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For release on delivery 9:00 A.M., E.S.T. January 25, 1989 Deficit Spending and the U.S. Economy Address by Manuel H. Johnson Vice Chairman Board of Governors of the Federal Reserve System before Conference Sponsored by Citizens for a Sound Economy Washington, D.C. January 25, 1989 Deficit Spending and the U.S. Economy I am pleased to be the keynote speaker at this conference addressing the Economic Growth. issues of Taxes, Spending, and With the new administration five days old and a new Congress in session, what could be more timely than a conference addressing these issues? The subject of my address -- "Deficit Spending and the U.S. Economy" -- is obviously elements of the conference's title. related to all three I want to talk about deficit spending not only because it is so closely related to the theme of the Conference but also because I believe the budget deficit is one of the most misunderstood and confusing issues of recent years. Accordingly, today I would like to, first, explain why I think there is so much confusion surrounding the issue of budget deficits. Second, I would like to suggest what I believe proper to be the goal of fiscal policy. And, 2 - finally, - I would like to emphasize what I consider to be four key elements of any viable solution to the deficit problem. Reasons for the Misunderstanding and Confusion Surrounding Budget Deficits Let me begin by making an observation that most of you will probably agree with: events in recent years have underscored the view that conventional macroeconomic theory is in disarray. At least part of the reason for this disarray is the way fiscal policy has been portrayed by many economists. And the budget deficit is one of the most misunderstood and confusing elements in these portrayals. I much think there are several basic reasons for so confusion surrounding deficit. First, concerning its deficit is the there proper most discussions are important measurement. commonly of used While the budget disagreements the nominal measurement, many economists contend that a real (price deflated) measure is more meaningful in an economic sense. Others contend that the deficit should be measured as a proportion of GNF or as a percentage of the savings pool. that off-budget budget budget. should spending be Arguments are also made should be divided into a included or that current and a the capital It is also common for the deficit to be adjusted for cyclical factors deficit or surplus. so as to measure Indeed, a ful1-employment researchers at the Board of Governors have devised a measure of fiscal thrust referred to as a fiscal impetus measure. This measure is a weighted difference of discretionary federal spending and tax changes (in 1982 dollars) scaled by real federal purchases,1 All of these alternative measures contain an element of truth and different measures may be appropriate for alternative perspectives. Nonetheless, these alternative measures do add to the confusion surrounding public discussions of the deficit. But, in spite of this confusion, these alternative measures do generally suggest - 4 - that the deficit has declined in recent years and provide a somewhat more sanguine picture than the nominal figure so often mentioned in the popular press. Deficits can be caused by very different factors. For example, they can be caused by changes in economic variables such as slowdowns in business activity; unanticipated decelerations of inflation; or by sharp, sharp increases in interest rates. On the other hand, increases in decreases government unrelated to spending economic or activity determinants of deficits. can in tax also be revenues fundamental Some economists believe that our current budget deficit was caused by tax cuts, others believe it is government spending. the result of continued whereas rapid Still others argue that it was caused by the recession and the sharp unanticipated deceleration of inflation experienced in the early 1980s. The their causes. effects of deficits depend importantly on Recession-caused deficits, for example, are not likely to crowd out private sector activity since decreases in private credit demands during recessions will likely outweigh borrowing. the effects of increases in government On the other hand, deficits caused by increases in government spending unrelated to economic activity will certainly crowd out private activity, particularly if such spending is additional government consumption. The effects of deficits depend in part on the reaction of (or expectations of) the private sector. If the private sector views tax-cut induced deficits as mandating future tax increases (and does not desire a future tax burden for its own generation or the next), then private sector savings behavior may change. In particular, saving may increase so as to finance the deficit without increasing interest rates or crowding out private sector activity. The reaction effects of monetary of deficits