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What Does It Really Mean? Fiscal Policy

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1970
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Henry C. Murphy

UNTIL the great depression of the 1930’s, and the fundamental economic rethinking that it occasioned, the term “fiscal policy,” in the rare instances when it was used at all, meant merely a policy (any policy) which affected the “fisc”—i.e., the public treasury. Such policies usually related principally to taxation. The term “fiscal policy” could also in those days have been applied, by extension, to policies concerning public expenditure—although it was generally assumed that there would be no policy concerning public expenditure other than to get the necessary work done as cheaply and as efficiently as possible.

Nowadays, the term “fiscal policy” appears much more frequently and has acquired a rather specific meaning. One occasionally reads in newspapers, even those of general circulation, that such and such a country is “tightening its fiscal policy” or is “relaxing its fiscal policy.” The term “fiscal policy,” used in a rather specific sense, is now very much a commonplace for economists, and even for politicians, and finds its way into articles written for the common man, particularly the type of article often labeled “news analysis.” What does it really mean today?

Developed in Industrial Countries

The particular meaning of the term “fiscal policy” which will be described in this article was developed in industrial countries and has primary application to them. For reasons that I shall give later, the main thrust of the particular type of fiscal policy here described—i.e., government financial policy for economic stabilization—has only a limited applicability to developing countries. While the term “fiscal policy” is frequently used at the present time in responsible policy prescriptions for developing countries, it is generally used in the wider sense of “government financial policies designed to benefit the economy” (largely by diverting resources from lower priority uses to higher priority uses, especially those stimulating economic growth), and as a measure of anti-inflationary policy; for reasons which will be developed later, fiscal policy has very limited usefulness in developing countries as an instrument for the cyclical stimulation of employment.

The Older Orthodoxy

When the author came to the U.S. Treasury as a young economist in the mid-1930’s, orthodox opinion held that the only proper criteria for taxation were fairness, public acceptance, and ease of administration. Furthermore, the only proper purpose in levying taxes was to meet government expenditures. The act of taxing or refraining from taxing was not to be used for ulterior purposes—such as, for example, increasing employment or increasing or holding down prices. The only proper purpose of taxation was to raise money to meet government expenditures and the taxes were to be as “neutral” as possible, i.e., they were to change the existing flow of income and expenditure as little as possible. (The change in income flow implicit in progressive taxation was justified solely on the basis of the “fairness” criterion of taxation.) Furthermore, the budget, i.e., the total of receipts and expenditures, was to be balanced as nearly as feasible in each peacetime year. This had been the orthodox opinion for generations, being based upon the teaching of the so-called classical economists of the eighteenth century and their successors.

This orthodoxy, of course, was never as pure in practice as it was in theory. Protective tariffs had been levied for many years—against the advice of generations of economists—and, as indicated by the name (and also by the effect), their principal motive was one ulterior to that of raising revenue. Furthermore, articles deemed to be of doubtful benefit to society, such as liquor and tobacco—or fine laces and fine linens—as determined by the sometimes shifting views of those in authority, had been taxed at higher rates than those applicable to articles deemed more socially beneficial.

Furthermore, in the United States, the judicial branch of Government had long since taken note of the tremendous potential of taxation for nonrevenue purposes in the dictum enunciated by Chief Justice Marshall that “the power to tax is the power to destroy.”

However, the exceptions to the old orthodoxy just noted were all on what would now be called a microeconomic scale—i.e., they were intended to affect the demand for particular commodities and the profitability—or even the existence—of particular enterprises, not to effect what we would now call macroeconomic adjustments in the economy—i.e., adjustments in the aggregate scale of employment, prices, and incomes. Indeed, the desirability—or even the possibility—of making such adjustments was never discussed or even imagined.

Forces of Change

During the 1930’s forces were already at work which would overturn the old orthodoxy just described and replace it with a new orthodoxy called fiscal policy, i.e., the policy that government receipts and expenditures should be consciously planned, particularly in their aggregate amounts, so as to effect beneficial changes in the over-all level of incomes, prices, and employment.

