Balancing the Federal Budget and helping the economy?

Conventional wisdom of the day seems to be that the Federal Government cannot balance the budget and help the economy at the same time.  I’m not a believer and will attempt in this post to explain why.

We start with Keynesian Economic theory which has been widely accepted by people of all political stripes.  The Keynesian model attempts to predict the effect on the economy of government fiscal actions.  It basically says that increases in government spending or decreases in Federal Taxes will provide a stimulus to economic activity.  This works by putting more money in people’s pockets either through government projects or by reducing individual taxes and they then spend all or most of that.  Their increased spending increases the demand for goods and services.  The increase in demand will provide incentives for businesses to grow and expand and thus provide more jobs, and more money more people will have to spend on more goods and services, etc. etc.  Increases in individual taxes or a decrease in government spending will have the opposite effect.  If government were running  a surplus because tax receipts were higher than expenditures,  increasing spending and/or decreasing taxes to help stimulate the economy and create new jobs would be a “no-brainer”.  But where we are today, with large deficits and relatively high unemployment create a dilemma .  Either increasing taxes or cutting spending in order to balance the budget is, based on the Keynesian model, going to make the economy worse and likely create more unemployment.  On the other hand, not balancing the budget in some reasonable time period runs the risk of bankrupting the country.  Some of the European countries, notably Greece and Spain, are in worse shape than we are.  We probably have some time to work through this, but some say we need to start now before things get more critical and more painful.  Some say, not now because the economy is still weak and unemployment is too high and we can’t do something that will surely make things worse.

I don’t believe that Keynes was wrong, but I think we need to look at the whole story (which we are not getting either from the media nor politicians).  Keynes considered only government fiscal policy – spending and taxes – which are only two of many variables which affect the economy.  Since Keynes’ model looks only at the result of changing one of only two variables, it makes the implicit assumption of “everything else being equal” or “normal”.  But everything else is rarely “equal” and today is no exception.  So what things are not “equal” or “normal”?  There are, I believe two or three critical things starting with monetary policy.  Keynes model doesn’t address monetary policy but assumes a stable, normal monetary environment.  But it would appear we are nowhere close to that.  No one I know believes that interest rates will remain at or close to zero forever.  Even the Feds public statements indicate they don’t believe that.  And the Fed is doing some things that it has never done before.  Some people think that unwinding all this abnormal activity will result in serious problems, others believe the Fed is too smart for that.  No one knows for sure.  But at best, the future here is highly uncertain, and markets (individuals, business people and investors) hate uncertainty.

The deficits themselves add to the uncertainty.  No one I know believes we can go on forever running the deficits we are running.  So how will we solve that and when?  If anything, at the moment, that is even less clear than what might happen on the monetary side.  When I was taking economics in the 70s, there was a theory that we should target a  government spending level based on full employment – a “full employment budget”.  One could calculate the expected tax revenue based on the existing tax rates with the working population fully employed.  At full employment, the budget would be balanced, but if we fell below full employment, the resulting deficit would help provide economic stimulus to get us back to full employment and a balanced budget.  So deficits would be short run and additional government action unnecessary.  That made a lot of sense to me at the time, but government spending levels appear to be well beyond that now.

The Keynesian model is also based on consistent and predictable human behavior.  The problem here is that people are not machines or inanimate physical elements.  We have brains that are influenced by a wide range of variables and expectations.  My experience with groups of people is that they almost never act in fully predictable and consistent ways.  This particular economic downturn is different from almost any we’ve had in many years.  Most bubbles and recessions we’ve had in the last 50 years  have been primarily supply/demand driven.  This one has been heavily financially driven.  The housing crises was as bad as it was because it was largely debt driven.  Too many loans at too high a % of the asset market value (real or imagined)  and at the same time individual credit card debt was also reaching new highs.  Then there were the financial derivatives which were owned by too many financial institutions.  Most believe the money supply is effectively the sum of currency in circulation plus debt.  If so, we had a large increase in money supply followed by a sharp decrease.  Individuals, companies, and banks have been busy the last few years “de-leveraging” i.e. paying off debt.  Everyone has done that it seems except the Federal Government.   I believe that some of the government actions early in the recession were needed to stabilize the monetary system and help individuals cope with a too high debt load.    But much of that’s been done and we now have a highly uncertain economic future because of much higher government debt and unsustainable monetary actions.

I would argue that the thing we need most today is not more stimulus, but more certainty.  People are not spending normally and companies are not expanding and creating new jobs because they don’t know what will happen next or when.  The government doesn’t need to reduce the deficit in one year, but it needs a realistic plan to do it over several years and an indication that it has started and is serious.  The Fed probably needs to start moving back toward a more normal environment as well.  When the government starts acting rationally, normally and predictably, people will also, and the economy has a good chance of finishing the recovery it has begun.

In the next installment, I’ll try to answer the question, WWCD – what would Campbell do?


About tjc13

BE - Chem Engineering, Vanderbilt Univ, MBA, University of Tulsa - Worked for an energy and chemical company for many years and then started a management consulting business working for both for-profit and not-for-profit organizations.
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2 Responses to Balancing the Federal Budget and helping the economy?

  1. Bob says:

    “when the government starts acting rationally, normally and predictably” What are you smoking Tom? Normally and predictably maybe, but rationally……….never! Unless your expectations are for more power gained by regulations on regulations. You get my drift.
    P.S. Can’t wait to see WWCD!


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