The Dangers of Fiscal Policy

Most economists agree that fiscal policy is useful when many resources are underemployed due to an aggregate demand shock, and the economy needs a short-run boost. There's less agreement when it comes to using fiscal policy to combat shifts in aggregate supply, and less agreement over the potential dangers of debt-financed fiscal policy.

Let's consider. Instead of a shift in aggregate demand, suppose the economy suffers a real shock, a shift in the aggregate supply curve. The economy moves from point A to point B and falls into a recession. Fiscal policy in this situation -- it's relatively powerless. A big increase in aggregate demand could increase real growth somewhat but mostly at the cost of much higher inflation. When real growth slows due to an aggregate demand shock, the economy is operating below its potential so there's more room for fiscal policy to bring the economy back to potential.

But when real growth slows due to an aggregate supply shock, it's the potential growth rate that has fallen. There's less inefficiency in the economy, and thus fiscal policy has less power. Keep in mind as well that all the earlier problems of fiscal policy -- timeliness, targeting, and crowding out -- they also apply to fiscal policy when combatting an aggregate supply shock. It's just that this time, more spending has the additional challenge that it can't really solve the underlying problem. The economy has fundamentally changed, and attempting to fix it leads mostly to higher inflation rates.

Fiscal policy can also be a dangerous tool when used too much. In theory, fiscal policy is like national consumption smoothing: increase aggregate demand in bad times, and pay off the bill in good times. But in practice, politicians usually only follow half of this advice. They spend in bad times, because they have to -- and they spend in good times because they can. Like many of us, politicians find it easier to add to the credit card bill than to pay down the debt. We're just not that great at national saving. And if a government's debt continues to grow, it'll end up spending a larger and larger portion of its budget on interest payments alone, making it more difficult to act in a future recession. In other words, if we repeatedly used debt-financed fiscal policy to stimulate the economy again and again, and we never pay down that debt, then we'll eventually back ourselves into a corner with no ammunition, just when we need it most.

Is it possible to have too much debt? Certainly. And here's where it gets really dangerous. Too much debt, especially when a country borrows money from another country in the other country's currency -- this can create uncertainty, and risk, and even lead to economic collapse. Take, for example, Argentina's financial crisis of 1999 to 2002. In the years leading up to the crisis, Argentina's government was spending and borrowing more and more and more, making investors and citizens a little nervous of its ability to pay off its debts.

So, when the economy suffered a financial crisis, and the government tried to spend even more to stimulate the economy, to get out of the crisis, citizens and investors took that as a bad sign rather than as a good one. In fact, citizens and investors drastically reduced their spending and investing -- so much so that the country experienced declines in real GDP rather than growth. In other words, consumption and investment fell by more than government spending increased -- over 100% crowding out! By 2002, Argentina's debt was 150% of GDP, and the government defaulted on its payments. This was the largest government default in the history of the world. But other developing countries -- Thailand, Indonesia, and Mexico, and even Greece - - they've experienced similar scenarios.

So how much debt is too much? Well, there's plenty of room for debate on this, but it's clear that if a government's credibility is low and its debt is high, then fiscal policy can have an immediate negative effect, at least in some economic situations. Fiscal policy is a useful tool, but to be used well, it must be used wisely.