Such major changes in the direction of economic theory are usually preceded, accompanied, or spurred on by changes in the external environment. In the present case, the relevant change in the external environment was the Great Depression of the 1930’s. Never before, since the development of industrial societies, had there been a depression on such a scale.

The spectacle of men unemployed amidst ample technological know-how, well-equipped factories, and plentiful raw materials; of little pigs slaughtered to reduce the “oversupply” of pork while men went hungry, forced on society a rethinking of its basic economic ideas.

Hitherto, unemployment had been explained negatively as due to “frictions” or imperfections in the working of the economic order; there was no positive explanation for unemployment in the old economic theory. It became increasingly clear, however, as the 1930’s dragged on, that the massive world-wide unemployment and depression which they brought with them could not be explained adequately by negative concepts such as “friction” or “imperfection.” A positive explanation was needed.

Monetary Policy

In the last few years prior to the onslaught of the Great Depression in 1929, there had been a basic optimism that depressions were a thing of the past because the discovery of “monetary policy” in the 1920’s had made them impossible in the future. Industrial countries, therefore, sought in the 1930’s to combat the oncoming depression by means of monetary policy, i.e., by lowering the cost and increasing the availability of money for business investment. For reasons which cannot be detailed here (as this article is on fiscal policy), monetary policy proved inadequate to the challenge. Businessmen were not tempted to borrow money when they took a pessimistic view of the profit outlook for business. Money became cheaper and cheaper, but the added cheapness became less and less effective as a means of spurring business. There is still some dispute whether monetary policy might have been successful in combating the depression of the 1930’s if it had been used earlier and more energetically. A few economists say it would, but most now believe that it is intrinsically inadequate for dealing with developing depressions except in their early stages, and is especially inadequate for deep depression situations. The basic difficulty is that the newly created funds simply pile up in the banks and will not move out into business. This was expressed in the economic bon mot of the 1930’s, “you can’t push a string.”

The Teaching of Keynes

In the meantime, what proved to be a more efficacious instrument for attacking economic depressions was being developed on another sector of the economic scene. The British economist, John Maynard Keynes, in his writings in the 1930’s, had pointed out that a decision to save does not necessarily lead to a decision to invest an equal amount, and that the earlier assumption of most economists that it did had been based on premises less general than they had supposed—premises which, in effect, assumed rather than proved that there would be full employment. Keynes, therefore, set out to develop a “general theory” of economics which showed that it was possible for economic equilibrium to be established at low—i.e., deep depression—levels of employment as well as at high levels of employment. This new economics knocked out the theoretical underpinnings of the old “Treasury view” (in the United Kingdom and elsewhere) which had held that government expenditures financed by borrowing did not increase employment because they merely diverted what would otherwise have been an equal amount of private (investment) spending to the government. Keynes had shown that, while public borrowing doubtless absorbed private saving, in times of deep depression the “counterpart” of the private saving so absorbed would more likely have been unemployment than private investment. This is the heart of the “general theory.” Keynes, in his practical, day-to-day activities, consequently advocated increased public spending financed by borrowing in times of depression, as his theory had shown that in such times the deficits of national governments should be viewed, not merely as the amounts by which taxes failed to cover expenditures, but as positive instruments by which the aggregate level of incomes and employment could be increased—while, again, under conditions of deep depression, prices would be increased very little.

Keynes’ ideas were picked up rather rapidly, particularly in the United Kingdom and the United States, and Keynesian economics, as the “new economics,” spread rather quickly in the academic world. Much modified, it now dominates economic teaching in all of the industrial countries of the Western world. The theoretical basis of this new economics will not be further enlarged upon; its leading policy prescription is that national governments should plan their revenues and expenditures and the balance between them, not merely with reference to the specific objectives of each tax and each type of expenditure, but also so that aggregate taxation and expenditure will, on the whole, promote desired over-all objectives.

