MMTed - Home Page of Public Education in Modern Monetary Theory

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OK, now we've been talking a bit about fiscal policy already, and what does that mean?

Well, fiscal policy is about government spending and taxation. And so typically each year, the government will design what they call a budget. You'll note that I don't use that term in relation to governments because it invokes the household budget analogy.

So it's a framing issue in my view.

So I call it a fiscal process or statement. But each year the government will sit down and work out their spending plans and their tax policies, and they have various ideas about why one would go up and down and all of that. So in this neoliberal era, governments have a tendency and this is reinforced by inputs from economists to think of the fiscal position.

That's the difference between government spending and taxation as a target in itself. So in an accounting sense, if the government spends more than it gets back in tax, it's running a deficit and if it spends less than it's getting back in tax, it's running a surplus. And the political narrative has been to say that surpluses are good and deficits are bad. And so we we need to target surpluses.

And you get a situation where, say, a government starts with a deficit. And economists advise them to introduce an austerity programme because that'll reduce the deficit if they cut spending and maybe increase taxes or do both.

And at the end of the year, when the accountants come out and tell the government what's happened, they observed the deficits actually gone up. And the national debt has actually gone up.

Because they match the deficits with debt issuance.

So what gives?

What gives is that the government really can't control its fiscal outcome. And what does that mean? It means that non-government sector is a determinant in what the final fiscal position will be in each period by our saving and spending decisions. How does that work?

Well, that works because when we spend more, for example, economic activity rises, firms produce more, national income rises, and as a consequence, tax revenue rises and welfare spending falls even if the government doesn't change anything.

And so when the economy stronger, operating at higher pressure, the fiscal deficit will fall automatically.

Now, take the opposite example. If the government starts hacking into spending with the target of reducing its deficit, you now know from the simple macro rules we've built up that that cuts in government spending will cause firms to lay off workers, incomes in the economy will drop, spending will drop and tax revenue will drop and welfare spending will increase. And so without the government doing anything other than trying to pursue austerity, the deficit rises even though it thought that it would be reducing it and debt rises because the deficit is rising.

And so it's a flawed strategy to target a particular fiscal balance, and this leads to us to understand that the purpose of fiscal policy is not to achieve any specific fiscal position, it's to achieve full employment and prosperity, material prosperity. And the deficit will be whatever's required to do that. Or it could be a surplus depending upon the non-government sector spending decisions.

So when the non-government sector is spending strongly, the government can spend less strongly.

And when the non-government sector decides to reduce its spending in the economy, the government automatically has to increase its net spending to maintain high levels of employment and economic activity.

That's the purpose of fiscal policy, and that should be the only concern of government.

End of Transcript

Study Notes:

Governments all around the World regularly release their forecasts of what the fiscal balance will be in the coming years. They even adopt voluntary fiscal rules which limit their discretion by imposing quantitative limits beyond which they claim it is dangerous to move.

In the Eurozone, for example, the Stability and Growth Pact restricts fiscal deficits to being no more than 3 per cent of GDP, except in exceptional circumstances, such as we have seen during the pandemic.

Much is made of these numbers in the media and they become ends in themselves. The problem is they have no meaning without context, and, the government cannot control the outcomes anyway. Further, they divert our attention away from the actual purpose of fiscal policy, which is to advance well-being.

Net government spending (that is, government spending minus taxes net of transfers) is determined by two broad forces:

The discretionary decisions that the government takes in setting its fiscal policy (that is, levels of expenditure and tax rate(s)).

The state of the overall economic cycle impacts on net taxes and hence net government spending. For example, when the economy is performing badly, net taxes will fall because of both lower taxes and higher welfare payments even without any explicit change in government policy settings.

The opposite will be the case when the economy is growing strongly, and unemployment is falling.

We call these effects cyclical because they vary with the state of the economic cycle. They are also termed the automatic stabilisers because they function automatically and act to stabilise total spending in both directions.

How do they stabilise?

When the economy is moving into recession as non-government spending declines (either in growth terms or absolutely), the fiscal deficit rises (tax revenue falls and welfare spending rises due to less people in employment). The rising fiscal deficit helps staunch the decline in total spending in the economy and attenuates the depth of the recession.

When an economy is overheating, the fiscal deficit falls or the government enters surplus (because of the strong tax revenue and lower welfare payments) and this automatic contraction in net government spending helps ease spending pressures in the economy.

Appreciate that these stabilising effects are automatic. The government doesn't have to alter any policy settings for them to kick in. They are intrinsic to any tax and transfer structure that is sensitive to the economic cycle.

Now how does this make it unlikely that the government can achieve any particular fiscal outcome?

While governments impose all sorts of voluntary rules on themselves which constrain their fiscal latitude, the reality is that the spending and tax legislation that ultimately emerges out of the political process does not determine what ex post spending and tax revenues will be since these depend on spending by the non-Government sector, due to the operation of automatic stabilisers.

Ex post is just a fancy expression for 'when the dust settles'!

So, what should governments being doing with fiscal policy if not chasing numbers that continually elude them?

MMT adopts the principle of functional finance, which was introduced in two important publications in the 1940s by American economist Abba Lerner.

In his article on functional finance, Lerner wrote (1943: 39):

The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money, and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound or unsound.

By way of summary, Lerner argued (1943: 41):

Functional Finance rejects completely the traditional doctrines of ‘sound finance’ and the principle of trying to balance the budget over a solar year or any other arbitrary period. In their place it prescribes: first, the adjustment of total spending (by everybody in the economy, including the government) in order to eliminate both unemployment and inflation, using government spending when total spending is too low and taxation when total spending is too high; second, the adjustment of public holdings of money and of government bonds, by government borrowing or debt repayment, in order to achieve the rate of interest which results in the most desirable level of investment; and third, the printing, hoarding or destruction of money as needed for carrying out the first two parts of the program.

In other words, the purpose of fiscal policy is to achieve advances in well-being (social and environmental), which includes providing jobs for all those who want to work, providing first-class public infrastructure and services (including health, education, transport, etc) and ensuring that everyone can participate meaningfully in society.

Of course, that purpose reflects my values (refer back to Week 1) and may not reflect yours.

The point is that the fiscal policy is there to achieve productive resource configurations that serve some purpose. Once the mission is set, then it doesn't matter what the final fiscal outcome is as long as the mission outcome is sustainable.

References

Lerner, A. (1943) 'Functional Finance and the Federal Debt', Social Research, 10: 38–51.

Lerner, A. (1944) The Economics of Control: Principles of Welfare Economics, New York, Macmillan.

3.2 Fiscal Balance and Automatic Stabilisers

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