Gunnar Myrdal: Fiscal Policy in the Business Cycle

This discussion of fiscal policy by Gunnar Myrdal appeared in the March, 1939 edition of The American Economic Review’s Papers and Proceedings.  

Much of it could have been written yesterday (I can’t find an open link):

Fiscal Policy in the Business Cycle, by Gunnar Myrdal, The American Economic Review, Vol. 29, No. 1, Supplement, Papers and Proceedings of the Fifty-first Annual Meeting of the American Economic Association (Mar., 1939), pp. 183-193: Underbalancing the budget during a depression is not primarily a deliberate policy but a practical necessity. … Depression, in modern society, causes a fall in all sorts of public income — rates of taxation remaining the same — and at the same time a rise in the bulk of public expenditure, especially for social purposes, standards of welfare policy remaining unchanged. The traditional, conservative reaction of the fiscal system to these influences by business on the budget is, as we all know, to raise the public income by increasing the rates of taxation, and at the same time to reduce expenditures as far as possible by lowering the standards of public activity. …

The depression following the crisis of 1929 turned out to be so serious that … an almost world-wide deliberate fiscal deficit policy … has been proposed and to some extent put in effect. In most countries, including Sweden (which has served as the laboratory in working out certain of the conclusions which I shall present at a later stage of this paper), this policy was carried out only half-heartedly. Public works were generally begun too late; they were not prepared in advance and were, for this reason, delayed and scarcely aimed at the works which should have been selected before all others if a rational choice had been made. They were also usually of much smaller scope than would have been desirable. … No country, so far as I know, has dared to carry out the expansionist policy even on the income side of the budget by actually decreasing taxation. On the contrary, taxation was generally raised, even such taxation on consumption and business as was certain to have deflationary

effects. Monetary policy and trade policy were very often not regulated to conform to the expansionist objects of financial policy. But in spite of these and other shortcomings, a new fiscal policy has been inaugurated…

In Sweden … we have, during the last years, been reshaping our fiscal policy in order to avoid these shortcomings the next time. Part of this fiscal preparation for crisis has been to take precautions in order to avoid delay in setting the spending program in motion. An intensive inventory of possible public works in the field of public buildings, road construction, and municipal investments has thus been prepared. A general program for social housing has been worked out in some detail. The state production enterprises — railroads, power plants, post office system, mines, forest preserves, etc. — are urged to prepare yearly building programs for ten years in advance. They are asked to have available at all times technical and economic plans, ready for speedy action. The idea is that next crisis we shall not be caught unawares. The blueprints shall be at hand, the measures shall be decided upon in advance, and the government shall have only to press the button to set the machinery in motion. Meantime, state investment, which had already been planned and decided upon, was stopped during the boom period.

This aspect of the economic planning problem is certainly of the greatest importance. In this paper I am, however, passing it over to devote my main discussion to the reconstruction of the budget system. The shortcomings of the new fiscal policy as it has been tested out in various countries during the last depression are, to a considerable extent, to be explained by the fact that this policy was frustrated as a result of being pressed upon a budgetary system which had been built on principles contradictory to this selfsame policy. It is, therefore, just at present an important problem of economic engineering to construct a new scheme of legal and institutional regulations…: a set of fiscal formulas which at the same time guarantees to a satisfactory degree the “soundness” of public finances in the long run and allows enough flexibility from year to year for fiscal policy to serve its purpose among other measures to mitigate the fluctuations in business activity. …

I want … to stress at the outset that soundness of public finance is a matter of the development in the long run. In principle there cannot exist any contradiction between the two postulated desiderata. Any degree of financial soundness in the long run is compatible with any amount of flexibility of the fiscal policy from year to year.

One of the obvious shortcomings of deficit spending during the last depression was, however, the adverse reaction of business confidence, which has too often restricted or even possibly reversed its stimulating effects. In itself it might seem astonishing that business is apt to react in this way. In a depression with falling demand, decreasing production, and increasing unemployment, there is temporarily a harmony of interests in society. Farmers, workers, businessmen-all should be interested in keeping up incomes, purchasing power, demand, production, employment, and prices.

If business, and public opinion more broadly, is afraid of a deficit spending program it must be because people fear a less sound trend of financial development in the long run. Could we, therefore, make some sort of arrangement giving guarantees for a corresponding overbalancing of the budgets in good times, the public confidence should be satisfied.

