The Means to Prosperity

Per Gunnar Berglund, Matias Vernengo, Per Gunnar Berglund, Matias Vernengo

• Publisher: Routledge
• Year: 2007
• ISBN:
  9781135991630
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Negocios en general

While recent developments in monetary theory have been fast to spread to policy analysis and practice and the media, the same is not true of fiscal policy, and a void has emerged. Issues such as timing, cyclical adjustments, long-term sustainability, and social implications are often seen as detached from discussions in the public arena.This book fills this gap. It delivers a keen assessment of the role and scope of current fiscal policy. New contributions and critical reviews of state of the art research analyze fiscal policy in terms of viability, potency, consequences and sustainability, and also shed light on its relation to economic and political ideas.The general tone of this volume is cautiously favourable of fiscal activism, although the emphasis is placed more on medium-term adjustments than on short-term 'fine-tuning'. The authors believe that the legacy of the last fiscal revolution has been an excessively negative view of deficits and debt, and believe that this volume will contribute to open a dialogue on fiscal issues, and bring back a more balanced view of fiscal policy. With contributions from leading authorities including Barbara Bergmann, Jeffrey Frankel and David Colander, this is a major new contribution to the field.

1 Fiscal policy reconsidered
Introduction
Per Gunnar Berglund and Matias Vernengo

Few nations can claim to have been built on the basis of a tax revolt, and even fewer can claim to have been obsessed with taxes throughout their history.¹ America, however, is a nation obsessed with fiscal policy, even if this obsession is a subconscious one. The American Revolution was based on the principle “no taxation without representation.” Benjamin Franklin said, “In this world nothing is certain but death and taxes.” We may add that it is all but certain that Americans will put up a fight, sometimes to death, if taxes are involved, as exemplified by Shay’s Rebellion, and the Whiskey Rebellion. The obsession has not subsided with time, and the twentieth century has had its fair share of fiscal revolutions.

Herbert Stein – the head of Nixon’s Council of Economic Advisers – wrote in 1969 an authoritative account of the last fiscal revolution in America at that point. The book told the story of the rise of Keynesian fiscal policies from Herbert Hoover to Lyndon B. Johnson. Policies did not change overnight. In fact, it was a long process in which the view of fiscal policy changed partly because facts changed, partly because the interpretation of facts changed. Policy priorities were guided by the experiences of the Great Depression and World War II, making full employment the prime objective, and fiscal policy served as the most important policy tool with respect to this goal.

Few anticipated the profound changes in economic environment and policy outlook that would take place in the following quarter century. The Keynesian consensus portrayed by Stein was largely abandoned in the turbulent 1970s, as economies were mired in concurrent inflation and mounting unemployment. In the course of this fiscal counter-revolution, monetarist ideas gained currency and combating inflation became first priority in economic policymaking. A new consensus gradually emerged, establishing the current hegemony of monetary policy over fiscal policy and independent central banks over Treasuries and ministries of finance.

The war on inflation has been overwhelmingly successful, even if the victory was not just won by monetary policy alone. Inflation is now virtually nonexistent in industrialized countries, and generally subdued in the developing world. The victory over inflation was, however, bought at a high cost in terms of sluggish growth, high unemployment and income inequality in many parts of the world, giving rise to a host of economic and social problems that take their toll. Social protection and the welfare state have become increasingly strained by mounting demands and deficient revenue flows, in what has sometimes been referred to as the fiscal crisis of the state.

There is now widespread discussion of the risks of general stagnation, and the specter of a liquidity trap rendering monetary policies ineffectual. The world economy is slowly recovering after three years in the doldrums. Little stimulus is to be expected from the Japanese and European economies, due not least to concerns about budgetary deficits and the limits imposed by the Stability and Growth Pact. The burden of pulling the world economy out of stagnation thus falls upon the shoulders of the United States, whose sizeable twin deficits (of the federal budget and of the current account of the balance of payments) may add further complications to this already difficult task.

Developing countries are strapped in a direr situation, if that is possible. In many cases external liberalization – forcefully pursued for more than a decade now – has meant that revenues have fallen at a time when globalization calls for increasing social spending. The increased fiscal strains derive from a fall in revenues, often associated with lower tariff revenues, and with higher spending on debt servicing, due to higher interest rates.

In these circumstances, the role of fiscal policy has become subject to renewed interest. With interest rates at their lowest levels in decades, and in some cases very close to zero, the scope for further monetary stimulus does seem limited. It is yet unclear whether monetary policy action taken hitherto will suffice to stage a broad recovery in asset prices and economic activity. Pessimists have warned that fiscal policy may be the only way to bring about the desired outcome.

