Yesterday I touched on Monetary Policy. After reading through that and this post on Fiscal Policy I hope to bring to the fore the sources of economic pitfalls bedeviling Zimbabwe, Greece and perhaps others in similar situation: Namely that having control over Fiscal Policy and not on Monetary Policy is like a bird trying to fly on one wing!
What is Fiscal Policy
Fiscal policy is most commonly viewed by economists as one-half of macroeconomic policy, the other half being monetary policy. In its most basic form fiscal policy describes how government funds its activities and what these activities are. The putting together of a government budget, for example, is fiscal policy. Fiscal policy is seen as sustainable or rational when the public and those buying government debt instruments perceive that a government’s fiscal policy is predictable and that the government will continue to make payments on its debt. The most obvious example of a rational fiscal policy is that a government’s revenues sources (taxes, tariffs, user fees) roughly equal its expenditures on government programs. A rational fiscal policy might also be defined by a government making public its budgets and the process by which these budgets are formulated. In addition, it is common practice and rational fiscal policy for governments to prepare financial statements and to have these statements audited. Fiscal policy goes hand-in-hand with monetary policy because a country’s currency will lose its value if its fiscal policy is not seen as sustainable.
Some economists, known as Keynesian economists, believe that fiscal policy can help governments manage the economy to ensure full employment. Keynesians believe that when private economic activity is not creating enough demand in the economy to create full employment that fiscal policy can be used to increase demand and therefore stimulate enough economic activity to create more jobs. This idea of active government management of the economy through fiscal policy is derived from John Maynard Keynes, whose book The General Theory of Employment, Interest and Money was published in 1936 during the Great Depression.
As is well known the Great Depression was a time when unemployment was prolonged at very high levels compared to preceding historical periods. This motivated Keynes to recommend that government should take action to increase employment. The General Theory is oftentimes seen as the first time that a respected economist proposed that government and not the private sector can create employment. The General Theory is also seen as the beginning of macroeconomics as a subfield of economics.
An active fiscal policy then is the use of government taxing and spending policy to stimulate demand in an economy. In political debates, the use of government fiscal policy to increase demand is now known as a “fiscal stimulus”. If the private sector is not investing enough in productive assets and not spending to increase output, including the hiring of employees, then Keynesians believe that a fiscal stimulus created by government will start an upward cycle of economic activity. As government spending increases through a fiscal stimulus, the stimulus will provide more income to private individuals who will therefore spend more through consumption. This increased spending, this increased demand, will encourage private companies to begin spending more for output to meet the higher demand. This increase in output in turn will mean the hiring of more people. These newly hired employees will then spend more themselves, more demand is created and more output is produced to meet this demand, and an upward cycle of economic activity ensues. This idea of an active fiscal policy is also known as “demand management”.
Keynesian economists believe that a fiscal stimulus is created when a government spends more than it receives in taxes and other revenue sources; this is called “deficit spending”. There are several ways that a government can use deficit spending to create a fiscal stimulus and the differences in these ways to create a stimulus are often the subject of political debates in the formation of government fiscal policy. Economists who believe that government programs help people recommend that government should spend more on government programs. This increased government spending then increase demand. Other economists recommend that a fiscal stimulus be created through a reduction in taxes because taxes are seen as a drain on private on economic activity.