Must Fiscal Stimulus Policies Put a Burden on the Future?

Conservative critics of fiscal stimulus policies usually criticise such policies because of the public debt burden they create. This column introduces a new CEPR Policy Insight, which takes a close look at the Keynesian theory underlying the policy of fiscal stimulus being undertaken or considered in many countries, led by the US.

Conservative critics of fiscal stimulus policies usually criticise such policies because of the public debt burden they create. It is indeed true that a burden on future taxpayers is imposed if budget deficits that result from stimulus policies are financed by borrowing on the market. But that is by no means the whole story. Rigorous analysis is needed.

On the basis of Keynesian principles stimulus policies are needed when monetary policy cannot, for various reasons, eliminate high unemployment that has led, or is expected to lead, to actual output being below potential output, that is, an output gap. When a policy causes output and hence incomes to rise, why must the net effect be adverse?

The direct effect is to raise output, which will raise current consumption and also private savings. The extent of the output increase will depend not just on the initial stimulus itself but also on the familiar multiplier, which, in turn, depends on the propensity to save. The current benefit is obvious; it reduces unemployment, raising output and incomes, and hence consumption. But what about the future?

The higher savings that finally result must be put in the balance when assessing net gains or losses for the future. These savings can finance the extra taxpayer liabilities created by the higher debt. In addition, there are the benefits for the future of the investment, for example infrastructure, that the government may have made as part of its stimulus program. Thus there are several future gains that must be set against the burden on taxpayers that higher debt creates. And, in addition, one must take into account the possibility of some of the government’s bonds being bought by the central bank, so that part of the debt is money-financed, rather than being financed on the market.

All this concerns the discretionary part of the stimulus. In addition, there are the automatic stabilisers. Here it is important to bear in mind that it is not enough that a tendency to budget deficit in a recession is automatic. These deficits must actually be financed if there is to be a stimulus effect. When there is a belief that budget deficits are undesirable (as there was in the Great Depression) it is likely that they will be quickly eliminated with higher taxes or reductions in government spending, rather than being debt-financed.

These and other issues are discussed rigorously in CEPR Policy Insight No. 34, which takes a close look at the Keynesian theory underlying the policy of fiscal stimulus being undertaken or considered in many countries, led by the US.

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