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Free Economics Essays - Fiscal policy is the policy of the government with regard to the level of government purchases, the level of transfers, and the tax structure (Dornbusch, R. and Fischer, S, 1990).

The government affects the level of equilibrium income in two separate ways. First, government purchases of goods and services are a component of aggregate demand in US economy. Second, taxes and transfers affect the relation between output and disposable income, hence, income available for household consumption or saving. Since fiscal policy normally influences the size of the actual public sector borrowing requirement (PSBR), changes in PSBR are usually used as an indicator of the government’s fiscal stance. The essence of fiscal policy is that it is the means to influence expenditure flows in the economy either directly through expenditure changes or indirectly through tax and transfer changes; such changes in flow magnitudes are seen to be a principal means of controlling the level of aggregate demand (Greenaway D. and Shaw, G.K 1991).
Government purchases and transfer payments act like increases in independent spending in their effects on equilibrium income. A proportional income tax reduces the proportion of each extra dollar of output that is received as disposal income by consumers; and thus has the same effects on equilibrium income as a reduction in the propensity to consume. Changes in government spending and taxes affect the level of income.
Fiscal policy can be used in various different ways. It may be used to try to boost the level of economic activity when the economy is flagging a little. In this case it is called reflationary policy. Reflationary policies are any policies aimed to boost the level of economic activity. These could be either fiscal or monetary policies. For example, a reflationary fiscal policy could be to reduce the level of taxation. This would increase the amount of disposable income people had and encourage them to spend more, therefore increasing output and employment.
Alternatively the economy may be doing a little too well and in need of slowing down. In this case the government through the annual budget implements deflationary policy. Deflationary policies are policies that are aimed to reduce the level of aggregate demand in the economy and therefore slow down the rate of growth of output. This may be necessary because of increasing inflation or a significant balance of payments deficit.
The final use for fiscal policy is as a tool of supply-side policy, supply-side policies are policies that improve the workings of markets. In this way they improve the capacity of the economy to produce and so shift the aggregate supply curve to the right. This should enable the economy to grow in a non-inflationary way. Supply-side policies are usually advocated by classical and Monetarist economists who believe that free market are the most important factor determining economic growth. Supply-side policies may include improving education and training, reducing the power of trade unions, removing regulations and so on.
Sustained economic growth in the US during the second half of the 1990s was accompanied by rising household and corporate indebtedness, together with a widening current account deficit. Financial imbalances often arise during periods of strong economic growth and can be financed by an inflow of foreign capital attracted by profitable investment opportunities. However, if they reflect overly optimistic expectations of future economic performance, any downward revision to expectations could prompt a sudden, sharp adjustment to economic activity.
Fiscal policy can be used to expand aggregate demand and thus raise the equilibrium level of output. Therefore, through use of fiscal policy the US government can affect the level of income, which can subsequently lead to the household indebtedness. All expansionary fiscal policies will raise the interest rates if the quantity of money is unchanged (Dornbusch, R. and Fischer, S, 1990). The tables below summarises the effect of expansionary fiscal policy on output and interest rate. The balance between government policy on countering inflationary pressures by increasing interest rates and countering the raising level of household indebtedness is another. This is a problem for the fairly large section of the population whose mortgages represent a substantial multiple of their income and which were, and probably still are, quite affordable because of low interest rates, but which will become progressively less affordable as interest rates rise.
Table 1: Summary Policy Effect on Income and Interest Rates (Dornbusch, R. and Fischer, S, 1990)

Policy Equilibrium income Equilibrium interest rate
Fiscal expansion + +
Monetary expansion + -
Table 2: Alternative Fiscal Policies (Dornbusch, R. and Fischer, S, 1990)

Interest rate Consumption Investment GNP
Income tax cut + + - +
Government spending + + - +
Investment subsidy + + + +
On the basis of the actual growth in US incomes, whether private wages and salaries or government tax revenues, there would have been, at best, very feeble growth between the onset of recession in 2000 and today. The US savings rate (which determines the pool of domestic funds available for investment), which was 10% at the end of the 1980s, fell to 5% in the mid-1990s, and has averaged around only 2% during the last five years (falling virtually to zero in some recent quarters). Apart from some improvement between 1996 and 2001, the real wages of the majority of workers stagnated for over two decades, and have declined since 2001. That is why consumer demand, which accounts for about 90% of US growth, has grown on the basis of mountains of debt.

