SESSION 6: CRITICISMS OF FISCAL POLICY AND DEFICIT FINANCING
You are invited to the final unit three session. We hope you have a solid understanding of the concepts we’ve covered in previous sessions. This unit would conclude by examining the criticisms of using fiscal policy as a weapon for demand management and the disadvantages of having a deficit budget.
Objectives At the conclusion of this session, participants will be able to:
- outline the criticisms put out against the fiscal policy
- explain the criticisms mentioned above
Now read on…
Read Session 5: GOVERNMENT BORROWING
6.1 Criticisms of Fiscal Policy and Deficit Financing
Traditional Keynesian techniques for demand management place a substantial emphasis on the use of the government budget to influence the level of economic activity.
After 1945, it was common for governments to borrow money to finance a budget deficit.
During the 1970s, economists grew increasingly concerned about the effects of persistent deficit financing on the economy. This was most prevalent among monetarists.
These economists had a number of criticisms regarding the manner in which fiscal policy measures via the budget were used to regulate the economy’s aggregate demand.
Monetarists were primarily concerned about the impact of government deficit financing on the development of the money supply and, consequently, inflation.
They criticized the discretionary fiscal policy management of aggregate demand and national income for destabilizing the economy.
In addition, they argued that discretionary fiscal policy had little long-term impact on the “real” economy.
By the real economy, they meant the increase in physical output and, consequently, employment, as opposed to a rise in prices, which only leads to an increase in the monetary value of production.
The monetarist critiques of discretionary fiscal policy and government deficit financing can be described in greater detail under the following five headings:
6.2 Intervention versus the Free Market
Keynesians and monetarists frequently have fundamental disagreements regarding the proper function of the government in economic management.
On the one hand, monetarists tend to support free enterprise and competition, contending that government intervention through demand management and fiscal policy measures hinders competitive forces and discourages the growth of enterprise culture.
Furthermore, they argue that government spending is used to shore up declining industries, fostering and perpetuating inefficient production.
Moreover, they contend that high taxation to finance these expenditures hinders the development of new industries and discourages work, saving, and investment.
6.3 Destabilizing the Economy
Keynesian economists view fiscal policy as an effective method for dampening business cycle-related economic fluctuations.
While monetarists argue that discretionary fiscal policy has the effect of destabilizing the economy by exacerbating peaks and busts, discretionary fiscal policy has the opposite effect.
They argue that this is because the government is endeavoring to maintain unsustainable levels of aggregate demand.
This exacerbates inflationary pressures, which are further fueled by increased government spending and a monetary expansion to combat rising unemployment as the industry loses price competitiveness. Also, if the multiplier effect is uncertain, it may be difficult for the government to accurately estimate the magnitude of the fiscal adjustments required to prevent recession (or inflation). Information lags, decision lags, and execution delays may be correlated with government fiscal measures.
6.3.1 Information lags:
Information latency refers to the time between changes in economic activity and the availability of information about recessionary or inflationary trends to policymakers.
For instance, government macroeconomic statistics are sometimes collected and analyzed months after the events they document.
6.3.2 Decision lag:
The lag between policymakers receiving information about macroeconomic changes and government officials deciding on counteracting fiscal measures.
For example, the government’s budget (tax and expenditure plans) may be established only once a year.
6.3.3 Execution lag:
refers to the delay between the announcement of tax and government expenditure changes and their effects on the economy.
6.4 Distortion of Government Expenditures
The majority of government expenditures cannot be ‘fine-tuned’ without negative economic and social consequences. Government-funded civil engineering projects, such as road-building programs, cannot be rapidly turned on and off.
Leaving initiatives incomplete may not be economically prudent.
Equally, adjusting state pensions, education spending, and health care based on the condition of the business cycle is difficult and could be economically and socially detrimental.
From this vantage point, government spending plans are not an effective instrument of discretionary short-term fiscal policy.
6.5 The Impact of Deficit Financing on Private Sector Investment
According to monetarists, when the government borrows to finance budget deficits, interest rates on the financial markets rise.
While the government has the ability to pay increased interest rates by raising taxes or borrowing additional funds, private firms do not have the same option.
Faced with higher interest rates, which can result in higher exchange rates, they may be compelled to reduce investment expenditure.
Economists refer to this phenomenon, in which increased government spending financed by increased borrowing reduces private sector investment, as crowding out.
Crowding out refers to the decline in private sector spending caused by an increase in government borrowing on the capital markets to finance government expenditure.
The extent of crowding out will depend on how much interest rates rise and how much private spending, particularly investment, is stifled by the higher interest rates.
6.6 Budget Deficit, Money Supply, and Inflation
According to monetarists, a persistent budget deficit forces the government to borrow more from the banking sector, which causes the money supply to expand much quicker than the output of goods and services, resulting in inflation.
This is summarized by the common monetarist slogan, “Too much money chasing too few goods causes inflation.”
As money supply and inflation increase, firms’ international competitiveness decreases and unemployment rises.
In this session, we have examined the arguments against the use of discretionary fiscal policy as an instrument for managing demand in a countercyclical manner.
On the basis of this premise, monetarists argue that governments should not attempt to directly manage aggregate demand but should instead concentrate on creating a stable monetary environment in which private enterprises can flourish.
Self-Assessment Questions
Exercise 3.6
- What do you understand by the term ‘crowding-out’ and when is it likely to be most prevalent?
- Why do economists tend to become more cautious about the benefits of Keynesian ‘fine-tuning’ of the economy?
- Explain information lags, decision lags and execution lags.
- Explain the criticisms put forward by monetarists against fiscal policies.
CONTINUE WITH UNIT 4, SESSION 1
