Fiscal Policy, Past and Present

RECENT EVENTS EXPOSE SOME OF the difficulties of making timely and rational fiscal policy choices. The recession that began in early 2001 has likely been over for several quarters, but as of early 2003 the Business Cycle Dating Committee at the National Bureau of Economic Research (NBER) had not yet declared its end, and economic growth has been tepid. The ideal time for countercyclical fiscal measures may have passed, but politicians remain under pressure to act. Politics aside, the current economic climate has many unusual attributes that may provide support for expansionary fiscal action. First, despite several quarters of positive economic growth, the unemployment rate remains relatively high, in part because of unusually rapid productivity growth during the recent recession. Second, the vigorous use of monetary policy over the last few years has left the federal funds rate at 1 percent, its lowest point in over four decades. With this primary tool of monetary policy so close to its lower bound of zero, there is concern that monetary policy will be helpless should the economy relapse. Third, the recent war in Iraq has contributed to an atmosphere of economic uncertainty. Finally, state governments face large budget deficits, which past practice suggests, and the laws of most states require, be followed by substantial tax increases and expenditure cuts in the coming months, possibly weakening economic activity. Apart from the usual problems of timing and uncertain efficacy, potential fiscal expansion in the current environment faces an additional hurdle: it would occur during a period of fiscal stress at the federal level. The federal budget surpluses of recent years have evaporated, and a major crisis of unfunded entitlement programs lies just beyond the moderate deficits projected for the near term. This significant fiscal imbalance lends an air of recklessness to proposed expansionary policies and could make some of these policies less effective, if they are perceived as unsustainable. Thus the long-term fiscal imbalance may have implications for attempts at short-term stabilization policy. What, then, is to be done? This paper approaches the question by first describing the current circumstances in greater detail and then considering the determinants of past fiscal policy actions. Although this discussion provides a reasonably good sense of how fiscal policy has reacted to the economy in recent decades, a harder question is how policy in turn has affected the economy. Indeed, given the extent to which today's circumstances differ from those in the past, there is reason to be cautious about past evidence on the economic effects of policy, at least as a guide for future policy decisions. The Fiscal Climate The NBER dates the most recent recession as having begun in March 2001, and current statistics from the Bureau of Economic Analysis (BEA) indicate that real GDP fell in each of the first three quarters of calendar year 2001, a period that ended just after the September 11 attacks. Growth has been positive for six consecutive quarters since then, but growth in the most recent quarters has been weak, and unemployment remains at or near 6 percent. Fiscal policy has been active during this period, with President Bush's 2001 tax cut followed by a smaller round of tax cuts in the spring of 2002 and large increases in spending on defense and homeland security. The combination of economic weakness, tax cuts, and increased spending has sharply altered the short-term fiscal outlook. The high-water mark for projected budget surpluses was January 2001, when, in the last in a long series of upward revisions, the Congressional Budget Office (CBO) projected a surplus of $359 billion for the current fiscal year, 2003, rising to $889 billion in fiscal year 2011. (1) At the time, some saw a novel fiscal challenge looming with the possible disappearance of marketable government debt, but this "problem" now commands less attention. …