A balanced Budget: goodbye fiscal policy

IMG_1589Before the Second World War all budgets were balanced.  It was not until the adoption of Keynesian demand management that the budget was seen as a method for managing the overall level of economic activity.

The simple rules followed were a balanced budget when national income was in equilibrium at full employment: a budget deficit to close a deflationary gap and a surplus to mop up the excess demand of an inflationary gap.

The simplicity of this technique overshadowed a number of inherent problems.  Firstly what was the full employment equilibrium level of national income?  Secondly could the level of demand be manipulated to sustain this equilibrium?  Thirdly the fact that politicians would always like to be advised that they must increase expenditure and cut taxation, but how to advise the opposite and make it politically acceptable?

These problems were not highlighted during the 50’s and 60’s because a cautious policy was pursued, constrained by the need to maintain a satisfactory balance of payments position and so protect the sterling exchange rate.  In contrast, after 1972 very large budget deficits began to be recorded.  The most extravagant year was 1975/76 when the PSBR approached 10% of GDP.  Budget deficits continued throughout the 70’s and into the 80s and at no time have they produced what the Keynesian textbooks predicted, namely a permanent rise in employment levels.  On the contrary thy have been linked with continually rising unemployment.  The first reason to remove budget deficits is that they do not create jobs.  Secondly budget deficits are incompatible with monetary targets.

It has been argued elsewhere that monetary targets are an essential part of a monetarist strategy and it is the fact that low monetary targets are inconsistent with deficit budgeting, particularly large deficits.  The reason for this is that a large budget deficit can be financed in one of two ways, either the money supply can be expanded or the debt may be sold nationally and internationally to real people.  Non-inflationary debt financing of large deficits requires interest rates to be raised at the expense of choking-off private sector investment and credit financed consumption.  This was illustrated during the early years of Tory office.

By contrast, if the budget is balanced, there is no threat to the pursuit of non-inflationary monetary policy.  Since the government has no need to borrow at all it does not have to borrow from the banks or print money.  Also it will allow market forces to determine the rate of interest with no choking effect of excessive government borrowing  At the same time if there is an excessive growth of private sector credit, this can be reined back by the traditional techniques of monetary management e.g. open market operations, special deposits etc.  A balanced budget is clearly consistent with, although not necessarily sufficient for price stability.

Another advantage of the balanced budget rule is that in political terms it is obvious and everyone can understand that more expenditure can only be financed by more taxation.  This now becomes transparent rather than hidden by inflation and debt financing.

The balanced budget rule offers a number of advantages and no long term disadvantages.  The only problem that may exist is of a short term nature and is associated with the rate at which you move from unbalanced to balanced budgets.  Nevertheless the argument will be completed by a quote from J.M. Keynes – “We have the experience of many countries to demonstrate that unbalanced budgets are the initial cause of collapse”.

John Hearn May 1983

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One thought on “A balanced Budget: goodbye fiscal policy

  1. ” . . . everyone can understand that more expenditure can only be financed by more taxation. ”

    “Here is a graph of the difference between cumulative tax revenue and cumulative federal spending in the US since 1789. The US started to run fiscal deficits systematically in 1931 and since then has run deficits 85 per cent of the time. Every time they had tried to run surpluses a recession has followed.
    Note the gap widens after the early 1970s, which of course is when the Bretton Woods system of convertible currencies and fixed exchange rates was abandoned and the US government adopted a fiat currency system.
    It seems that public spending is not paid for by taxes over a long period of time. Funny about that!”
    http://bilbo.economicoutlook.net/blog/?p=29761#more-29761

    Like

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