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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. I am pleased to be addressing conference Economic Growth. the keynote issues the Economy speaker at this of Taxes, and Spending, With the new administration five days old and a new Congress what could be more in session, 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 the budget deficit is one of I believe 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. believe to be the Second, proper I would like to suggest what I goal of fiscal policy. And, - finally, 2 - I would like to emphasize what four key elements of any viable I consider to be solution to the deficit problem. Reasons for the Misunderstanding and Confusion Surrounding Budget Deficits Let me begin by making an observation that most of events in recent years have you will probably agree with: underscored the view that conventional macroeconomic theory is in disarray. least part At 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 think therthink thereraarebaseveralasbasicfcreaso much confusion deficit. First, concerning its deficit is the surrounding there proper most discussions are important measurement. commonly economists contend that a real of used the budget disagreements While the measurement, (price deflated) nominal many measure is - 3 - Others contend that more meaningful in an economic sense. the deficit should be measured as a proportion of GNF or as a percentage of the savings pool. that off-budget budget divided into a included or current and that a the capital It is also common for the deficit to be adjusted budget. for should be spending should be Arguments are also made cyclical deficit or factors surplus. so as to measure Indeed, researchers a ful1-employment 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) All of scaled by real federal purchases,1 these alternative measures contain an element of truth and different measures may be appropriate for alternative perspectives. alternative measures do add to Nonetheless, the confusion public discussions of the deficit. confusion, But, these surrounding in spite of this 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, slowdowns such as variables unanticipated in economic caused by changes they can be of decelerations activity; in business or inflation; by increases in interest rates. On the other hand, in government unrelated to or spending activity economic determinants of deficits. current budget others believe deficit it government spending. decreases can in also sharp increases tax be sharp, revenues fundamental Some economists believe that our was is the caused by result tax of cuts, whereas continued 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 Recession-caused deficits, importantly for example, on are - not likely out crowd to - 5 activity sector private since decreases in private credit demands during recessions will likely outweigh the effects On the other hand, borrowing. of increases in government deficits caused by increases in government spending unrelated to economic activity will particularly if such certainly crowd out private activity, spending is additional government consumption. depend in part on the reaction of (or expectations of) the private sector. If the The effects of deficits private sector views tax-cut induced deficits as mandating future tax increases (and does desire not burden for its own generation or the next), sector savings behavior may change. a future tax then private saving In particular, may increase so as to finance the deficit without increasing interest rates or crowding out private sector activity. reaction The effects of monetary of also deficits policy. If persistently monetizes budget deficits, the depend on central the bank increased inflation - 6 - is likely to follow. Such inflation has often occurred in countries that do not have independent central banks. it can occur whenever any monetary authority attempts But to stabilize interest rates at low levels in the face of large deficits. In such money circumstances creation and inflation become another form of financing budget deficits. But if the central bank is committed to price stability, will not monetize budget deficits and inflation will it not result. The effects of budget deficits part on the savings pool, rest of the world. also depend not just in the U.S. More specifically, but in the the effect deficits may depend on saving and borrowing all world, U.S. not just in the U.S. government, must compete All borrowers, for savings and credit in global markets. that is large relative the of over the including the limited Thus, in supply of even a deficit to GNP or to the domestic savings pool may not crowd out domestic private investment if it is '7 financed internationally. 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 there see, are many very important reasons for misunderstandings about budget deficits. so much confusion about deficits--and deficits, With 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 underlying fiscal policy is to promote economic objective long-term economic - growth, 8 - 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 special circumstances demand, after all, inappropriate may have been appropriate of the Great Depression. had collapsed in the monetary policy, and a in the Aggregate 1930s because of restimulation of aggregate demand was desperately needed to foster spending. In this special situation, financial where 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. But today, 2 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 it is appropriate to question the common contention mind, that in recent years the U.S. has adopted the wrong policy mix. specifically, More it is commonly asserted that the combination of "expansionary" fiscal policy and restrictive monetary of Advocates inappropriate. is policy this position interpret the goal and purpose of fiscal policy to be the management of aggregate demand. policy and objective. If interpreted to growth, policy fiscal however, proper the be as the this They view monetary tools substitute role of fiscal fostering of long-term characterization of policy is economic "easy" policy and tight monetary policy is misplaced. this for fiscal If fiscal policy is primarily a tool for expanding economic potential, monetary policy and fiscal policy are complements in an - 10 - strategy overall macroeconomic growth. And a strategy of cuts in marginal tax rates, with commitments price-stabilizing to both for contain monetary price spending is policy, and stability along a and pursue certainly an not inappropriate policy mix. Key Elements in Any Solution to the Budget Deficit Where does all this leave us with regard to strategy for solving our current deficit problem? a I believe we must keep four key points in mind. First, it continuous deficits therefore should be is undoubtedly potentially reduced. true can be large and disruptive and that 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 potential as a primary objective. of fostering economic 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 monetary policy, specifically, given a price-stabilizing 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, incentives to work, and save, taxation invest, adversely and innovate. affects Yet there is little evidence indicating that reductions of government spending have lasting adverse effects on overall economic growth. Indeed, government spends, it is most likely that it is the amount not the particular form of finance, is the real burden imposed upon the public. that Accordingly, it is likely the case that reductions in government spending, especially in its most wasteful forms, actually work to - 122 - increase long-term economic growth. supports this view. It And empirical evidence 3 should be recognized reductions that 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. reduce reasons. the as deficit suggested are If potential fiscal policy, above, inappropriate growth is an tax increases to for a number of goal for important 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, invest, and innovate. reduce the deficit affected. government save, Tax increases likely will not work to significantly, if growth is adversely And if tax increases work to promote additional 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 - 14 - expansions reductions of this and monetary policy. century occurred after major tax during periods of relatively rate restrained 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 1/ 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. 2/ 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. 3/ 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.
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