The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
lli\((;; cc: (G) January 9, 1981 GaugingFiscalPolicy: I The incoming Reagan administration is committed to cutting tax rates and nondefense expenditures, while increasing defense expenditures. Lower tax rates would strengthen incentives for suppliers of labor and capital, and might therefore eventually speed economic growth from the supply side. Combined with lower expenditures, such tax cuts also could ultimately be consistent with a budget that does not preempt saving from private capital formation. But the Federal budget deficit may initially increase rather than decrease, because of the lag that cou Id be expected in bri ngi ng nondefense expenditures under control, at a time when defense expenditures were being raised and taxes were being reduced. Even iftax cuts are successful in stimulating economic growth from the supply side, fiscal policy will continue to affect capital markets and aggregate demand. Given the rather large and uncertain budgetary changes in prospect, we shou Id try to gauge the size of these more trad itional impacts of fiscal pol icy as the new Administration's program unfolds. The generally accepted measure in this area is the surplus or deficit in the highemployment budget -the size of the budget surplus or deficit when the economy is operating at a "natural" (full employment) rate of unemployment. Unfortunately, this indicatoroffiscal policy is subject to problems of both concept and measurement. One important conceptual problem is the question of what should be included on both the expenditures and receipts side of the budget. An equally serious measurement problem relates to the need to infer the natural rate of unemployment by means of econometric modeling, since it is not directly observable. In this article, we examine the rationale of the highemployment budget and then consider the differences'created by alternative assumptions about the natural rate of unemploy- ment. In a second article, we consider certain factors-additions to both the expenditures and recei pts sides of the budget -that shou Id be included in any such analysis. Budgetrationale Budget analysts introduced the concept of the high-employment budget into policy discussions during the early 1960's, for the purpose of separating the effect of the economy on the Federal budget from the impact of discretionary fiscal-policy changes. Higher levels of economic activity boost tax receipts and reduce some expenditures, such as unemployment compensation; and lower activity does the opposite. These induced changes in receipts and expenditures act as automatic stabilizers by helping to reduce the economy's response to any shift in total spending, but they do not themselves represent independent sources of stimulus or restraint. By measuring the budget surplus or deficit at a constant rate of unemployment, analysts can remove cyclically-induced changes in expenditures and receipts from their calculations. The resulting surplus or deficit is a rough measure of the budget's contractionary or expansionary influence on the level of total spending. A budgetary surplus indicates a "tight" fiscal policy, in the sense that the budget tends to add less to aggregate spending than it takes away, whereas a deficit implies an "easy" fiscal policy in a reverse sense. Fiscal policy affects output and employment in the short run-and by a multiple of the deficit or surplus if monetary pol icy is accommodating by providing sufficient money to stabilize interest rates. But if the Federal Reserve instead holds to a fixed moneysupply target, the fiscal stimulus or restraint has a much smaller impacton total spending, and therefore on output and employment. In the case of a deficit, the debt issues required to finance the deficit bid up interest rates in capital markets, which in turn discourage IE1 ©.\illl Ik\CGJ IT Opinions eXDressed in this newsietter do not necessarily r'efiect the views of the management of the Federal Reserve Bank of San Francisco, nor 01 the Board of COV2nl<:}rS of the Federai economic activity faiis back to where It was before. At this point, the increased fiscal stimulus will be completely offset by the decline in private investment spending caused by higher interest rates. Even with monetary accommodation of the stimulus, additional money simply raises wages and prices further, and does not affect output and employment in the longer run. private investment spending. On the other hand, in the case of a budget surplus, the lower interest rates induced by debt retirement stimulate private investment spending, which provides some offset to the budget's restrictive effect on aggregate spending. However, with a given stock of money, the investment-spending offset to fiscal stimulus or restraint is less than complete in the shortrun. The resulting impact on total spending is accommodated by movements in the velocity of money ci rcu lation caused by the changes in interest rates. Consequently, the level of the highemployment budget measures the degree of crowding out that can be expected if the current fiscal policy is permanently maintained. A high-employment deficit registers the average amount of credit that would be preempted by the Federal budget. On the other hand, a high-employment surplus indicates the amountof private capital formation stimulated in the long run by the extra credit made available through the retirement of government debt. From the point of view of short-run stabilization policy, the importantthing is not whether the high-employment budget is currently in surplus or deficit, but rather in what direction the budget is moving. This is because most of the effects of the current deficit or surplus on current output and employment have al ready been felt. Thus, a surplus in the highemployment budget doesn't mean that fiscal policy is currently slowing the economy, but only that it helped slow itdown in the past. In short, the change in the high-employment budget measures