US Fiscal Policy- Then, Future & Now

Government Budget Tax Revenue – Spending If < 0, then government is running deficit.

Why run deficits? Deficits aren’t a problem, so long as the deficit spending that is occurring is making the economy more productive by an amount that is greater than the interest that must be paid when US Treasury bills are issued. Spending that doesn’t help increase the productive capacity of the economy is burdensome because there is little benefit and much cost.

Why run deficits? Similar to an individual’s decision to take loans for school versus use a credit card to take a vacation. The former allows for increased income to be earned in the long run, while the latter, although fun, is a short run benefit with high long run costs.

Why run deficits? When deficit spending levels outpace the increases in the productive capacity of the economy, then economies can have trouble paying back the IOU’s (US Treasury bills) that were issued in order to deficit spend in the first place. Persistent deficits, even during economic expansions, are evidence of structural problems in an economy. (Structural Deficits)

Why run deficits? When the US economy enters a contractionary phase, unemployment benefits must be paid, which adds to the size of the deficit. (Tax revenues fall and spending rises because unemployment rises.) (Cyclical Deficit) Often, stimulus programs are created in order to increase demand and change the trajectory of the economy. Tradeoff- avoid short run pain while adding to long run burdens. ( BudgetUpdate.pdf ) BudgetUpdate.pdf

Why run deficits? GDP Trend Without stimulus With stimulus Time

Fiscal Policy Then US Government ran large deficits in the 2000’s. This happened despite several years of expansion. Causes of deficit, in no particular order of importance: a) 2001 Tax Cuts (decreased tax revenues) b) Homeland Security/Defense Spending c) 2003 Medicare Modernization Act (See: Surplus to Deficit in a Decade at website)

Fiscal Policy in the Future Aging population means that Medicare/Medicaid/Social Security payments will rise dramatically in near future. ( c/cf/Medicare_and_Medicaid_GDP_Chart.svg) c/cf/Medicare_and_Medicaid_GDP_Chart.svg Payments will not only be larger, but will last longer because of increased life expectancy. Puts squeeze on US government’s ability to meet other fiscal responsibilities. (See McLean and Walker articles)

Fiscal Policy Now 1)Must address current cyclical downturn. Blinder estimates that stimulus helped economy avoid a larger, perhaps longer, downturn. 2)Must address structural deficits that will eventually present themselves in the very near future.

Fiscal Policy Now Option 1- Cut government spending. Hurts economy in short run because government spending is about 20% of GDP. Even small decreases are difficult to swallow. Also, politically infeasible. (See Brooks article at my website) Option 2- Raise revenue by either moderately increasing taxes or addressing laws that could increase growth. (See Leonhardt and Friedman articles at website.)

Summary US wasted a golden opportunity to shore up structural problems in last decade. Tax cut decision coupled with increased military spending and Medicare Extension Act (!) was a time bomb. Recession, although unforeseen, reduced future options. US faces tough decisions going forward.