The discussion of the 3-equations model in the previous chapter has shown that the New Consensus Model does not envisage an active role for fiscal policy. The resultant focus on monetary policy and the concomitant neglect of fiscal policy is justified by reference to the latter's alleged ineffectiveness. In their critique proponents of the NCM model have advanced various arguments against the use of fiscal policy that can be grouped under the headings of “crowding out”, the sustainability of budget deficits and the institutional problems associated with fiscal policy. In the following each of these arguments will be outlined and subsequently evaluated in order to establish whether it warrants the absence of fiscal policy in the NCM Model.
Crowding out - an unavoidable corollary of fiscal policy?
Advocates of the “crowding out” hypothesis base their criticism of fiscal policy on several arguments, the first of which relates to the effects of expansionary fiscal policy on interest rates. In this context it is argued that an increase in government expenditure raises the rate of interest, which in turn reduces investment and thereby neutralises the impact of fiscal policy on aggregate demand (Hemming, Kell and Mahfouz, 2002, p. 4). While this line of argument is repeatedly cited in order to substantiate the alleged ineffectiveness of fiscal measures, closer analysis reveals that it only holds true under very specific conditions.
The argument was first developed in the context of the IS-LM model with the assumption of an exogenous money supply and the idea that the interest rate is determined by the interaction of money supply and demand. Although a “crowding out” effect through rising interest rates is possible in this scenario, it should be noted that the effects of an expansionary fiscal policy on the rate of interest can be (at least partly) offset by a simultaneous increase of the money supply (Arestis and Sawyer, 2003, p. 8)
Against the background of endogenous credit money, with an independent central bank in control of the key interest rate the argument for crowding out through interest rates is even less convincing since the central bank is likely to raise interest rates only if expansionary fiscal policy results in intolerable inflationary pressure. “Crowding out” would then ‘not occur through the response of the markets' (Arestis, 2006, p. 5) but ‘arise from the deliberate actions of the Central Bank'(ibid). Consequently, “crowding out” is a potential rather than an unavoidable corollary of expansionary fiscal policy since the monetary authorities have the discretionary power to determine whether an increase in government spending has adverse effects on private expenditure. Moreover, the causal relationship between rising interest rates and a decline in investment expenditure, which is assumed in this way of reasoning, is disputable as the rate of interest may not be the determinant variable in investment decisions (Arestis and Sawyer, 2003, p. 9). In this context Hemming, Kell and Mahfouz (2002) point out that ‘if investment is an increasing function of current income, multiplier-accelerator models can generate quite large fiscal multipliers even if there is crowding out through interest rates' (p. 4).
A second line of argument denies the need for fiscal policy on the grounds that a monetary policy focused on attaining a supply-side equilibrium - in order to maintain a stable inflation rate - will automatically generate a sufficient level of aggregate demand. The “natural rate of unemployment” and the “non-accelerating inflation rate of unemployment” (NAIRU) are examples of such a supply-side equilibrium position, at which the economy attains its potential output level and inflation is kept at a constant rate. As it is assumed that there is an automatic mechanism which adjusts the level of aggregate demand to this supply-side equilibrium, any increase in government spending will not affect the level of economic activity but merely crowd out private expenditure (Arestis and Sawyer, 2004, p. 71).
In the exogenous money supply scenario this adjustment was assumed to be brought about by market forces, more specifically the so-called real balance effect: when aggregate demand is at a low level, prices will fall, thereby causing the real value of balances of wealth to rise. This effect will allow people to increase their consumption so that aggregate demand is automatically brought back to a higher level (Arestis and Sawyer, 2003, p. 12). Yet, Arestis (2006) indicates that is highly questionable whether this effect does really operate since ‘in an economy of credit money does not constitute net worth and hence a change in price level does not generate any change in net wealth' (p. 5).
In an endogenous money approach, the supply-side equilibrium is not attained through market forces but generated by the central bank's monetary policy. By varying the key interest rate - according to an interest rate-based monetary policy rule as expressed in equation 3 of the NCM model - the central bank does not only ensure a constant rate of inflation but also brings the level of aggregate demand into line with the supply-side equilibrium (Arestis and Sawyer, 2004, p. 71).
While this argument is generally persuasive, the effectiveness of this adjustment mechanism critically depends on the central bank's ability to conduct a powerful monetary policy. If the monetary authority is unable to appropriately adjust the interest rate, fiscal policy can thus play an important role in securing a high level of aggregate demand (Arestis, 2006, p. 5). Moreover, ‘the supply-side equilibrium [...] is not to be seen as something immutable and unaffected by the level of aggregate demand' (Arestis and Sawyer, 2003, p. 12). Rather the increase in investment resulting from expansionary fiscal policy can increase the economy's capital stock and thereby also its future productive capacity, leading to a new supply-side equilibrium with a higher level of both output and employment (ibid).
