Is US Fiscal Policy About to Go Procyclical, Again? How Can We Tell?

As 2017 begins, the US economy is in the middle of a boom, or at least a boomlet. The official unemployment rate is at or below its target level, stock market indicators are hitting all-time highs, and the Fed is starting to get serious about raising interest rates. All this is reflects the expectation of an orgy of tax cutting and infrastructure spending by the incoming Trump administration and a new Republican Congress.  If such a turn in policy comes to pass, will it be a good thing, or too much of a good thing?

Too much, in my opinion.  Republicans like to portray themselves as the party of fiscal responsibility, but their record says otherwise. In practice, GOP budget policy so far this century has been consistently procyclical—expansionary when it should show constraint, contractionary when it should support a weak economy. All signs point to another procyclical episode in the making.

Patterns of Fiscal Policy

To set the stage, here is a little background on patterns of fiscal policy—the good, the bad, and the ugly. Economists of all political views show surprisingly broad agreement on the general principles. Good fiscal policy should moderate the business cycle (or at least not make it worse) and should do so in a way that avoids unsustainable increases in public debt. Bad policy amplifies booms and busts. Ugly policy can lead to major crises.

First, some essential  terms and concepts:

• The output gap is the difference between the economy’s level of output at the moment and the output it would produce if it were operating at full employment. During a slump, the output gap is negative. During a boom, it is positive.
• The actual balance of the government budget is the current value of government expenditures minus revenues . This is the headline deficit (-) or surplus (+) that politicians usually talk about.
• Economists pay more attention to the structural balance— that is, the surplus or deficit that would prevail if the output gap were zero.
• To estimate the structural balance, economists adjust the actual balance by removing the effects of automatic stabilizers. Automatic stabilizers are budget components like unemployment benefits and income tax revenues that vary automatically (that is, without action by policymakers) as the economy expands and contracts over the business cycle.

The structural balance is useful because it isolates changes in policy, such as tax cuts or new spending programs. Changes in the actual balance, on the other hand, represent the combined effect of changes in policy and changes in the state of the economy. Even if there are no changes in policy at all, automatic stabilizers cause the actual balance to move toward surplus when the economy expands and toward deficit when it contracts. 

We can use these concepts to identify three patterns of fiscal policy. The simplest is a “cyclically neutral” policy that holds the structural balance at zero throughout the business cycle. Holding the structural balance constant does not prohibit all policy changes. Rather, it requires that any spending changes be financed by equal changes in revenue, or equal but opposite changes in spending elsewhere in the budget.

Under a cyclically neutral  policy, the relationship of our three key variables over the business cycle would look like this:

Starting from zero, the output gap becomes positive as the economy expands. Automatic stabilizers come into play as rising incomes push up tax revenues and a strong labor market reduces outlays for unemployment compensation, food stamps, and other transfer payments. As a result, the actual balance of the budget moves into surplus. Once the cycle passes its peak and the economy begins to contract, the actual budget surplus decreases. As the output gap turns negative, automatic stabilizers operate in reverse and the actual budget balance moves into deficit.

Cyclically neutral fiscal policy is good policy. It doesn’t completely tame the business cycle, but it does allow automatic stabilizers to moderate excessive booms and busts. If the target for the structural balance is set at or near zero, the national debt will remain within sustainable levels. (Although we set the structural balance target at zero in our example, the optimal target may, in practice, be a little higher or lower, as explained in this earlier post.) For a number of years, Chile, by some measures the most prosperous country in Latin America, has used a version of cyclically neutral  fiscal policy to good effect.

An even better pattern of policy is one that is actively countercyclical, while holding the structural balance at or close to zero on average over the business cycle, like this:

In this pattern, policymakers use spending cuts or tax increases to move the structural balance toward surplus as the economy begins to expand,. As automatic stabilizers come into play, the actual balance moves even more strongly toward surplus. The combined effect of automatic stabilizers and active policy changes ensures that the economy does not overheat. During a downturn, policymakers enact stimulus measures in the form of tax cuts and spending increases to move the structural balance toward deficit. Those measures, together with the operation of automatic stabilizers, prevent the contraction from turning into a deep recession. 

Sweden has used countercyclical policy with the budget balanced over the business cycle since the early 1990s. That approach has allowed the country to prosper while deeply reducing its once-excessive deficits and debt. However, such a policy is not feasible for every country. For one thing, it requires good forecasting and long-range policy planning, since countercyclical policy changes work best when they are made somewhat in advance of cyclical turning points. If action is delayed until  the economy overheats or falls into a deep slump, it can be too late to apply effective restraint or stimulus.  Furthermore, combining short-run countercyclical measures with long-run structural balance year after year requires a degree of political maturity, discipline, and agreement across party lines that not all countries have.

Finally, we can use the same kind of diagram to illustrate bad fiscal policy—policy that is procyclical, making the business cycle more severe rather than moderating it. One variant of bad policy looks like this:

This variant of procyclical policy holds the actual budget balance constant over the business cycle. When the economy enters an expansion, policymakers increase spending or cut taxes, thus neutralizing the operation of automatic stabilizers. That moves the structural balance toward deficit but holds the actual balance at zero. When the economy enters a recession, higher tax rates and discretionary expenditure cuts move the structural balance toward surplus to offset the tendency of automatic stabilizers to move the actual balance toward deficit. On balance, this policy pattern stimulates the economy during booms, causing it to overheat, and then subjects it to measures that turn moderate recessions into deep slumps.