policy. also If the depend on central the bank persistently monetizes budget deficits, increased inflation is likely to follow. Such inflation has often occurred in countries that do not have independent central banks. But it can occur whenever any monetary authority attempts to stabilize interest rates at low levels in the face of large deficits. In such circumstances money creation and inflation become another form of financing budget deficits. But if the central bank is committed to price stability, it will not monetize budget deficits and inflation will not result. The effects of budget deficits also depend in part on the savings pool, not just in the U.S. but in the rest of the world. More specifically, the effect of deficits may depend on saving and borrowing all over the world, not just in the U.S. U.S. government, must compete All borrowers, for the savings and credit in global markets. including the limited supply of Thus, even a deficit that is large relative to GNP or to the domestic savings pool may not crowd out domestic private investment if it is - financed internationally. 7 - While investment may not be affected in this case, exchange rate adjustments may work so as to affect other sectors of the economy. Consequently, the precise effects of deficits may depend on the exchange rate regime as well as the degree of integration of world credit and capital markets. The Role of Fiscal Policy As you can see, there are many very important reasons for misunderstandings about budget deficits. With so much confusion about deficits--and deficits, after all, are the conventional measure of the thrust of fiscal policy -- there can be little doubt that there is confusion about fiscal policy. In this regard, let me make one additional point. And this point is a most important one concerning budget deficits and the confusion surrounding conventional analysis of fiscal policy. If the fundamental economic objective underlying fiscal policy is to promote long-term economic - 8 - growth, then fiscal policy is not an appropriate tool to manage aggregate demand in order to fine-tune or stabilize cyclical economic behavior. The view that fiscal policy was needed to help in stimulating spending may have been appropriate special circumstances of the Great Depression. in the Aggregate demand, after all, had collapsed in the 1930s because of inappropriate monetary policy, and a restimulation of aggregate demand was desperately needed to foster spending. In this special situation, where financial intermediation long longer adequately functioned to expand money through the private sector, fiscal policy could be used as a vehicle to enhance the effectiveness of the monetary mechanism and in this way help to bolster aggregate demand. In short, deficits might have served a useful function by working to re-generate the velocity of money. 2 But today, the central bank fully understands both its mission and the tools at its disposal. Monetary policy 9 - - can and will influence aggregate demand so as to promote price stability. Consequently, a longer-term orientation of fiscal policy is called for. With this forward-looking role of fiscal policy in mind, it is appropriate to question the common contention that in recent years the U.S. has adopted the wrong policy mix. More specifically, it is commonly asserted that the combination of "expansionary" fiscal policy and restrictive monetary policy is inappropriate. Advocates of this position interpret the goal and purpose of fiscal policy to be the management of aggregate demand. policy and fiscal objective. If interpreted to growth, however, policy the be as proper the this They view monetary substitute tools for role of fiscal fostering of long-term characterization of policy is economic "easy" policy and tight monetary policy is misplaced. this fiscal If fiscal policy is primarily a tool for expanding economic potential, monetary policy and fiscal policy are complements in an - 1 0 - overall macroeconomic strategy for price stability and growth. And a strategy of cuts in marginal tax rates, along with commitments to both contain spending and pursue price-stabilizing monetary policy, is certainly not a an inappropriate policy mix. Key Elements in Any Solution to the Budget Deficit Where does all this leave us with regard to a strategy for solving our current deficit problem? I believe we must keep four key points in mind. First, it continuous therefore deficits is undoubtedly potentially should be reduced. true can be that large and disruptive and Such deficits, after all, absorb saving that could otherwise be employed in financing more productive private sector activity and additional economic growth. Second, any deficit reduction strategy should keep the longer-term fiscal policy goal of fostering economic potential as a primary objective. - 1 1 - Third, if this longer-term objective of potential growth is the primary goal of fiscal policy, then restraint in government spending is clearly the best