Public Budget, Economic Cycles, and Fiscal Policy
The Public Budget and the Economic Cycle
The budget is related to the different phases of the economic cycle. However, the opinion on this relationship differs according to the school of economic thought.
Monetarist View
Monetarists believe that the economy has mechanisms to correct all imbalances without state intervention. Therefore, public spending should be limited as much as possible, and the budget should remain balanced annually; expenditures must match revenues.
Keynesian View
According to Keynesian economics, the economy cannot adjust by itself and does not have steady growth at full employment. This means that during a recession, caused by insufficient aggregate demand, the state must intervene by changing government spending and taxes. The budget should be balanced cyclically, not annually. That is, there should be deficits during recessions and surpluses during periods of expansion.
Relationship Between Deficit and Economic Cycle
During recessions, government spending increases due to rising unemployment benefits, and income decreases due to the decline in production. During expansions, government spending decreases because fewer unemployment benefits are paid, and revenue increases due to rising production. This causes the deficit to increase in the first case and decrease in the second.
Part of the budget deficit is caused by the phase of the cycle. This part of the deficit is called the cyclical deficit, the part of the budget deficit that varies with the business cycle: deficits during recessions and surpluses during expansions.
However, if an economy has emerged from a recession and the budget deficit continues, it is not caused by the cycle but by a mismatch between revenues and expenditures. This deficit is called the structural deficit.
Discretionary Fiscal Policy and Automatic Stabilizers
Discretionary fiscal policy is when the government changes tax rates or spending programs, usually through legislative action. The most important measures are:
- Public works programs and other expenses.
- Public employment projects (hiring unemployed workers for short periods).
- Transfer programs (unemployment insurance, pensions, and others).
- Alteration of tax rates.
The problem with such measures is that they require extensive paperwork, especially public works programs, and their effectiveness may be delayed until after the recession. Therefore, this policy is not ideal for short-term action.
Automatic stabilizers are any features of the economic system that mechanically reduce the strength of recessions and/or expansions of demand without requiring discretionary economic policy.
When taxes are proportional to income, collection is automatically altered as the national product changes. Tax increases during periods of national product growth will reduce the strength of the expansion, and the opposite will occur during a recession. The same applies to public expenditure. Increasing the national product decreases unemployment costs, and vice versa. Consequently, during times of expansion, the budget shrinks economic growth, and during times of recession, the budget works to expand economic growth.
Fiscal Policy and Crowding Out
The crowding-out effect occurs when government expenditures, budget deficits, or public debt reduce the amount of business investment. This can happen in two ways:
- Public spending may crowd out private investment if resources are scarce.
- When interest rates rise significantly due to rising public debt, they reduce private investment sensitive to interest rates.