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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.