When one category of national production, such as consumption spending, decreases, then one or more of the three other categories must increase by at least the same amount or Gross Domestic Product will decline. And that means national income declines.
That has been true for centuries, well before Russian-American economist Simon Kuznets helped develop “national income and product accounting” for the U.S. Congress in 1934. There is no cause and effect in this; it is a simple arithmetic question of four categories of output being added together.
The question for economists is whether government can or should do anything to affect cyclical fluctuations in GDP. These questions are inherent in the current “fiscal cliff” debate and the degree to which the inevitable tax hikes and government spending cuts after Jan. 1 would harm economic growth.
Government does not control consumption or business investment or the level of net exports. It does, however, control its own spending. And, by varying taxes, it indirectly influences the amount of money available for households to spend or businesses to invest.
Moreover, the Federal Reserve, the politically independent branch of government we call the central bank, can change the money supply and hence interest rates. This inherently changes incentives for households to borrow or pay down debt and for businesses to invest in new plants and equipment or not.
For more than a century, from the emergence of economics as a discipline in the late 1700s, the consensus was that government should not try to manage the overall economy. Its role should be as minimal as possible.
Moreover, the principles of “sound finance” meant that if a recession reduced tax revenues, spending should be cut commensurately to avoid adding to a national debt.
In the 1930s, British economist John Maynard Keynes rejected this, arguing that government could temper the impacts of such business cycle fluctuations by increasing its own spending and decreasing taxes in recessions.
At the same time, the central bank should increase the money supply and lower interest rates. In an unsustainable boom, the other end of the cycle, government should do the reverse: increase taxes, cut spending while the monetary policy authorities crimped money growth, driving up interest rates.
Note that Keynes did not advocate large or sustained increases in a nation’s debt. The idea was that governments would run deficits during recessions, but surpluses during booms.
Over the business cycle, a nation could follow Keynesian policies without necessarily increasing its debt.
That often was not the case in practice, although the national-debt-to-GDP ratio for the United States fell continuously from World War II until Keynesian ideas began to lose dominance in the 1970s.
That ratio has risen at a rate unprecedented in peacetime over most of the years since.
Keynes’ arguments dominated thought within the economics discipline for about 45 years and still dominate practical government policymaking in both Republican and Democratic administrations, even though most Republicans now renounce Keynes.
Understand that some such “countercyclical” tax and spending changes happen automatically even if Congress and a president take no action to change laws.
When an economy slows, people earn less and pay less in taxes. More people qualify for unemployment compensation and income-based transfer programs like Food Stamps. More people go on Social Security before their “normal retirement age.” So tax revenues drop and treasury outlays increase in recessions. The reverse occurs when the economy grows.
Increased government spending on goods and services obviously has a direct effect on output of these goods. The effect of tax changes is indirect. Lower taxes on households leaves them with more to spend on consumption or to save. Lower taxes on businesses leaves these with more cash to either spend on new facilities and equipment or to give to the business’s owners who can then either spend or save it.
Money supply and interest rate changes also have effects on households and businesses, but these are peripheral to the “fiscal cliff,” so let’s set them aside for now.
The $260 billion stimulus package in the last year of the George W. Bush administration and the $787 billion one in the Obama administration were classic Keynesian measures. Both cut taxes temporarily and increased government spending on goods and services.
The Obama package also included substantial transfers to state and local governments to keep these from cutting spending as much as they otherwise would have been forced to do because of their own falling tax revenues. So while there was an increase in federal outlays, this was much less true for government as a whole.
Economists will debate the effects of these two stimulus packages for a long time. To the extent there is any consensus, it is that they did more good than harm. But a majority of the public may perceive them as failures.
The U.S. economy is still sluggish, so Keynesian theory would suggest that this is not the time to cut spending or increase taxes. Continued deficits instead are indicated.
But that is predicated on the assumption that we ran surpluses when the economy was good. We did for a few years in the last half of the 1990s, but the rest of the past three decades saw deficits and a rising national debt regardless of where we were in the business cycle.
Many people, including a few Nobel prize winners like Edmund Phelps, argue that it is more important to deal with long-run deficit and debt problems than to seek dubious benefits of additional “fiscal stimulus.”
Indeed, many of the brightest people, the most respected within the discipline, reject Keynes.
At the same time, nearly all Republicans, in rejecting Keynes, argue instead for a combination of lower spending and lower tax rates. Most assert this is “supply-side economics,” although that is a term rarely used within economics, even by those most critical of Keynes. And, just as “Keynesian policies” in the forms implemented since 1970 often differ greatly from what Keynes proposed, so does “supply-side economics” differ greatly from that advocated by the tiny group of economists and promoters who originated that school in the late 1970s.
But that is the subject of a column for next week.