Development of the “New Economics”

It should be noted that, in the course of extensive academic discussions, principally in the 1940’s, what had originally been conceived as a one-purpose policy for use in fighting depression had become enlarged to become a two-purpose policy, for use either in offsetting inflation or depression, as was appropriate at the time. This development had the corollary of discovering a useful ulterior purpose for fiscal surpluses as well as for fiscal deficits—i.e., fiscal surpluses were helpful in controlling inflation. While, as previously stated, the spread of the new economics was rapid throughout the academic world, acceptance of its policy recommendations in the world of politicians and businessmen came much more slowly.

The spread of the new economics had very little effect in ameliorating the hardships of the last years of the Great Depression. The depression was in fact brought to an end by heavy government expenditures in preparing for and fighting World War II, which were not accompanied by commensurate tax increases. Government finance in World War II, consequently, provided a massive “demonstration effect” of what could be done for depressed economies by large government expenditures financed by borrowing.

In the light of this demonstration effect, and spurred on by the urging of young men coming from the universities, politicians and businessmen asked themselves in the late 1940’s and early 1950’s whether the good economic side effects which had come about incidentally as the result of the war could not be recreated in peacetime by conscious fiscal policy. In addition, the transition of the ideas of the new economics to the realm of practical politics was helped by the fact that “peace,” as it had been understood earlier, never really came after World War II; military expenditures remained very high and so provided a continuation on a smaller scale of the “demonstration effect” of the war. In many cases such military expenditures, combined with other large expenditures and lax tax policies, overshot the mark of high employment, and so provided a “demonstration effect” in the opposite direction—namely, one concerning the effect of undue government deficits in stimulating inflation in overextended economies.

Limitations of Fiscal Policy

In the early days of the development of fiscal policy it was assumed, particularly by young graduates of Western universities returning to their homes in developing countries, that the new gospel of fiscal policy was as applicable in their own countries as in the industrial countries in which they had studied. In those days, it will be remembered, fiscal policy was still rather one-sided, directed more against depression than against inflation. It was assumed that it could be applied with as much success in reducing chronic unemployment in, say, India, as in reducing cyclical unemployment in the United States or the United Kingdom. This assumption proved to be incorrect. In times of depression industrial countries have large pools of unemployed productive resources of skilled and unskilled labor, of unused or underutilized (but efficient) capital equipment, and of managerial skills which, given increased demand, can be rapidly put to use for increasing production. This situation is not duplicated in the developing countries, which suffer from chronic unemployment. In these countries the unemployed factors are unbalanced; the “pools” are especially lacking in labor of the necessary skills, in managerial techniques, and in unused (but efficient) capital equipment. In these circumstances, therefore, the injection of increased purchasing power by fiscal policy tends to work itself out, not primarily in increased production, as it does in industrial countries in times of depression, but principally in increases in prices and imports.

Chronic unemployment, not susceptible to successful treatment by fiscal policy, is the commonest in developing countries, and cyclical employment, which is subject to successful treatment by fiscal policy, is the commonest in industrial countries. Chronic unemployment, however, exists in industrial countries—e.g., note the inability of the United States to reduce its unemployment rate much below 4 per cent even with substantial inflation—while some cyclical unemployment exists in the developing countries. As the proportion of cyclical unemployment to total unemployment is low in the developing countries, and fiscal policy is a blunt instrument which cannot be pinpointed by sector or industry, it cannot be much used for relieving cyclical unemployment in the developing countries without important adverse effects in the form of domestic inflation and balance of payments difficulty. Consequently, responsible prescriptions of unemployment-oriented fiscal policy for developing countries are now generally concentrated on ways of using the power of government finance to divert resources from lower priority uses to higher priority uses (particularly investment in productive capital) and to providing, through taxation or otherwise, incentives for productive investment.