"This is the worst government the US has ever had in its more than 200 years of history. It has engaged in extraordinarily irresponsible policies not only in foreign and economic but also in social and environmental policy. This is not normal government policy. ...This is a form of looting." - George A. Akerlof, 2001 Nobel Prize Laureate in Economics referring to the Administration of George W. Bush.
The ratio of household debt to disposable income rose to a record 108% of disposable income at the end of 2003 (16 percentage points above the 2000 level). This was mainly due to mortgage debt, but consumer credit (car loans, credit card debt) was also at record levels. If household debt continued to grow at the 2000-03 rates, the ratio would rise to 152% of disposable income by the end of Bush’s second term. However, further rises in interest rates will make the existing burden of debt unsustainable for many households.
The US economy has experienced rapid growth since the second half of 2003 and the expectation now is that the rate of growth will continue indefinitely. However with both the government and private sector so heavily indebted, the rate of growth cannot be maintained without a sustained and discontinuous increase in net export demand. But this will not come about with out a cut in domestic absorption of goods and service by the US, which would impart a deflationary impulse to UK.
It shows that the recent economic expansion in the US was driven by financial imbalances that were allowed to persist much longer, and go much deeper, than the point at which both financial rebalancing and growth could be attained simultaneously and painlessly. An ongoing retrenchment of private sector spending and a growing deficit in the current account are causing an unprecedented large aggregate demand deficiency. Recent trends in financial balances in the US since the 1960 shows that the private balance and the balance of payment are both drawn as surpluses while the government balance is drawn as a deficit (Wynne Godley and Alex Izurieta (2004). The fiscal sector has emerged to partially compensate such leakage by an unusually rapid reversion to deficit (a movement from surplus to deficit equal to five percent of GDP in only two years!). Though this proves --against the consensus view of the last decades-- that fiscal policy matters, but it will not be enough.
A continuation to acceptable and sustainable growth in the U.S. requires both relaxation of the fiscal stance and strengthening of net export demand. However, the latter can no longer be achieved by an adjustment in the real exchange rate alone, since the world economy is contracting. Indeed, preliminary assessments of the U.K. (forthcoming CERF publications) reveal that a similar implosion is here underway. Furthermore, the sluggish performance in the Euro area, exacerbated by the damaging, pro-cyclical implications of the ‘Growth and Stability Pact’, suggests that stagnation is being allowed to persist here too (Alex Izurieta, 2003).
In the US, the marked acceleration in productivity over recent years suggests that expectations of stronger economic growth in the future are well founded. But the willingness of foreign investors to continue financing the US current account deficit will depend heavily on whether they expect recent relative productivity gains to be sustained. A kind scenario in relation to the unwinding of imbalances would see productivity in other major economies starting to catch up with that in the US, as they also benefit from 'new economy' gains. This would widen investment opportunities, allowing the dollar to adjust which, together with higher US domestic saving, would allow the imbalances in the US economy to unwind in a relatively slow and orderly manner.
An alternative scenario is that recent productivity gains in the US are not sustained, prompting households and firms to revise expectations and rebalance their financial positions more rapidly than anticipated. This could also reduce the supply of foreign capital, prompting a sudden adjustment in the value of the dollar. At the time of the Pre-Budget Report, it was feared that uncertainty surrounding the likely supply-side impact of the events of 11 September might bring about such a scenario. These fears have now largely abated, but there remains a risk that these imbalances will unwind rapidly at some point in the future, prompting financial market instability and presenting risks to global economic prospects.
The synchronised slowdown of growth in the US, Europe and Japan was a major influence on developments in the UK economy during 2001. But, in contrast to previous episodes of faltering global demand and rising economic uncertainty, the platform of low inflation and sound public finances delivered by the Government's new macroeconomic framework enabled policy to sustain stability and growth in the UK.
Annual growth of household consumption has remained stable at around 4 per cent in each of the past six years, with households adjusting saving to cushion the effects of fluctuating income growth on spending. At the same time, growth of household consumption has, on average, exceeded that of real disposable incomes. The persistent relative strength of consumption growth may partly be accounted for by rising housing wealth, but it has also been accompanied by a significant increase in household indebtedness. This may, in part, have reflected lower and more stable inflation and interest rates relative to past experience, which have kept debt servicing costs stable relative to disposable incomes. However, growth in consumption cannot be sustained indefinitely at rates exceeding the trend growth rate of the economy. Households are therefore expected to limit further borrowing over the forecast horizon as they approach desired balance sheet positions (Budget Report - April 2002)
The UK almost certainly reached the £1 trillion level of household indebtedness, which is broadly equivalent to our gross domestic product. Household indebtedness has recently increased annually by approximately 12 per cent, despite having slowed a little from an even higher figure. Much of that has been in the form of mortgage indebtedness or secured lending. According to the latest reckoning, some £818 billion of mortgage debt forms part of the £1 trillion total. Mortgage debt, at around 13 per cent a year, has been growing even faster than overall household indebtedness, although it, too, has slowed slightly.

