The Procyclicalists: Fiscal Austerity vs. Stimulus

The world is in the grip of a debate between fiscal austerity and fiscal stimulus. Opponents of austerity worry about contractionary effects on the economy. Opponents of stimulus worry about indebtedness and moral hazard.

Is austerity good or bad? It is as foolish to debate this proposition as it would be to debate whether it is better for a driver to turn left or right. It depends where the car is on the road. Sometimes left is appropriate, sometimes right. When an economy is in a boom, the government should run a surplus; other times, when in recession, it should run a deficit.

True, it is hard for politicians to get the timing of countercyclical fiscal policy exactly right. This is the reason, more than any other, why Keynesian policy lost its luster. “Fine-tuning” it was called. Sometimes the fiscal stimulus would kick in after the recession was already over.

But this is no reason to follow a pro-cyclical fiscal policy. A procyclical fiscal policy piles on the spending and tax cuts on top of booms, but reduces spending and raises taxes in response to downturns. Budgetary profligacy during expansion; austerity in recessions. Procyclical fiscal policy is destabilizing, because it worsens the dangers of overheating, inflation, and asset bubbles during the booms and exacerbates the losses in output and employment during the recessions. In other words, a procyclical fiscal policy magnifies the severity of the business cycle.