That would mean that the budget reaction to changes in business activity should be built on a fixed pattern, regulating deficits and surpluses in budget

balancing. It must be admitted that the general public is quite right in feeling its confidence disturbed by rapid, unregularized changes within the field of budget policy, or, to state it in another way, by a fiscal policy which is not integrated and regularized into a system of long-range budget planning, but instead constitutes a break with acknowledged budgetary principles. We must, therefore, not only make a virtue of the sins but also incorporate them in the regular fiscal system in order to avoid the adverse confidence reaction.

The chief technical problem of fiscal policy in the business cycle is, therefore, to design formulas for public finance which, as part of the regular system, make room for deficit spending during depressions by securing the building up of corresponding surpluses in good years. …

Finally, only by integrating the fiscal policy during depressions into a

long-range scheme will it be possible to give deficit spending the magnitude actually indicated in the situation. I mentioned that … the actual deficits have been very small when compared with brave theories… This is all because the new policy is still in conflict with the basic principles of the budget system. Only by organizing it into a permanent budget system will a more

courageous fiscal policy during depressions be possible. …

That is, of course, the big problem: how to tie the hands of governments and legislators in good times and hinder them from expansion beyond the trend at that time, but to be able to release their hands and spur them to action in depressions. If we want public finance to react as a countercycle, we must change the political psychology and give the state plenty of resources in depressions, but hold them back in booms. Such a change in psychology can be carried out by appropriate alterations in the institutional setup. We must, in financial as well as in monetary matters, try to come back to a reasonable degree of automatic reactions. But we must build up these automatic reactions so that they are better adapted to the needs of present-day society. It is not contradictory to ask the legislative body to create for itself, by enacting appropriate rules, new conditions for its own functioning. It is in fact a primitive democracy where the representation does not regularize its own action. …

I think this statement is important relative to our current situation:

If business, and public opinion more broadly, is afraid of a deficit spending program it must be because people fear a less sound trend of financial development in the long run.

Sound fiscal policy — the type that would have given us the flexibility we need in the short-run — should have started years and years ago. Tax cuts trying to starve the beast that only increased the deficit, the failure to reform our health care system to rein in costs, and so on, and so on, left us in a situation where people are worried about the long-run debt, and have little trust that legislators have the will and resolve to address the long-run problems we face. Instead of getting the budget in better shape during the boom times, Congress allowed it to deteriorate.

The trust that legislators will do what’s right in the long-run is essential for the public to give them the free hand they need in the short-run to aggressively attack problems. Right now that trust does not exist. Unfortunately for the many people still struggling with the recession — people who could use more help — that trust cannot be built on the spur of the moment as it’s needed, it must be built up over time. But, if anything, in recent years trust has eroded not increased.

We economists can scream until we are blue in the face about how more deficit spending has almost no impact on the long-run debt, and those arguments are perfectly logical. But I think people are making a different calculation. They aren’t asking how $787 in spending as a one-shot change will affect the long-run budget. They see this, or a good part of it anyway, as a permanent year after year change in spending (with the Bush tax cuts remaining in place as well). They see a ratchet effect to both spending and tax cuts, and have no trust that legislators will move to close the gap later by cutting spending or increasing taxes. And they believe that any further stimulus, which they see as also likely go on year after year after year given past congressional tendencies, will only make it worse.

People have justifiably lost faith in Congress, and I don’t know how to fix that. I think further stimulus is needed, very much, and that there are ways to make the spending temporary and targeted (the other of the “three t’s,” timely, is harder to defend). Cutting the deficit will only make things worse. But I also understand why people don’t trust anything that politicians (or, and I say this reluctantly, economists) have to say.

[Update: Let me be clear, I am not endorsing the idea that cutting the deficit now would restore confidence and lead to a recovery, not at all. I am saying that there is no trust in Congress due to past behavior and nothing in the short-run, cutting deficits or anything else, can fix that. Restoring trust will take time, but now is not the time to begin the process. There’s plenty of time to do that later, cutting the deficit now would only make things worse and further erode trust and confidence in policymakers. As I’ve said many, many times, if anything, a larger deficit is needed.]

Originally published at Economist’s View and reproduced here with the author’s permission.
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