Widget Image
Connect with:
Monday / March 27.

How Can Fiscal Policy Be Used to Stimulate an Economy Out of a Recession?

By Pallavi Mehra

According to Post-Keynesian (PK) economists, fiscal policy has to be used to stimulate the economy out of a recession and also, during ‘normal’ times. In other words, fiscal policy (aggregate demand management) is constantly required even during stability until prosperity meets full employment.

economic-crisis-istock-e1313066717657The United States economic crisis, 2008 has brought the importance of the use of fiscal policy in the forefront once again. Most modern economies only use the interest rate policy to help them out of a recession. This has failed numerous times, for instance, in Japan in the 1990s¹. Economists, including PK economists are restating the importance of financial regulation to avoid a crisis such as that of 2008; however, not many are proposing the revival of discretionary fiscal policy other than some PK economists (Skidelsky 2009)² such as Arestis and Sawyer.

Economist Robert Skidelsky asserts the importance of discretionary fiscal policy along with the use of ‘automatic stabilizers’. He claims that ‘fine tuning’ has proved to be insufficient to stabilize the economy after a severe recession. Additionally, the budget deficits that have resulted in widespread paranoia were not created because of more spending under the Obama administration to aid the economy but due to military spending and tax cuts for the wealthiest of the society, the policies which were first implemented under the Bush administration. (Skidelsky 2009, 178)².

He uses the Kalecki equations to depict the importance of government spending in the process.

Hyman Minsky also stresses that fiscal policy is the main macroeconomic stabilization tool. He uses the Kalecki equations to depict the importance of government spending in the process. The model developed by him is based on the works of Michal Kalecki and has macroeconomic considerations and implications for the economic crisis of 2008. The final equation depicts the following in an open economy:

Profit (Private Sector)= Investment+ State Deficit+ Consumption out of Profits- Savings out of Wages+ Surplus in Balance of Payments

Tropeano, following Minsky and Kalecki states that, the US economy in the past couple of decades has been relying on consumption (which is financed by debt) to increase aggregate demand.

Whereas, in a closed economy, with no surplus from balance of payments; investment, consumption out of profit and government spending are the only avenues for the private economy to have a profit (Tropeano 2011, 6)³. Tropeano, following Minsky and Kalecki states that, the US economy in the past couple of decades has been relying on consumption (which is financed by debt) to increase aggregate demand. However, with the 2008 crisis and the fall in consumption spending, the economy has a chance to switch to relying on investment as a way of coming out of the crisis. Since, the private sector is saving rather than spending, it is the public sector’s responsibility to finance this investment. Tropeano suggests that the US government could perhaps invest in infrastructure in line with the Keynesian public works tradition (Tropeano 2011, 7)³.

Likewise, economist Randall Wray uses the accounting identity of financial balances to show the importance of discretionary fiscal policy in creating wealth for the private sector. According to the accounting identity, private sector balance/account is equal to federal budget balance plus current/foreign account balance:

(S-I) = (G-T) + (X-M)

Applying this equation to the US economy that usually has a high current/foreign account deficit, for the private sector balance to be in surplus, the government has to be in deficit. In other words, according to the accounting identity, the only way the government can ensure private savings to be more than investment is through the use of fiscal policy, in particular, deficit spending (Wray 2011)4

Pallavi Mehra graduated from Dickinson College, USA (Economics Major with Honors) and begins her Masters in Economic Policy, Columbia University in 2016.

Sources

1http://www.bbc.com/news/business-19559191

2Skidelsky, Robert. 2009. Keynes: The Return of the Master. New York: Public Affairs

3Tropeano, Domenica. 2011. Quantitative Easing in the United States After the Crisis: Conflicting Views

4Wray, L.Randall. 2011. Money and inflation. In a New Guide to Post Keynesian Economics, ed. Richard P.F. Holt and Steven Pressman, 79-90. London and New York: Routledge