Severity of Economic Fluctuations under a Balanced Budget Amendment

Economists generally accept the notion that fiscal policy has been an important contributor to economic stability in the United States since World War II. The Clinton Administration founded its objections to the Balanced Budget Amendment on the argument that tying the government's hands during times of recession and eliminating the automatic stabilizers built into the federal budget would increase the economy's instability. However, the view of fiscal policy as a stabilizer has not gone unchallenged. First, as any macroeconomic textbook will point out, active fiscal policy is subject to "inside" and "outside" lags. Mis-timing of fiscal policy actions due to these lags can be a source of instability rather than stability (Mankiw, 1994). In support of this argument, Carlson (1987) surveys fiscal policy since 1946 and finds that most fiscal policy action was the "wrong" policy from the perspective of moving output towards its potential level. Second, even if fiscal policy reacts in a timely, countercyclical fashion to economic fluctuations, it is not clear whether the actions taken or their associated multipliers are large enough for fiscal policy to have a significant effect. Whether fiscal policy has helped stabilize the economy is an important empirical question in light of the recent debate on the balanced budget amendment. However, little empirical work has appeared on this topic in recent years. In fact, since the mid-1970s, only Romer and Romer (1994), study the contribution of monetary and fiscal policies to economic recoveries in the post-war era. They find that fiscal policy has played only a minor role in generating recoveries, while monetary policy has had strong stabilizing effects. The analysis here extends Romer and Romer's examination of the role of fiscal policy (both active policy and automatic stabilizers) during economic recoveries and to the recession periods as well. Most importantly, unlike Romer and Romer's single equation approach, the study here uses a vector autoregression (VAR) approach to modeling the output-policy interactions. Based on the estimated dynamic multipliers from their regression equation, Romer and Romer find that fiscal policy makes a modest contribution to GDP growth during economic recoveries. As Cochrane (1994) argues, however, the dynamic multipliers on fiscal policy are mix-specified because they do not take the monetary or fiscal policy "reaction functions" into account. In the VAR approach, the impulse response functions characterizing the dynamic response of output to fiscal policy variables incorporate the endogenous response of the Federal Reserve and fiscal authorities and therefore provide a more accurate reading of the "true" effect of fiscal policy actions. An ancillary advantage of the VAR approach is that it reveals which types of exogenous shocks tend to be important in generating recessions and assisting in recoveries. The main question here is whether automatic stabilizers and active fiscal policy have helped stabilize the U.S. economy during recent recessions. The answer to this question bears directly on the current debate over the wisdom of a balanced budget rule, whether enforced by a constitutional amendment or by political consensus. The data show that fiscal stabilizers have had a large stabilizing effect in the last four recessions and in the recoveries that followed. While monetary policy plays a major role in generating recoveries, the Federal Reserve's typical response to movements in output would be insufficient to compensate for the greater instability brought on by a balanced budget rule. I. STABILIZATION POLICY IN A VAR MODEL The following structural vector autoregression (VAR) model (Y-F-B) represents the interactions between economic activity (Y), monetary policy (F), and fiscal policy (B): [Mathematical Expression Omitted] In these equations, y, is the log of real GDP;[f.sub.t] is the real federal funds rate, which measures monetary policy(1); and [b. …