By Ahmad Mobeen
Fiscal policy, treated as a two-sword wielding arrangement in most textbooks, is as catholic and eclectic as one can imagine. In most introductory as well as intermediate courses, it is taught as an action plan with respect to government expenditures and revenue streams, specifically public consumption and taxes. Students are told that, for instance, increasing government consumption would increase the interest rates and “crowd out” i.e. partially eliminate private investments from the economy. Subsequently, this could result in a short-term boom. Similarly, a tax spike is seen to elicit the antithetical response from the economy.
However, the reality is not that simple. Fiscal multipliers vary across countries and time and are contingent upon the sources of policy implementation. Secondly, whether “crowding out” occurs or not depends on whether the level of output (GDP) before implementation was deemed to be above or below the “natural” level. This further relates to the concept of idle resources and their respective capacity costs. Indeed, “crowding in” of private consumption and investment can very much be the direct response to government spending spree if too much of labour force and infrastructure were untapped before the stimulus began.
This discussion is important to understand and disseminate. However, the dangers associated with such a policy initiative must also be highlighted. This article strives to elucidate the under exposed facets of fiscal expansions and contractions.
The Economics of Psychology
[su_pullquote align=”right”]People are much more loss averse than previously thought. They would be willing to take a higher risk for saving losses than, for example, betting for a gain of equal magnitude. [/su_pullquote]
Insights from behavioural economics show us that people are much more loss averse than previously thought. They would be willing to take a higher risk for saving losses than, for example, betting for a gain of equal magnitude. Tax cuts, therefore, would seem like a “discount” to them and they would be much more willing to spend the surplus income than they would have had it been a lump sum increase in their income. This is because spending directly from income is classified as a “loss” by humans, while discounts are treated as “house money” in a game of poker. So spending it does not hurt them in absolute terms.
Conventional economics has a term for this sort of blissful naivety: money illusion. People, most often than not, tend to measure losses and gains in absolute terms rather than in real terms, which exponentially exposes them to economic blunders and mismanagement of resources.
Psychology buttresses the notion that a fiscal expansion of such sort (decreasing taxes) would result in material stimulus in spending due to rising confidence. However, when we refer to the permanent income hypothesis of consumption put forward by Friedman and the eventual Ricardian Equivalence proposition arising from it, we begin to see a model that considers and analyses future-oriented consumption.Rational economic agents realise that the budget deficit due to the decrease in taxes would be taken care of in future by the government. | Photo Courtesy: Visual Hunt
According to it the rational economic agents never fall for the magic trick of tax decreases and rebates. They quickly realise that the resulting budget deficit would have to be taken care of and balanced sometime in future, and that could potentially mean higher taxes up the road to compensate for the present decline. Such an intertemporal approach would result in saving instead of spending. Moreover, when in future the taxes rise, they would be able to pay them off in a uniform and consistent manner.
The Policy in Fiscal Policy
Effective utilisation of resources is also a conundrum when implementing fiscal policy through increased spending and investment. Investing in, for example, public roads and special economic zones would result in a better “multiplier” to boost the GDP; as such an action kick starts a cycle of transactions that ultimately generates a surplus over the original expense borne by the government. This could be in the form of increased wages resulting in increased shopping. Triggering purchases have an effect up to the supply chain, culminating in what is called the “bullwhip” effect: a transaction effect reverberating with increasing amplitude throughout the market chain.
[su_pullquote align=”right”]The ruling parties increase spending and tax cuts when the elections are near, focusing especially on areas and people where their popularity is threatened or where their presence is novel.[/su_pullquote]
However, fiscal policy is notorious for its widespread abuse by the governing authorities, who often rely on it to forward their self-interests. There is a much-discussed notion of “political business cycle” of fiscal policy. Under this policy, the ruling parties increase spending and tax cuts when the elections are near, focusing especially on areas and people where their popularity is threatened or where their presence is novel. As soon as the eventual victory is achieved, however, the spending is abruptly stopped and fund’s recollection and re-utilisation begin. Tax amnesty schemes, farmers support programs, metro structural initiatives etc., are all examples of the electorally implemented fiscal policy.
Where the Government Gets Revenue From
Furthermore, when we begin to scrutinise the operational mechanisms of fiscal expansions, it is clear to conclude that it is costly, and not just to the governments. This is because the government has, broadly speaking, four main sources to fund its budget deficit for fiscal expansions: financing through the central bank, through private banks, through nonfinancial private sector or via foreign assistance. Each of these sources, when utilised, have repercussions on the economy.Every source of financing budget deficit for fiscal expansions can have repercussions on the economy. | Photo Courtesy: Pixabay
Consider the central bank first. The government can fund its expenditures through the central bank either by borrowing (asset extension for the central bank) or by reducing its deposits there (resulting in a decrease in the liabilities of the central bank). Each of these would put a strain on the bank’s balance sheet and it would have to respond by upsetting the position of other assets (decreasing them, in this case) or incurring more liabilities to regain the equilibrium.
Asset reduction would result in the above mentioned crowding out effect as loans to private banks and financial intermediaries would decline, while liability extension would result in inflationary pressures (via increased monetary base, for example) and/or increase in foreign borrowings. Private Banks would face the same complexities as well because there would be a reduction in the amount of loans available to the general public. The banks would have to borrow internationally to maintain the balance sheet equilibrium.
The Role of Households and Firms
Coming towards households and firms, when governments would use them directly as a source of funding, they would be facing asset expansion but would have to reduce other assets such as local and foreign deposits and the company shares they might be owning.
They might also face the need to increase their bank loans and foreign borrowings to manage their day to day affairs, thus increasing liabilities. Also, we can see how these would indirectly affect the balance sheet of the private banks, and eventually the central bank. The whole process triggers a chain reaction throughout the economy which becomes increasingly hard to pacify.
I would not elaborate on the role of foreign debt as a source of government finance, as debt sustainability analysis on its own is one of the most difficult and intricate dilemmas that the nation states face on a broad scale. Suffice to say that an economy overburdened by debt, especially of foreign origin, has to persistently battle profound concerns such as repayment inconveniences, liquidity crises, and stunted growth.
In the light of the arguments and implications discussed above, it is little wonder then that fiscal operations are subjected to substantial criticism and are often not advised except when implemented to support the monetary policy.
The author is a University of London graduate.
Featured Image Credits: Pixabay
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