Fiscal policy is as effective in counteracting inflation in developing countries as it is in industrial countries, and it can, to a limited extent, mitigate the hardships arising in developing countries from external causes (e.g., declining export prices) inasmuch as reserves are available or can be borrowed to offset the external drain inevitably incident to expansive fiscal policy.

The basic idea of stabilizing the economies of industrial countries by using government surpluses and deficits as counterweights is so simple that it may seem surprising that it had not occurred earlier to the many acute economic thinkers of the nineteenth and early twentieth centuries, who were also spurred on by what appeared to them to be rather severe depressions in their own time. It may seem strange that the idea of fiscal policy had to wait until the mid-twentieth century to be born.

Perhaps the principal reason for the late development of the idea of “fiscal policy” is that fiscal policy can be really meaningful only when the expenditures of national governments have come to comprise a substantial proportion of their respective gross national products (GNP). This was not so in most industrial countries until well on into the twentieth century, and, consequently, the development of the macroeconomic concept of the use of government finance as a counterweight to fluctuations in the rest of the economy had to wait until the size of government expenditures relative to total private expenditures in the respective economies had grown to somewhat near its present magnitude. The causes of the growth in the relative magnitude of the expenditures of national governments were primarily social and political, rather than economic, in character. An inquiry into the nature of these causes is outside the scope of this article. It should be noted, however, that the forces bringing about this change have been pervasive throughout the world—operating in the industrial and the developing countries alike. Indeed, the proportion of the expenditure of a government to total expenditure in its economy, while higher for the industrial countries than for the developing countries, is related more to the time of the observation than to the phase of the economic development of the country. When the United States was a young, struggling, developing country, its government expenditures were so small as a proportion of its GNP that even an energetic fiscal policy, as that is now understood, could have provided no important counterweight to unemployment or inflation in the private sector of the economy. The same thing can be said, to a somewhat lesser degree, of the other principal industrial countries of today. On the other hand, the expenditures of the governments of the poor developing countries of today are, in general, many times greater as proportions of the total size of their respective economies than were the expenditures of the governments of the principal industrial countries of today at the same stage in their economic development.

It should be added that, as fiscal policy depends heavily on planning, in addition to the development of sufficiently large underlying aggregates “in the real world,” it was also necessary, in order to make fiscal policy practical, that these magnitudes should be perceived by planners and politicians. When the magnitudes of the underlying aggregates are approximately—and contemporarily—known to economic planners, an entirely new type of thinking arises in which the aggregates, instead of being taken in isolation, are understood and operated upon as affecting one another. This “new type of thinking” is the heart of the modern science of macroeconomics. It is difficult for anyone familiar with the subject today to realize how little was known before the Great Depression of the underlying magnitudes of current developments—at least in time to be of practical policy assistance. The development of modern techniques for data gathering and data organization—and especially the development of national income accounting—may, therefore, be put down as a secondary “necessary condition” for the development of fiscal policy as we know it today.

Relationship with Monetary Policy

In discussing the events leading to the advent of fiscal policy, it has been necessary to touch glancingly on “monetary policy,” as the first (and unsuccessful) refuge of the public authorities in combating the Great Depression. Both types of policy—fiscal and monetary—are now very much alive and there is a growing academic literature, and even public discussion, of the proper “mix” of fiscal and monetary policies to be applied on different occasions. Before considering the matter of such a mix, however, it is necessary to distinguish further between fiscal and monetary policy, as they are easily confused.

Monetary policy, as already noted, is the policy of increasing or decreasing the cost and availability of money for business purposes as a means of influencing the general level of prices, incomes, and employment. Fiscal policy is the policy of changing the total amount and kinds of government receipts and expenditures and the over-all surplus or deficit for the same purposes. While the kinds as well as the total amounts of government receipts and expenditures are important, fiscal policy might be said, as a first approximation, to be the policy of planning government surpluses and deficits for the purpose of effecting changes in desired directions in the general level of prices and incomes in the economy. Under present conditions in the principal industrial countries, a “strong” fiscal policy or a “strong” monetary policy means one which is strongly oriented in the contractionary direction.

