomes of households that spend most of their income. (Such “austerity” measures can also spur a political backlash, as we are seeing now in Greece and France.)

In contrast, in a fully-recovered, full-employment economy, the size of the economy is limited by the level of productive capacity, or the aggregate “supply side” of the economy. Increasing demand without increasing supply only creates inflationary pressures. Under these conditions, higher private and/or public saving will most effectively expand the economy.

Deficits harm economic growth by reducing national saving (public plus private saving), which reduces the capital stock, labor productivity and household incomes. So deficit financing of tax cuts or spending designed to encourage the supply of productive resources handicaps the likely payoff. If policies can be structured to preserve the positive incentive effects on the supply of labor and capital while avoiding deficit financing, then those policies are much more likely to increase GDP.

As the economy gets closer to full employment and there is less need to stimulate demand, fiscal policy should transition from deficit-financed policies that encourage consumption, to paid-for policies that increase national saving.

Over the past few years net national saving (gross national saving minus economic depreciation of the capital stock) has been near zero or even negative. The U.S. saving rate is currently low by both historical and international standards. This lack of saving hurts the prospects for supply-side economic growth to return to historical norms of around 3 percent per year. It also produces a “double whammy” to the deficit-reduction effort: Deficits will not naturally decline as easily with the growth of the economy, and they will have to be even lower than 3 percent of GDP to be “economically sustainable” (meaning economic growth can keep pace with the growth of the debt).

A recent analysis of the economic impact of President Obama’s Fiscal Year 2013 budget by the Congressional Budget Office underscores this distinction between the U.S. economy’s shorter-term and longer-term ailments. It also shows how the higher deficits (relative to current law) under the President’s proposals have different effects on those different ailments.

The CBO finds that the President’s proposals would raise national income (real GNP) between 0.6 and 3.2 percent in calendar year 2013, but would reduce national income between 0.5 and 2.2 percent from 2018 to 2022. For the period in between, the effects range from slightly negative (-0.2 percent) to slightly positive (+1.4 percent). (See Table 4, page 8.) The CBO analysis emphasizes that in the shorter term (2013-17), the predominant economic effect of the proposals is that deficit spending increases disposable incomes and hence consumer demand. In contrast, after 2017 when the economy is projected to be back around full employment, the negative effects of larger deficits on public saving and slightly higher marginal tax rates on capital income on private saving outweigh any positive effect on labor supply from the slightly lower marginal tax rates on labor income. The estimates for the intermediate period, when the economic effects move from clearly positive to clearly negative, reflect a time when the economy will be transitioning from a cyclically “recovering” economy to a fully “recovered” one -- from one needing a boost to demand, to one needing increased supply.

The latest economic news and the CBO analysis serve as a reminder that any deficit reduction efforts over the next year need to be designed so as to not stifle personal consumption too much in the short term and yet substantially and credibly increase public saving over the longer term.

The President’s budget proposals seem to be appropriately mindful of the short-term fragility of the economy. But in the longer term, their deficit financing becomes the most significant feature in terms of their (adverse) economic effects, causing their costs to outweigh any of the economic benefits associated with the finer structure of the policies. The best way to turn the longer-term numbers around is to keep the basic structure of the policies but change their financing -- i.e., offset their cost without offsetting their good incentive effects.