A third argument against the use of discretionary fiscal policy relates to the so-called Ricardian Equivalence Theorem (RET). This approach suggests that an increase in government spending will not affect the level of economic activity as the fiscal boost to private expenditure will be offset by reductions in consumption spending due to anticipated future taxation. Knowing that the government faces an intertemporal budget constraint and will raise taxes in the future in order to fund the emerging budget deficit, forward-looking consumers will reduce their present consumption expenditure and increase saving. The reverse process will take place in the case of contractionary fiscal policy: if the government raises taxes, consumers are aware that the concomitant reduction in government debt reduces future expenditure and will therefore not alter their consumption but merely reduce saving, leaving aggregate demand unaffected (Fontana, 2009, p. 199).
Just like the previous arguments the Ricardian equivalence proposition has also attracted considerable criticism. First of all, the RET is based on several unrealistic assumptions such as perfect capital markets (i.e. all actors can borrow and lend money at the same rate of interest), the absence of liquidity constraints and perfect foresight of consumers. The approach is also based on long time horizons and ignores the uncertainty associated with future incomes and taxes (ibid). Moreover, people are unlikely to take into account taxes and budget deficits that arise after their death when making decisions about consumption and saving in the present. Yet, the Ricardian equivalence outcome can only occur when people are altruistic in the sense that they care about the tax rises that future generations will have to shoulder in order to pay for the current increase in government spending (Arestis and Sawyer, 2003, p. 13).
In addition to these objections, Post-Keynesian scholars argue that the RET is largely irrelevant as far as “crowding out” is concerned since the proposition only holds true if ‘a budget deficit were introduced into a situation where ex ante investment and savings were equal at full employment (or equivalent)' (Arestis and Sawyer, 2004, p. 73). There is thus a paradox inherent in the RET: “crowding out” can only arise, when aggregate demand is already at a sufficiently high level - a scenario in which no one would call for expansionary fiscal policy. If, on the other hand, there is an excess of ex ante savings over ex ante investment, private effective demand is not at an adequate level and can thus not be “crowded out” by government spending (Arestis and Sawyer, 2003, p. 15). If there are no effective adjustment mechanisms (either in the form of “Say's Law” or a potent monetary policy) that ensure an adequate level of aggregate demand, fiscal policy can then be a powerful tool of stabilisation - without the risk of crowding out private effective demand.
Fiscal policy and the budget position - the question of sustainability
In addition to the argument related to the risk of ‘crowding out', the use of expansionary fiscal policy has also been rejected because of its effects on the budget position. Critics of fiscal policy warn of the risk of unsustainable budget deficits because increased government spending will raise the primary budget deficit as well as interest payments and thereby lead to a continuously growing debt burden. Yet, Lerner (1943) and Domar (1944) and others have demonstrated that this argument only holds true if the rate of interest on government debt exceeds the growth rate of the economy (Arestis and Sawyer, 2004, p. 70). Mathematically this can be illustrated by equation (1), reflecting the growth of government debt, and equation (2), which states the rate of change of the debt to income ratio. In these equations B is the government debt, D the primary budget deficit, r denotes the (post-tax) real rate of interest on government debt and g the rate of growth of income Y. The ratio of the primary budget deficit to gross domestic product (GDP) is then denoted by d= D/Y and the ratio of government debt to GDP by b = B/Y.
It thus applies, that for a given primary budget deficit to GDP ratio of d, the ratio of government debt to GDP, b, would stabilise at b = d/(g - r), if g > r. Consequently, a permanent primary budget deficit does not pose any sustainability problems as long as the growth rate surpasses the rate of interest on government debt (ibid).
Arestis and Sawyer (2004) have extended this argument and maintain that ‘the budget deficit is always sustainable in the sense that the debt to income ratio stabilises rather than continues to grow indefinitely, provided that nominal growth is positive' (p. 70, emphasis added). This proposition rests on the assumption that it is the overall budget deficit (including interest payments) which matters rather than the primary budget deficit as it is the former which absorbs the excess of private savings over investment. Mathematically this can be illustrated by equation (3) which shows that the use of expansionary fiscal policy does not result in unsustainable budget deficits unless nominal growth is negative:
Institutional problems of fiscal policy
The previous analysis has shown that fiscal policy does neither have to result in crowding out nor does it inevitably lead to unsustainable budget deficits. Yet, there are certain institutional and political factors that could potentially limit the effectiveness of discretionary fiscal policy and are therefore used to justify the preference of monetary policy as an instrument for macroeconomic stabilisation.
