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Adopting the Right Fiscal Policy Can Prevent a Major Recession

March 11, 2019

Switzerland set the precedent for this type of policy

Martin Feldstein, the George F. Baker Professor of Economics at Harvard University and president emeritus of the National Bureau of Economic Research, recently posed the question, “Is another recession looming?”

Feldstein’s answer: A recession is inevitable, and there is nothing the United States can do to prevent it.

In a recent speech, Federal Reserve Chairman Jerome Powell said, “These last innovations in fiscal policy, at least in the medium term, have probably reduced the amount of fiscal room we have to react.” Ben Bernanke, a former Fed chairman, predicts the economy will continue to grow in 2019 but “Wile E. Coyote will go off the cliff in 2020.”

These economists are referring to the return of trillion-dollar deficits that will undermine monetary policies and overwhelm the U.S. Treasury very soon. Whether we expect a debt crisis in 2020 or shortly after, the outcome would be a global economic disaster. Just look at the turmoil in Argentina resulting from its debt crisis.

Unfortunately, such gloomy forecasts are becoming ubiquitous, lending credence to the view that economics is the dismal science.

 

Fiscal Policy Rules

To test the hypothesis that a recession is inevitable, we simulated a mild recession with budgetary rules in place that would allow the government to pursue a countercyclical fiscal policy.

These fiscal rules impose a government spending limit tied to population growth and inflation. The rules provide for disbursement of emergency funds to offset revenue shortfalls. These funds can be used to finance the increased spending required for automatic stabilizers such as unemployment insurance and other transfer payments. Funds are also disbursed from the capital fund when the growth in gross domestic product is below the long-term average.

With the fiscal rules in place, discretionary spending is stabilized and countercyclical expenditures sustain the level of spending in a mild recession.

A mild recession makes it more difficult to reach the long-term goal of a sustainable fiscal policy. It also increases the magnitude of savings required each year to reach that goal. But our simulation underscores the importance of linking countercyclical fiscal policy to fiscal rules. With the proposed fiscal rules in place, the United States would have the fiscal room to pursue countercyclical fiscal policy.

 

Switzerland’s Cyclically Balanced Budget

Switzerland set the precedent for this type of policy. For decades, Switzerland has pursued a cyclically balanced budget, with deficits in periods of recession offset by surplus revenue in periods of growth.

Economists often argue that fiscal rules tie the hands of elected officials and preclude them from responding to business cycle fluctuations. Switzerland’s experience refutes that argument. Effective fiscal rules let Switzerland pursue a countercyclical fiscal policy during the 2008 financial crisis without increasing its debt-to-GDP ratio.

Because the United States is now a major debtor country, it has less room to pursue a countercyclical fiscal policy. Even so, the fiscal rules we propose would allow the government to pursue countercyclical policies in response to a mild recession. However, the rules would not allow the government to continue to pursue discretionary fiscal policy as it has over the last two decades. Continuing to incur deficits and debt of that magnitude would result in a financial crisis accompanied by stagnant economic growth, as the Congressional Budget Office predicts in its long-term forecast under current law.

 

Action Required

Our proposed fiscal rules allow us to turn Feldstein’s argument on its head. The United States will likely experience a recession and financial crisis if elected officials don’t act. If we fail to enact effective fiscal rules required for a sustainable fiscal policy, his gloomy prediction will likely come true. It is not that we don’t have effective rules available, it is that elected officials refuse to make the difficult choices that would be required.

We should not watch as Wile E. Coyote goes off the cliff. We do not have to wait for credit markets to more strongly signal an unfolding debt crisis in the United States. By enacting new fiscal rules, we can prevent a financial crisis and put the country on the path toward a sustainable fiscal policy.

 

John Merrifield (John.Merrifield@utsa.edu) is a professor of economics at the University of Texas at San Antonio. Barry Poulson (barry.poulson@colorado.edu) is professor emeritus at the University of Colorado, Boulder. This article was originally published at American Greatness and is reprinted with permission.

 

Author
Dr. Merrifield is a professor of economics at The University of Texas at San Antonio, a position he has held since 1987.
john.merrifield@utsa.edu