"This is something I have long wondered about. And reading Jeff Frankel's complaints (HT Mark Thoma) about pro-cyclical fiscal policy made me wonder about it again. And I do mean "wonder about". I am not at all sure that this idea is right, or even theoretically coherent. But I wonder if it might be."
"In a nutshell: if there is a unit root in GDP (so that some part of any fluctuation in GDP lasts forever), or if there is perceived to be a unit root, might that explain why fiscal policy is, or appears to be, pro-cyclical?"
http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/03/the-unitroot-zombie-dead-but-still-wreaking-havoc.html
Is it me or does Nick seem not to post so much anymore? It's my perception anyway. If so it is a pity though there is more than enough in the archives for me to feast on for awhile.
He also links to his colleague over at Worthwhile Canadian Initiative, Stephen Gordon. I honestly have never read anyone but Nick before, but after seeing some of Stephen's work I realize that's a mistake.
I will quote Nick's paragraph where he links to him:
"From what I read (but don't properly understand) from econometricians like Stephen, econometrics tests of unit roots just aren't powerful enough to tell us for sure whether or not there exist some permanent effects. They can only maybe tell us that, if there are permanent effects, those permanent effects won't be bigger than some proportion. Econometricians don't know if there are permanent effects, so we can't expect policymakers to know."
This whole issue of a unit root is interesting stuff though for now I just want to stick to the idea of whether fiscal policy is indeed pro-cylical.
In principle, simple intuitiion says that you don't want that, and Keynesian theory certainly dictates that you want deficits during a recession and surpluses during a boom. However, it's clearly not how fiscal policy has been done in recent years in the U.S. or Europe. Indeed, as Frankel aruges, it hasn't been counter-cyclical in any first world country in recent years:
"The world’s advanced economies remain divided over whether to strengthen budget balances in the short term or to use fiscal policy to promote recovery. Those worried about the short-run contractionary effects on the economy call the first option “austerity”; those concerned about long-term sustainability and moral hazard call it “discipline.”
"Pro-cyclical fiscal policy worsens the dangers of overheating, inflation, and asset bubbles during booms, and exacerbates output and employment losses during recessions, thereby magnifying the swings of the business cycle. Yet many politicians in the United States, the United Kingdom, and the eurozone seem to live by it. They argue against fiscal discipline when the economy is strong, only to become deficit hawks when the economy is weak."
"Consider the positions taken over the last three decades by some American politicians.
In his 1980 campaign and again in 1981, a period of recessions, President Ronald Reagan urged immediate action to reduce the national debt."
"In 1988, however, as the economy approached the peak of the business cycle, candidate George H.W. Bush was unconcerned about budget deficits, even though the national debt was rapidly approaching three times the level that it had been under Reagan. “Read my lips: no new taxes,” Bush famously declared.Predictably, Bush and the US Congress finally summoned the political will to raise taxes and rein in spending growth at precisely the wrong moment – in 1990, just as the US was entering a recession. Although the timing of the legislation was poor, the action was courageous: pay-as-you-go (PAYGO) budgeting rules and other reforms deflected government finances back onto a path that eliminated the budget deficit by the end of the decade.".
"But, three years later – at the start of the most robust recovery in American history – all Republican congressmen voted against President Bill Clinton’s 1993 legislation to maintain Bush’s spending caps, PAYGO, and tax increases. Even after seven years of strong growth, at the peak of the business cycle in 2000, with unemployment at record lows, George W. Bush based his 2000 campaign on a platform of large tax cuts.After recovery from the 2001 recession had gotten underway, and the inherited budget surpluses had nonetheless turned to record deficits, the Bush administration pushed through a second round of tax cuts in 2003, and maintained a rate of spending growth that was triple the rate under Clinton. As Vice President Richard Cheney put it, “Reagan proved that deficits don’t matter.”
"These policies were maintained for another five years, as another $4 trillion was added to the national debt. Predictably, when the worst recession since the Great Depression hit in 2007-2009, politicians were reluctant to launch an adequate fiscal response, owing to the huge deficits and debts that the government had already been running."
"Republicans suddenly re-discovered the evil of budget deficits. They opposed Obama’s initial fiscal stimulus in February 2009, and succeeded in blocking further efforts when its effects petered out two years later. In my view, the government spending cutbacks of the last two years are the most important reason why the economic recovery that began in June 2009 subsequently stalled in 2011."
Indeed, Frankel argues that now it is the developing countries that now practice counter-cyclical policy.
However, the recovery in 2003 didn't make him reconsider. I've often argued that what we've actually had here in the U.S. is a policy where deficits don't matter but only when Republicans are President.
In this sense the first Bush broke the contract. We have certainly been doing a pro-cyclical fiscal policy here in the U.S. in the last few years with state and city governments continuing to contract. Indeed, when you read economic analysis for states and municipalities, the very language assumes pro-cyclicality.
However, to just touch on what Nick was talking about-if pro-cyclicality is true what is the cause-the fact that state governments have contracted is not according to some natural law of economics but because Congress had cut their funding.
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