Source: Budget Report - April 2002
No economy is immune to the impact of the current global slowdown or the events of 11 September. But because the Government has taken tough decisions since 1997 to create a platform of macroeconomic stability, the UK is in a better position than on previous occasions to cope with turbulence in the world economy. The economic challenge is to maintain stable growth through these testing times, while continuing to work to deliver stronger productivity growth and employment opportunity for all. Rising to this challenge is imperative in order to maintain the foundations for meeting the Government's objectives for reducing poverty and delivering high quality public services.
It is evident from the discussions that the UK household indebtedness is not as distressing as the current US position. However, the US indebtedness will pose significant risk to the UK in terms of changes in US government policy in relation to its very growing current account deficit. The fear is that the US government’s borrowing would make it difficult for private firms to borrow and invest, and thus would slow the economy’s growth. So what potential risk does this pose to UK?
Since Budget 2001, G7 activity and trade have been weaker than expected. For the first time since 1974, there has been a significant and simultaneous slowdown of growth in the US, Europe and Japan. Following the terrorist attacks of 11 September, heightened uncertainty and declining confidence have further weakened demand and delayed the recovery in the major economies. By raising security and insurance costs, the attacks may also have had a negative impact on supply. In the UK, economic growth has remained relatively strong during 2001 despite the weaker external environment.
The UK economy has been affected by the global slowdown. Growths in the UK’s major export markets slowed dramatically during 2001. Business investment has fallen, and business confidence, which was already weakening, has deteriorated further since 11 September. The global slowdown also appears to have had a negative impact on consumer confidence.
Satisfactory growth in the medium term cannot be achieved in the US without a large, sustained and discontinuous increase in net export demand (Wynne Godley, Alex Izurieta and Gennaro Zezza (2004). This can only happen with a cut in domestic absorption of goods and services by the US, which would impart a deflationary impulse to the UK. The UK balance of Payment is also at a risk of further budget deficit, as it is dependent on factors outside the control of government, and depends on what private economic agents (including foreigners) decide to do. With full stock/flow accounting respected, the two-country open economy portfolio balance model has just two independent equations for asset market clearing. It can determine home and foreign interest rates but not the exchange rate. If asset market equilibrium varies smoothly over time, the balance of payments equation in the Mundell-Fleming model is not independent and cannot set the exchange rate either (Lance Taylor (2004).
As the capital movements are interest sensitive, as the US looks to increase interest rates to counter inflationary pressures, the UK relative interest rate is too low it affects the current account by stimulating expenditure on imports, and the capital account by encouraging capital to seek more lucrative returns elsewhere. Therefore, a change in the interest rate affects both current account and the capital account of the balance of payments.

1. Budget Report - April 2002 -
2. The US economy ‘running on fumes’ Socialism Today Issue 88 Dec-Jan 2004-05
3. Alex Izurieta (2003): Economic Slowdown in the U.S., Rehabilitation of Fiscal Policy and the Case for a Coordinated Global Reflation. CERF Working paper Series No.6
4. Wynne Godley, Alex Izurieta and Gennaro Zezza (2004): Prospects and Policies for the US economy. Why net exports must now be the motor for US growth.
5. Wynne Godley and Alex Izurieta (2004): Balances and imbalances and fiscal targets - a new Cambridge view.
6. Lance Taylor (2004) Exchange rate indeterminacy in portfolio balance, Mundell-Fleming and uncovered interest rate parity models, Cambridge Journal of Economics Vol.28 No.2
7. Greenaway, David; Shaw, G.K., Macroeconomics Theory and Policy in the UK Second Edition (1991), Basil Blackwell.
8. Dornbusch, Rudiger; Fischer, Stanley, Macroeconomics Fifth Edition (1990) McGraw-Hill International Editions

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