way to pursue this goal. More specifically, given a price-stabilizing monetary policy, government spending must be financed either by borrowing or taxation. But both government borrowing and taxation have adverse effects on economic growth. Borrowing absorbs savings that could otherwise be used for productive private investment, and taxation adversely incentives to work, save, invest, and innovate. affects Yet there is little evidence indicating that reductions of government spending have lasting adverse effects on overall economic growth. Indeed, it is most likely that it is the amount government spends, not the particular form of finance, that is the real burden imposed upon the public. Accordingly, it is likely the case that reductions in government spending, especially in its most wasteful forms, actually work to - 1 2 - increase long-term economic growth. supports this view. It And empirical evidence 3 should be recognized that reductions in government spending do not necessarily mean that particular goods or services no longer are available. When government spending as a proportion of GNP becomes large--as is now the case--it is likely that many services provided by government can be provided more efficiently in the private sector. This is the message of the privatization literature and the unambiguous empirical evidence that supports it. It is this more efficient provision of services and thus more efficient utilization of resources that ultimately brings about more rapid economic growth and higher living standards. Fourth. as reduce reasons. the deficit suggested are If potential above, tax increases to inappropriate for a of number growth is an important goal for fiscal policy, increases in taxes will most likely conflict with such objectives. This conflict is due to the adverse - 13 - effects higher tax rates have on incentives to work, save, invest, and innovate. Tax increases likely will not work to reduce the deficit significantly, affected. if growth is adversely And if tax increases work to promote additional government spending, as some economists argue, almost certainly will not reduce the deficit. then they In any case, it is not clear that taxation is superior to borrowing as a form of financing government spending, especially when the deficit is declining as a percent of GNP. It may well be the case that increased taxation is as costly or crowds out private sector activity just as much as borrowing. Lessons for Resolving the Budget Deficit Dilemma: In conclusion, there are important lessons to be learned from the federal budget experience of recent years. Reorienting budget strategy to promote longer-term economic growth appears to be a most sensible goal of fiscal policy. I do not believe that it is just a coincidence that two of the longest, most vigorous noninflationary economic expansions of this century occurred after major tax rate reductions and during periods of relatively restrained monetary policy. But there can be no doubt that this is what happened following the Kennedy tax cuts of the 1960 's and the Reagan tax cuts of the 1980's. One could argue that it was the excessive spending habits of the federal government in the second half of the 1960's that ultimately led to the disruption of the prosperity of that period. Hopefully, it will not be our failure to effectively restrain government spending in the 1980's and early 1990's that finally derails the current expansion. Footnotes See, for example, Darrel Cohen, "Models and Measures of Fiscal Policy," Working Paper Series, Board of Governors of the Federal Reserve System, No. 70, March 1987. In some interpretations of the period, the collapse of the U.S. money stock had promoted a loss of confidence and made a proper functioning of monetary policy very difficult. In the U.K., Keynes' writing reflected the fact that British monetary policy had been severely constrained by the return to the gold standard at its pre-World War I par value. Consequently, monetary policy was rendered ineffectual in both countries and, in these special circumstances, possible temporary alternative roles for fiscal policy were proposed. See, for example, Landau, Daniel, "Government Expenditure and Economic Growth: A Cross Section Study," Southern Economic Journal, January 1983; Landau, Daniel, "Government Expenditures and Economic Growth in the Developed Countries, 1952-1976," Public Choice, 47, 1985; Plosser, Charles, "Government Financing Decisions and Asset Returns," Journal of Monetary Economics, Vol 9, 1982; Marlow, Michael, "Private Sector Shrinkage and the Growth of Industrialized Economies," Public Choice, Vol. 49, 1986; Saunders, Peter, "Public Expenditure and Economic Performance in OECD countries," Journal of Public Policy, Vol. 5, Part 1, February 1985; U.S Treasury Department, Office of the Assistant Secretary for Economic Policy, "The Effect of Deficits on Prices of Financial Assets: Theory and Evidence," U.S. Government Printing Office, Washington, D.C. 1984.