The kind of policy illustrated in this diagram has not actually been used in the United States, but it has been championed, in the form of a balanced budget amendment,  by many Congressional conservatives.  A balanced budget rule that focused on the structural balance might make sense, but one that aims at the actual budget balance, as all proposals introduced in Congress to date have been, is one of the worst ideas in the GOP playbook.

To be sure, even annual balancing of the actual budget would not be the worst possible kind of fiscal policy. A really ugly policy pattern would be one that combined procyclical stimulus during  expansions  and austerity during recessions with deficits deep enough, on average over the business cycle, to threaten the sustainability of the public debt.

Back to the real world

It is time, now, to see what US fiscal policy looks like in the real world. The next chart shows output gaps and deficits for the US federal budget since the start of the twenty-first century, drawn for easy comparison with the theoretical patterns discussed above.

The century began with the mild recession of 2001, which lasted just eight months and followed the record-setting 120-month expansion of the 1990s. The incoming administration of George W. Bush reacted swiftly with the Economic Growth and Tax Reconciliation Act of 2001, which sharply cut tax rates.  In its timing, the 2001 tax cut was countercyclical, but very large in relation to the relatively shallow recession. 

A further round of tax cuts followed in 2003, after Republicans gained control of both houses of Congress. At the same time, the invasion of Iraq and a continuation of the war in Afghanistan  added  to federal expenditures. The combined effect of these measures swung the structural balance from a surplus of 1.6 percent of GDP in 2000 to a deficit of 2.9 percent by 2004. Meanwhile, the business cycle was well into its expansion phase. Taken as a whole, then, fiscal policy in these years was procyclical.

The years from 2005 to 2007 saw a moderation of the fiscal stimulus. The structural balance moved from a deficit of 2.9 percent of GDP in 2004 to a deficit of just 1 percent by 2007. The result was mildly countercyclical, although perhaps insufficiently so, in view of the housing boom.  The Federal debt continued to grow in absolute terms throughout the Bush years, although it declined slightly as a percentage of GDP in 2006 and 2007. 

In 2008, the Bush administration reacted with commendable quickness to the onset of recession and the developing financial crisis. In February 2008, Congress passed a stimulus package that included both business tax cuts and one-time tax rebates for individuals. That was followed  by a much larger stimulus package early in 2009, soon after Barack Obama’s inauguration. In combination, these actions were strongly countercyclical, with the structural balance moving from a deficit of just 1 percent in 2007 to a deficit of 7.3 percent by 2009.

In mid-2009, boosted by these actions, the economy began to recover. The federal budget continued to provide significant fiscal stimulus for the next two years. Things changed, however, after the Democrats lost control of the House in 2011. A series of fiscal high-wire acts followed, including a debt ceiling crisis in 2011, a government shutdown in October 2013, and the “fiscal cliff” crisis at the end of that year. These crises led to a series of tax increases and spending cuts that brought an end  to the stimulus. The policy change was marked by a decrease in the structural deficit from 6.1 percent of GDP in 2011 to just 1.6 percent by 2014.

The burst of fiscal austerity came at a time when GDP was still far below potential. In 2011, the output gap was still -4.25 percent of GDP and the unemployment rate was over 8 percent. The premature withdrawal of stimulus was widely regarded as procyclical, especially by the Federal  Reserve, which was doing its best to speed the recovery with its policy of quantitative easing. Fed Chairman Ben Bernanke repeatedly warned Congress that tight fiscal policy was undermining the pace of recovery and making the Fed’s work much harder.

Ironically, in 2016, just as the economy was struggling back toward something close to full employment, fiscal policy began to ease again. The structural deficit increased from 1.6 percent of GDP in 2015 to 2.4 percent in 2016. Projections released by the Congressional Budget Office in August of that year, before the election, already pointed to continued procyclical increases in the structural deficit and a disappearance of the output gap by 2018.

As we enter 2017, with a new president and a new Congress, those earlier projections are beginning to look too moderate. Everyone is talking about more tax cuts, more infrastructure spending, and increases in the military budget. The dashed lines at the far right of the above chart reflect my adjustment of the output gap and deficit projections by +0.25 percentage points for 2017 and 1.0 percentage points for 2018.

The bottom line: Little to be proud of

This tour of fiscal policy in the twenty-first century shows little to be proud of. True, the government, under both Republican and Democratic administrations, was able to muster strong countercyclical responses to the 2001 and 2007-2009 recessions. However, procyclical policy predominates. Lingering and unneeded stimulus in the early years of the expansion that followed the 2001 recession undoubtedly  contributed to the housing bubble and the financial crisis of 2008. Premature austerity after 2011 slowed the recovery from the Great Recession, despite extraordinary measures by the Fed to provide monetary stimulus.

Is the stage now set for the strongest dose of procyclical fiscal policy yet? That is a very real possibility. Tax cut fever is in the air. Despite the rhetoric of fiscal hawks, Congressional Republicans have, in the past, found it hard to resist demands to spend the revenue generated by economic expansions rather than using it to pay own the debt. A bad record of fiscal policy may be about to turn ugly.