whether fiscal policy is currently propelling the economy forward or restraining it. Movement towards a lower surplus or larger deficit indicates greater fiscal stimulus-an easier policy tending to expand current output and employment-and the reverse signifies a tighterfiscal policy tending to slow economic activity. Which unemploymentrate? In theory, the high-employment budget should be calculated on the basis of the "natural" rate of unemployment, which is the unemployment rate towards which the economy gravitates in the long run. However, this number is not directly observable, but instead must be estimated. We know that the natural rate of unemployment has tended to rise over time as a consequence of a number of changing demographic and legislative factors, but we don't know the exact size of the rate. The official calculation of the highemployment budget assumes an unemployment rate of 5.1 percent. However, recent estimates by Phillip Cagan, RobertHall, Alfred Tella and others suggest that the figure actually should be in the range of 6.0 to 6.S percent. As indicated above, budget deficits can "crowd out" a certain amount of private capital formation even in the short run (before wages and prices fully adjust), provided the central bank holds to a fixed monetary target. Over a longer period, an easier fiscal pol icy (even with monetary accommodation) doesn't stimulate output and employment at all, but only creates an equal amount of crowding out. For example, a shift to an easier fiscal policy can expand output and employmentfor a time. Butthe resulting pressure on wages and prices must lead to an increased demand for a given stock of money, which raises interest rates until We can estimate the size of the highemployment budget at a 6.S-percent unemployment rate by linear interpolation from the historical differences between the highemployment budget and the actual budget. Raising the assumed natural rate to 6.5 percent substantially increases a deficit or 2 reduces a surplus (see chart). For example, in 1 979 the high-employment budget (nationalincome accounts basis) would have been in deficit by $29.2 billion, compared to an officially recorded surplus of $6.9 billion. The deficit has been understated in past years also. The high-employment budget since 1 973 has generated an average annual deficit of $33.7 billion, instead of the officially calculated $7.6 billion average deficit. Since the level of the high-employment budget measu res the amou nt of permanent crowd ing out, the budget as currently calculated apparently greatly understates the extent of discouragement of private capital formation. in 1 974 and then easing in 1975. Both also show a relatively neutral effect on aggregate demand during the next two years, but show tightening again in 1 978 and 1 979, and little change in 1 980. While the assumed unemployment rate makes little difference to measured changes in the degree of short-run fiscal stimulus or restraint applied to aggregate spending, it can have a substantial effect on the calculated amount of credit permanently preempted by the Federal budget. Indeed, the highemployment budget -measured at a 6.S-percent unemployment rate-indicated about $29.5 billion of crowding out in 1 980. This suggeststhat if the new administration wishes to spur growth, it should take strong steps to reduce expendit.ures or increase tax receipts in order to el iminate th is cu rrent drag on private capital formation. However, actual crowding out would be of this magnitude only if expenditures and receipts were measured on a realistic conceptual basis. These conceptual problems are examined in our next Weekly Letter. Changes in the high-employment budget, in the short run, indicate changes in the degree offiscal stimulus or restraint applied to aggregate demand, and in the longer run, indicate changes in the amount of crowding out. But the use of a more realistic unemployment rate basically makes only a level adjustment, and makes little difference in year-to-year changes in the high-employment budget (see chart). Both of these measures of the highemployment budget indicate fiscal tightening $ Billions AdrianW. Throop HIGH EMPLOYMENT BUDGET 20 LEVELS J-At 5.1% Unemployment "..,.;', '....... ............. -20 ..,.,/.-' ', ----------------- -40 40 ------ ---- At 6.5% Unemployment ANNUAL CHANGES "."'\ 20 o -20 "./ ". \ \ ...At 6.5% Unemployment -- \ " ....... ,..,.... "\ / / ;/ 3 At 5.1%Unemployment-1' u013U!ljSl:?M.ljl:?ln • uo3aJO • l:?pl:?i\aN • oljl:?pl !!l:?Ml:?H• l:?!UJOj!Il:?) l:?uozpV. l:?>jSl:?IV (G) JJ BANKINGDATA-TWELfTH FEDERAL RESERVE DISTRICT (Dollaramountsin millions) Selected AssetsandLiabilities largeCOO1mercial Banks Loans(gross, adjusted) andinvestments* Loans(gross, adjusted)- total# Commercialandindustrial Realestate Loansto individuals Securities loans U.s.Treasury securities* Othersecurities* Demanddeposits- total# Demanddeposits- adjusted Savings deposits- total Timedeposits-total# Individuals,part.& corp. (Largenegotiable CD's) WeeklyAverages of Daily Figures MemberBankReserve Position Excess Reserves (+ )/Deficiency(-) Borrowings Netfreereserves (+ )/Netborrowed( -) Amount Outstanding Change from 12/24/80 146,510 124,223 36,959 49,985 24,144 1,496 6,689 15,598 46,298 32,253 27,619 73,618 63,772 29,451 12/17/80 196 200 90 70 207 173 37 33 109 - 757 807 2,639 2,139 1,390 Changefrom yearago Dollar Percent - - Weekended Weekended 12/24/80 12/17/80 8,077 8,700 3,365 6,671 297 252 590 33 2 1,610 889 14,630 13,642 7,610 5.8 7.5 10.0 15.4 1.2 20.3 8.1 0.2 0.0 4.8 3.1 24.8 27.2 34.8 Comparable year-ago period n.a. n.a. 28 130 127 64 n.a. n.a. 35 * Excludes tradingaccountsecurities. # Includesitemsnotshownseparately. Editorialcommentsmaybe addressed to the editor(WilliamBurke)or to theauthor.... Freecopiesof this andotherFederalReserve publications canbeobtainedbycallingor writingthePublicInformationSection, FederalReserve Bankof SanFrancisco, P.O.Box7702,SanFrancisco 94120.Phone(415)544-2184. 11 I C@I
@FedFRASER