Fiscal Policy? Forget It, the Economy Runs Itself ; the Healthy State of Public Finances Has More to Do with Luck Than Political Judgement
Coyle, Diane, The Independent (London, England)
AS THE two US presidential candidates gallop towards the finish line, it is worth reflecting on a very unusual aspect of the electoral contest. Thanks to the healthy federal budget surpluses, Messrs Gore and Bush have been able to make competing offers to give away money. Tax cuts, higher public spending, reduced national debt - what a delightful menu of options for the would-be presidents. The same pleasing dilemmas lie in wait for next year's General Election in the UK, with a choice between reduced taxes and increased public spending shaping up as the main difference between the Labour and Conservative parties.
Before they rush to divvy up the unaccustomed annual surpluses, however, politicians ought to be made to read a series of articles about US fiscal policy in the current issue of the Journal of Economic Perspectives. The message is that the healthy state of the public finances has more to do with luck than political judgement and so, perhaps inevitably, will not last.
The luck comes in because of the length of the current economic expansion. That, according to estimates presented in the journal, provides most of the explanation for the budget surpluses. In fact, little of the size of the surplus or deficit since the 1960s can be accounted for by discretionary fiscal policy. Rather, automatic stabilisers such as tax revenues that expand because growth picks up, or social security benefits that rise and fall with unemployment, which is highly cyclical, explain most of the variations.
Not all of them. John Taylor - well-known for his estimates of monetary policy rules for central banks, linking interest rates to the deviation of inflation from target and of GDP from its potential level - adds a fiscal policy rule. US budget gaps turn out to be well explained by a rule that says the actual surplus or deficit is equal to the structural surplus or deficit plus 0.5 times the output gap. In other words, a two percentage point decrease in the output gap in a recession would increase the cyclical component of the deficit by 1 per cent of GDP. The fact that actual deficits follow structural deficits with such a clear rule points to scant impact from discretionary policy, or deliberate fiscal expansion or tightening.
Professor Taylor goes on to argue that this is a virtue. As long as monetary policy is keeping the economy close to its potential because this is what helps keep inflation on target, the fiscal authorities can only do harm by trying to improve on the automatic adjustment mechanisms in the tax and spending system. He concludes: "Given the transparent and systematic approach to monetary policy that has been followed in recent years, it is more important than ever for fiscal policy to be clearly stated and systematic. …