The aim of this introductory chapter is to analyze the evolution of the dominant views on fiscal policy, clarify questions regarding the efficacy of fiscal policy in the short run as well as its long-run sustainability, and to explore the different dilemmas imposed on the developing world. As such, this chapter will serve as a guide for the original contributions in the subsequent chapters. The rest of this introduction is divided into three subsections. The following one will discuss briefly the changing views on fiscal policy within the profession, and provide a picture of what is the current tendency in the profession regarding short-term efficacy and long-term sustainability. The final section provides an overview of the chapters to follow and an evaluation of their convergence and divergence from conventional wisdom.

The changing consensus on fiscal policy

Most economists in recent decades would agree that future generations bear a burden resulting from public spending financed internally by public debt and taking place in the current period. The burden of public expenditure financed by debt consists of the reduced private consumption supposedly required by the withdrawal of resources from the private sector. The view of government debt as a burden on society, particularly an intergenerational burden, is however relatively new. It derives from the work of James Buchanan, starting in the 1950s, and was consolidated around the 1970s, in the midst of the crisis of Keynesian economics.

In historical perspective, economists’ views on whether public debt is a blessing or a burden have changed significantly. During the eighteenth and nineteenth centuries they were dominated by the principles of sound finance and balanced budgets. Yet most laymen and politicians at the time saw government debt, albeit in moderation, as a blessing rather than a curse. For example, Alexander Hamilton, the first Treasury Secretary and main strategist of the economic system in the post-independent United States, argued for the development of a national public debt as a form of providing a strong central government. Hamilton saw government debt and a national public bank as the pillars of the British economic success that he wanted to emulate in America. Economists, on the other hand, saw public debt with apprehension.

This changed in the early part of the twentieth century. The Keynesian Revolution, and even more emphatically Abba Lerner’s functional finance theory, provided the rationale for the idea that public debt would be helpful in a crisis. Functional finance established that, under certain conditions, government debt is an essential feature of a healthy economy. Within the mainstream of the profession, it was also argued that debt was a useful policy instrument. In a general equilibrium system with incomplete markets, public debt may assist capital formation and lead to higher rates of growth. Politicians, on the other hand, were not quite convinced about the positive effects of debt.

Starting in the 1950s, the benign view of public debt gradually gave way to a more pessimistic position. In most industrialized countries, the ratio of public debt to Gross Domestic Product (GDP) showed a declining tendency in post-war era, the downward trend turning only with the onset of serious unemployment and inflation in the 1970s. The change in views on the debt must therefore be attributed primarily to concerns about the potential consequences of the brisk growth in public expenditures and the expanding welfare state. The process of globalization – the liberalization of movements of goods, services and capital – since the end of Bretton Woods, has led to a proliferation as well as an increased accessibility of tax havens. Moreover, the increase in tax competition and interest rates made public debt more difficult to service. Finally, the stagflation of the 1970s, and the conservative reaction that followed, fed a tax revolt that made increasing tax burdens to finance public debt unlikely. Measures to contain spending, and to reduce the burden of debt became more common. The most well-known policy measure to curb debt is undoubtedly the Maastricht limits on the ratio of public debt to GDP, which is imposed on the member countries of the European monetary union.

In the nineteenth century, as economics established itself as a respectable discipline with a place in the most important universities, balanced budgets were seen as essential, not just to keep the debts at sustainable levels, but also to avoid excessive burdens on the poor. William Gladstone, the prime minister that dominated British politics in the second half of the nineteenth century, believed that the miseries of the poor stemmed from the unnecessary burden of indirect taxes, which are paid mostly by the poor (Maloney, 1998, p. 32). For this very reason he fought for the imposition of income taxes.

With the depression and the advent of Keynesian economics, the role of the state changed significantly. Income tax and social security contributions became the main source of revenue, and the role of indirect taxes diminished. A progressive income tax – once advocated as a radical measure – became standard in the Western world. By the late 1970s, tax revenues in the developed countries ranged from slightly less than 30 to more than 50 percent of GDP, and some authors foresaw a fiscal crisis. According to O’Connor (1973) a structural gap developed, the ability to raise taxes was limited, and the social demands were virtually unlimited. Tanzi and Schuknecht (2000) argue that the increase in the size of government, and the pervasive fiscal deficits in the last 30 years did not lead to any social or economic advantages. According to them, since the 1960s the size of the state increased without leading to higher levels of income per capita or a better distribution of income. As a result in their view, the tax burden and expenditures should be considerably scaled down.

The growth of government measured by spending or tax revenues as a share of national income exhibits a secular trend. Wagner’s Law – a positive long-run relationship between public expenditure and output – is apparently alive and kicking. The reasons for the secular growth in government are varied and related to the public view of what a government should do. The processes of industrialization and urbanization intertwine with the growth of government. Factory work and city life gives rise to pressures for the provision of public goods and social protection. It is also clear that the enlargement of the franchise and the general movement toward democratic institutions allowed for an expansion of social rights, and the number of tasks imposed on governments. The welfare state – the apotheosis of Wagner’s Law – then results from technological and demographic trends, as well as democratic institutions and hard-won battles for social rights.

