Quick note here
Neutral Fiscal Policy
I mentioned ‘augmented fiscal stabilizers’ and a neutral fiscal policy in the last message. And subsequently, I thought I should link out to a piece I published on these topics two years ago. Read that piece in full here. But let me quote from the piece and post a few additional comments.
Here’s the crux:
First, remember that the fiscal balance is mostly pre-determined. It’s almost entirely the result of things outside of the government’s control like the private sector’s desire to save net of investment and the trade balance with influence from the currency. What the government does control is the spending and taxation choices.
I would argue that making spending and taxation choices based on a debt or deficit metric – the way the eurozone does by the way – creates undesirable reflexivity. What I’m saying is that the government is supposed to make tax and spending choices to fulfill the public purpose for which it was elected. And that means that when the deficit expands during a recession, a government which responds by cutting spending or raising taxes is abrogating its duties. And it is doing so merely to meet a moving target.
Goodhart’s Law tells you to never use a yardstick as a target for exactly this reason.
So what DO you do? The neutral macro policy is to let the cycle just happen and do nothing. Neutral means not deviating from the overall macro policy course in response to fluctuations in the business cycle.
The public sector is the swing consumer. And that’s because of its public purpose – which is largely to set a framework for fairly and effectively marshaling real resources for its electorate. In a country sovereign in its currency, the federal government also has infinite financial resources at its disposal. So it can meet whatever financial obligations it must in its own currency, and merely needs to focus on how best to get all real resources utilized effectively.
So, when you have a recession because too many agents in the private sector are money-constrained, its incumbent on government to maintain that the transition doesn’t end in debt deflation. That doesn’t mean intervening to prop up asset prices or capital investment or real resource misallocation. It means smoothing the transition to a sustainable longer term where real resources can be allocated properly and fully.
That’s going to mean larger deficits. But those deficits are dictated by the private sector’s need, not by the public sector’s actions. The government is simply accommodating the private sector. That’s neutral.
The question is how the government makes the accommodation. I believe that doing so with as many pre-defined rules as possible tamps down on the political aspect of policy choices during a downturn. Instead policy choices would be driven by the longer-term needs of the economy.
I would give two examples here. First, on public works, we could use that as a way to move people away from unemployment benefits toward more soul-satisfying employment, when their jobs are eliminated. If the scheduled priority of public works was pre-defined and all that was a variable was the magnitude of spending, then these programs could run simply based on how much of the private sector’s net savings desire the government needs to accommodate.
In recessions, there would be more works spending. And in upturns there would be less. The US desperately needs to upgrade its infrastructure. It could have government prioritize how to do so as well as work out a schedule of how quickly that upgrade occurs depending on the state of the economy.
Another example is payroll taxes, a regressive form of taxation. This also hits employers in the US. By adjusting the level – or the maximum amount of income that can be taxed – with the business cycle, we could have a built-in broad-based means of automatic economic stabilization. There would be no need for political intervention.
The goal here is to avoid partisanship but to provide a safety net webbed enough to prevent people from slipping through the cracks when the economy turns down. That way, resources can be utilized more fully across the business cycle without government dictating which sectors of the economy enjoy the fruits of government largesse.