It is very difficult to separate the two kinds of policy. Suppose, for example, that a government runs a surplus and “saves” the same amount by holding the surplus in idle bank balances—even more effectively, in idle central bank balances. As a fiscal policy instrument, the surplus will have a restrictive effect on the economy because the government will be subtracting more from incomes in the private sector by taxation than it will be adding to them by expenditure. But, the act of saving the surplus will have the side effect of reducing the money supply available to the private sector and so making credit less available and more expensive. This added side effect may have an even more contractionary influence on the economy than the “direct” effect of the fiscal policy “proper”; and this added side effect will be an instance of monetary, not fiscal, policy.

To take the matter the other way around, suppose a government incurs a deficit. As a fiscal policy measure, this will have an expansionary effect on the economy because the government will be adding more to the incomes of the private sector by expenditure than it will be taking away from them by taxation. But, by analogy with the earlier discussion of a surplus, if the government finances the deficit by increasing the money supply, this will have the added side effect of increasing the availability and decreasing the cost of money to the private sector. This additional expansionary force, which may or may not be more powerful than the “primary” effect of the net addition to private incomes, will be an instance of monetary, not fiscal, policy.

The general principle that may be derived from the two preceding paragraphs is that a governmental action can be said to be “pure” fiscal policy only if it is taken in such a way as to be neutral in its effect on the availability of money to the private sector, i.e., if the government forthwith pays any surpluses back to the private sector (as by the retirement of debt not held by banks) and finances any deficits without adding to the money supply or otherwise making money more available to the private sector. Monetary policy, likewise, can be said to be “pure” only when it is conducted in such a way as to have no effect on the amounts which government receipts and expenditures add to or subtract from private incomes.

Examples of “pure” monetary policy are fairly common in the real world. Examples of “pure” fiscal policy, however, are much harder to come by, as any policy involving a change in government receipts and/or expenditures almost inevitably involves a corresponding policy with respect to financing the associated surplus or deficit. It follows that the fiscal policies that are actually discussed by journalists are almost always mixed with monetary policy. A pure fiscal policy is almost as rare as a pure metallic element occurring in nature. Just as it is the task of metallurgists to reduce metallic ores to pure metals (so that they will be more useful), so it is the task of economists to reduce actual policies to their pure fiscal and monetary elements so that their effects can be better understood.

Determining the most appropriate mix of fiscal and monetary policies in the present circumstances of any particular country is a complex task and beyond our present scope. There are, however, some generally agreed elements that should be considered in determining the correct mix of fiscal and monetary policy on any particular occasion. They might be listed as follows:

  • 1. Fiscal policy, although it affects business investment, has its greatest impact on consumer incomes, adding to them by public expenditure and reducing them by taxation. This, in turn, increases or decreases consumer demand and so has an important impact on prices and employment.

  • 2. Monetary policy, although it has some effect on current consumer expenditure, has its greatest impact on business investment (including private investment in housing).

  • 3. Fiscal policy, although it affects the balance of payments to an important extent, has its greatest impact on domestic incomes, prices, and employment.

  • 4. Monetary policy, although it affects domestic activity importantly, has an especially great impact on the balance of payments, as it directly influences international capital flows by changing the interest rate differentials among the several countries.

  • 5. Fiscal policy has a particularly strong impact when the need is to expand the economy—as it creates income directly—rather than merely creating a potential for increased income if businessmen feel inclined to invest.

  • 6. Monetary policy is apt to be ineffective in a deep depression, as the funds which it creates may merely pile up in banks if, as is then apt to be the case, businessmen take a dim view of profit prospects. Monetary policy can be particularly effective, however, in braking an inflationary boom, as there is no veto on business expansion more absolute and effective than the lack of funds.

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