The impressive increase in the flows of trade and capital, that came to be denominated globalization, are seen by many authors as having dealt the last blow to the welfare state. In particular, tax competition might seem to erode the tax base, while globalization requires a more comprehensive social safety net. Globalization then forces higher spending while it erodes the ability to obtain higher revenues, leading to a fiscal squeeze. Also, the previously fiscally friendly demographic conditions, with many contributors and few recipients of pension benefits, will change in the next quarter century in most developed countries, increasing the burden of payments, and making a fiscal crisis more likely. But, like the proverbial decease of Mark Twain, rumors of a fiscal crisis may be considerably exaggerated so far.

Alarmist academic and public debate notwithstanding, trends of expenditures on social protection are stubbornly pointing upward in most parts of the world. A quarter century of sustained efforts on the part of policymakers to check spending growth seems to have taken its toll mainly on government purchases of goods and services, with public investment suffering most drastically from the cutbacks. Although the effects of these reductions are subject to some controversy, there is widespread consensus that investment in infrastructure, education and health care are more conducive to long-term economic growth than are transfer payments. In this perspective, one cannot help noting the irony that it is the relatively productive activities of government that have been sliced while the unproductive expenditures keep pouring from the public coffers like an unstoppable lava stream. These trends carry an important a message about the sometimes-loose relationship between public discourse about political priorities on the one hand, and economic realities and necessities on the other.

While anti-government sentiments have long since permeated the political rhetoric, there is in fact no clear evidence of the death – or even a significant reduction of the size – of the state, at least in macroeconomic terms. The last 30 years, however, usually associated with globalization, have seen an increase in the size of the debt. These budgetary difficulties emerged alongside rising unemployment and sluggish growth, with the former forcing higher expenditures and the latter restraining revenues.

High levels of public debt, some fear, may reduce – for political reasons mainly – the ability of governments to run deficits in times of crisis. The impressive growth of the size of the debt over the last two centuries in most developed countries went hand in hand with the process of industrialization and capital accumulation that raised the welfare levels of their populations. However, the increase in public debt led to rising fears of a collapse of the tax state. The question of whether government debt is a blessing or a burden on society is a crucial one that economists have been groping with for the last two centuries at least.

If economists’ views on the effects of government debt have swung back and forth over the years, the same is true in the political arena. For example, with the foundation of the National Debt in 1693, and the Bank of England in 1694, public finance became a major topic in political economy debates in England (Hamilton, 1947). As a general rule, conservatives saw the debt as an inappropriate increase in the power of the crown and a threat to individual liberties. On the other hand, Whigs saw public debt as the basis for the development of the financial sector, and the expansion of trade. The political conflict can be seen as a dispute between creditor’s interests (Whigs) versus debtor’s interests (Tories).

Among the founding fathers of political economy, David Hume and Adam Smith expressed clear ideas about government debt. The usual identification of Hume as a Tory – in particular because of his historical writings – means that his views on public debt are usually associated with the conservative country party. Hence, Rotwein (1955, p. lxxxvi) in his authoritative introduction to Hume’s writings on economics argues, “what he [Hume] seeks to show is that the inevitable continued rise in debt will not only have the gravest consequences for society but will ultimately terminate in total bankruptcy.”

While it is clear that Hume was concerned, and was critical of the increasing size of public debt, he was not a dogmatic critic of the fiscal policies of the crown. He clearly refers to the ill resulting from public debt, but he also claims that some good results from a national debt (Hume, 1955, pp. 90–107). Adam Smith was also more concerned about the dangers of bankruptcy than the possibilities for expanded trade that government debt facilitated (Smith, 1776, Book 5). However, one must note that Smith thought that taxes hindered capital accumulation in a way that government debt did not. As noted by Winch (1998, p. 13), McCulloch criticized both Hume and Smith, for not perceiving that output growth made the burden of debt easier to carry.

David Ricardo’s contributions to the question of public finances have cast a long shadow. Ricardo was even more concerned than his predecessors about the negative effects of taxes and public debt on capital accumulation, and considered the British debt, together with the Corn Laws, one of the two great evils plaguing the nation (Winch, 1998, p. 18). For Ricardo (1817, pp. 150–2) taxes either reduce capital accumulation or force tax payers to reduce consumption. Debt, as deferred taxes, had the same effect, and hence Ricardo was for paying down government debt, and maintaining a relatively low level of taxes – measures that at that time were opposed by both Whigs and Tories. This view was later revived as the Ricardian equivalence theorem (Barro, 1974).

Thomas Malthus – personal friend and main intellectual foe of Ricardo – not surprisingly held different views reg...