View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

For release on delivery
April 27, 1989
8:15 P.M. E.D.T.

U,S. Budget Deficits and Economic PoliƧy

Address by
Manuel H. Johnson
Vice Chairman

Board of Governors of
the Federal Reserve System

American Enterprise Lecture

Furman University
Greenville, South Carolina
April 27, 1989

U.S. Budget Deficits and Economic Policy

I

am

honored

to

present

American Enterprise Lecture this year.

the

Marsh-McLennan

As you know, part of

the objective of this lectureship program is to discuss
concerns relating to the private enterprise system.
The subject of my address tonight is the federal
budget deficit and its impact on the U.S. economy.

I want

to talk about the budget deficit and economic policy not
only because it is closely related to the theme of this
lecture program, but also because I believe the way in which
we attempt to deal with this issue is so important to our
future.

Unfortunately, I believe the budget deficit issue

is one of the most misunderstood and confusing issues of
recent years.
Accordingly,

tonight

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 to be the proper goal of fiscal
policy.

And,

finally,

I would like to emphasize what I

consider to be four key elements of any viable program to
deal with the deficit.

-

2

-

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

think there are at least six basic reasons for

so much confusion surrounding discussions of the budget
deficit.

First,

concerning

its

deficit

is

there

proper

the

most

are

important

measurement.
commonly

disagreements

While

used

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 GNP or as
a percentage of the savings pool.

Arguments are also made

that off-budget spending should be included or that the
budget

should be divided into

budget.

Still

others

a current

suggest

that

and a capital

state

and

local

government deficits or surpluses should be included in the
overall measure.
adjusted

for

It is also common for the deficit to be
cyclical

factors

full-employment deficit or surplus.

so

as

to

measure

a

Indeed, 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

-

3

-

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
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.
A second reason for misunderstandings about the
budget deficit is that these 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; sharp, unanticipated decelerations of inflation;
or by sharp increases in interest rates.

On the other hand,

increases

decreases

revenues

in

government

unrelated

fundamental

to

spending
economic

determinants

of

or

activity

deficits.

can

Some

in

tax

also

be

economists

believe that our current budget deficit was caused by tax
cuts, whereas others believe it is the result of continued
rapid government spending.

Still others argue that it was

caused

and

by

the

recession

the

sharp

unanticipated

deceleration of inflation experienced in the early 1980s.

4

-

A

third

discussions
deficits

reason

of budget
depend

-

for

deficits

confusion
is

importantly

Recession-caused deficits,

that
on

for example,

surrounding

the

effects

their

of

causes.

are not likely to

crowd out private sector activity since decreases in private
credit demands during recessions will likely outweigh the
effects of increases in government borrowing.

On the other

hand, deficits caused by increases in government spending
unrelated to economic
private

activity,

activity will

particularly

if

certainly crowd out
such

spending

is

additional government consumption.
Fourth, the effects of deficits depend in part on
the reaction of (or expectations of) the private sector.

If

the

as

private

sector

views

tax-cut

induced

deficits

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.
Fifth, the effects of deficits also depend on the
reaction

of

monetary

policy.

If

the

central

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

5

-

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.
Sixth, 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,

All borrowers, including the

must compete for the limited supply of

savings and credit in global markets.

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.

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

-

6

-

-- 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
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 no
longer adequately functioned to foster monetary expansion
through the private sector, fiscal policy could, in effect,
be

used

as

a vehicle

to

enhance

the

effectiveness

of

monetary policy 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

can and will influence aggregate demand so as to promote

7

-

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 view the goal and purpose of fiscal policy to be
the management of aggregate demand.
policy

and

fiscal

objective.

If

interpreted

to

growth,

policy

the
be

however,

as

proper

substitute

tools

for

role

of

fiscal

promotion

the

this

They view monetary

of

long-term

characterization

of

this

policy

economic

"easy"

policy and tight monetary policy is misplaced.

is

fiscal

If fiscal

policy is primarily a tool for expanding economic potential,
monetary policy and fiscal policy are complements in an
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?
we must keep four key points in mind.

I believe

-

First, it
continuous

deficits

therefore

8

-

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.
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,

-

9

-

especially in its most wasteful forms,
increase long-term economic growth.

actually work to

And empirical evidence

supports this view.'*
It

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

the

reasons.

deficit

suggested
are

If potential

above,

tax

increases

to

inappropriate

for

a

number

of

goal

for

growth is an important

fiscal policy, increases in taxes will most likely conflict
with such objectives.

This conflict is due to the adverse

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

-

10

-

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.