The first argument relates to the uncertainty associated with economic forecasts. As the future development of the economy cannot be accurately predicted, fiscal policy might be used in a situation, where it is actually unnecessary and could then lead to undesired crowding out effects (Arestis and Sawyer, 2003, p. 17).
In addition to this forecast uncertainty, the efficacy of fiscal policy can also be reduced by inside and outside lags. Inside lags are caused by political decision-making processes and denote the time which policy-makers need to establish whether fiscal intervention is necessary and to introduce appropriate policy measures. Outside lags, on the other hand, refer to the time span that emerges between the adoption of fiscal measures and their actual impact on aggregate demand. Depending on the relationship between these time lags and the length of business cycles, fiscal policy can result in being pro- rather than counter-cyclical and thereby aggravate rather than alleviate an economic downturn. While discretionary fiscal policy does indeed involve long inside lags, outside lags vary according to the chosen fiscal instrument and the economy's institutional system (Fontana, 2009, p. 200; Hemming, Kell and Mahfouz, 2002, p. 4).
While time lags do occur, it is, however, questionable whether they are a valid argument against the use of fiscal policy. As far as outside lags are concerned, monetary policy does not fare any better than fiscal policy so that the preference for the former seems unjustified. The problem of inside lags, is indeed more severe in the case of fiscal policy because changes in taxation or government spending have to be approved by parliament and are thus subject to longer decision-making processes. Yet, this shortcoming could be overcome by adopting a fiscal policy rule which would perform a role similar to the Taylor rule in the case of monetary policy (Setterfield, 2007, p. 416). How such a “pseudo-Taylor rule” (ibid) could be integrated into the NCM model will be set out in detail in the following chapter.
Another argument against the use of fiscal policy can be categorized under the heading of “deficit bias”. For political reasons governments often hesitate to adopt a contractionary fiscal policy during an economic boom and engage in deficit spending even in situations where aggregate demand is already at a sufficient level. This can push the economy beyond the level of full employment and lead to persistently higher deficits. While empirical studies show that political economy considerations and institutional path dependency do indeed make governments averse to cuts in government expenditure and tax increases, this finding cannot be used as a general argument against fiscal policy (Arestis and Sawyer, 2003, p. 19; Hemming, Kell and Mahfouz, 2002, p. 10f.).
As has been illustrated in the previous section, advocates of a “functional finance” approach to fiscal policy hold that a clear distinction has to be made between ‘necessary' and ‘unnecessary' budget deficits (Arestis and Sawyer, 2003, p. 19). While the latter will only increase the public debt burden, the “necessary” deficits are an indispensable tool to absorb excess private savings and stimulate aggregate demand (ibid).
Another criticism of fiscal policy relates to supply-side inefficiencies that could arise from tax-rate volatility. It is assumed that - given the international mobility of capital and labour - changes in tax rates will have an impact on the supply of labour and capital and thereby on economic growth and competitiveness (Hemming Kell and Mahfouz, 2002, p.9). Yet, the validity of this argument is ‘an empirical issue about which clear-cut conclusions have yet to be provided' (ibid) and should thus not be taken to downgrade the use of fiscal policy.
Finally, it has been controversial whether fiscal policy could be an effective instrument for macroeconomic stabilisation in developing countries as most research has focused on its effects in advanced economies. On the one hand, it has been argued that developing countries' susceptibility to supply rather than demand shocks means that there is generally little room for fiscal policy. In addition, governance problems will make it harder to implement fiscal policy measures and financing constraints might seriously circumscribe the government's scope for expansionary fiscal policy. The comparatively high marginal propensity to consume does, on the other hand, entail an increase of the multiplier effect and could thereby enhance the impact of fiscal policy (Arestis and Sawyer, 2003, p. 20).
While it remains questionable whether fiscal measures can be effectively used in a developing country context, this chapter has illustrated that the arguments against the use of fiscal policy in advanced economies do not hold up to scrutiny, when a “functional finance” approach is adopted. With these findings in mind, the next chapter sets out to redress the NCM model's one-sided focus on monetary policy by integrating a fiscal component into its system of equations.
- Given the limited scope of this paper, our analysis will focus on the NCM model in a closed economy setting. It should, however, be noted that ‘international crowding out' (Arestis and Sawyer, 2003, p. 9) can also occur. In this scenario the rise of interest rates resulting from expansionary fiscal policies is assumed to attract capital inflows which trigger an appreciation of the exchange rate and thereby negatively affect the country's current account balance (Hemming, Kell and Mahfouz, 2002, p. 4f.)
- In contrast to discretionary fiscal policy, automatic stabilisers in the form of social security benefits and graded tax rates are associated with only minimal inside lags.