The Purpose of Fiscal Policy

Most of the public does not understand fiscal policy in the context of how national government spending works (taxation, deficit spending) and so, they also fail grasp what the purpose fiscal policy is. It is strange at best and totally frightening at its worst that people who follow politics as their main hobby have an understanding of voter ID, Obamacare, the Supreme Court ruling on Hobby Lobby and any other issue manufactured by politicians for them to be distracted by, but have no comprehension of nor any real interest in fiscal policy beyond the false notion that “very serious people” say that it is bad. Of course, they cannot explain monetary policy to you either, and that’s the whole point, isn’t it? Keep people in the dark by making things so confusing that the public simply finds it too boring. Just hand them a few simple household analogies and leave it at that. You want to know why economics is really the “dismal science”? It is for that reason. The nonsense is so thick and the explanations of that nonsense are so abstract and convoluted (which they have to be to prove that fantasy is reality), that there is no hope of your average person understanding anything and taking an interest in it. Perhaps the aforementioned might help to answer questions that some of you have concerning why I spend so much time writing articles that concern only basic concepts. Simply put, I’m trying to reach the uninitiated, the misinformed public, students before they become totally lost and interested laypersons. If you do not understand deficit spending, taxation, a budget surplus, banking operations and central bank operations, then what good would it do you were I to discuss my objections to the Hodrick-Prescott Filter? How would that solidify an understanding in your mind of basic concepts – the things that ensure you are better informed? I mean, seriously – if you do not understand what we mean by “cyclical”, then I am telling you right now that you aren’t going to understand the HP filter, no matter how simple of a language I use. Furthermore, I seriously doubt discussions of the HP filter would engender a fascination with macroeconomics. If you are a mathematician, maybe it would sow some interest. But then again, if you are a mathematician and you simply cannot wrap your head around (G – T) = (S – I) – (X – M) which amounts to a simple linear equation, then the HP decomposition needs to wait. You would only end up wasting time developing a method to make it work with certain DSGE models or perhaps you would think it proper to begin analyzing trends and “proving” to me that fiscal policy can be easily and efficiently managed if only we (insert anti-knowledge that you’ve developed here), and I’d only end up responding to you with (G – T) = (S – I) – (X – M) yet again. That being said, let us turn to the purpose of fiscal policy.

What is fiscal policy? In simple terms, fiscal policy is when the representative body within a national government decides on things that it will fund, defund, who and what to tax, how much it will tax, etc., which we ridiculously refer to as a “budget” when it comes to sovereign currency-issuing governments like the UK, US and Australia. The word “budget” used in conjunction with the US government is highly misleading, really. It implies that the government’s finances are just like a household’s and so, it must budget its money, lest it go broke. It would be far more honest of us if we ceased using the term budget for these national governments and began using the term “Fiscal Agenda” (ex – “The Fiscal Agenda of the Government of the United Kingdom, 2017”). “Budget” implies the potential for insolvency and “Fiscal Agenda” implies how the government intends to manage the economy and the nation. But I digress.

So, fiscal policy in the US is determined by the legislative and executive branches of government and it is the only way that the economy can obtain more US Dollars. The US government, through fiscal policy, adds more needed dollars when the economy is doing poorly and subtracts dollars as well. Once the “budget” is approved, Treasury begins to credit bank accounts with numbers created out of thin air, which we call “spending” and also deletes US Dollars previously issued through deficit spending from reserve accounts in the banking system held at the Federal Reserve, effectively destroying US Dollars, which we call “taxation”.

If the number of US Dollars created out of thin air and spent into the economy is greater than the US Dollars that the federal government destroys through taxation in a fiscal year, then that is what we call a “budget deficit”, or (G > T) where government spending (G) is greater than taxation (T). The national government is the sole supplier of currency (US Dollars, British Pounds) for the domestic private sector (you, me, Walmart) and the external sector (The rest of the world). Together, these two sectors are what we call “the non-government sector” and are represented as (S – I) – (X – M), where savings is (S) minus investment (I) minus exports (X) minus imports (M). When we attach the national government to the non-government sector, we have what we call the “sectoral balances” equation:

(G – T) = (S – I) – (X – M)

Which basically says that whatever the government sector spends will be found in the non-government sector, or in plain English, when the US government creates more dollars out of thin air and spends than it taxes away, that exact amount will be deposited in the non-government sector. So, if G = $20 and T = $10, then G – T = $10 and so $10 from deficit spending will end up in [(S – I) – (X – M)]. Also, if G = $20 and T = $30, then G – T = -$10 and so $10 will be withdrawn by the budget surplus from [(S – I) – (X – M)] and destroyed, leaving the non-government sector short $10. So, we understand that the federal government is the entity that adds and subtracts the dollars we use in our daily lives. Let us take a closer look now at the three sectors.

On the left is the government, on the right is the rest of the world outside of the United States and squished in the middle between the two are you and I, the domestic private sector. When the US government deficit spends, it is creating and then spending more dollars than it is destroying and so, when it credits bank accounts with numbers created out of thin air, those dollars enter the banking system and then can flow out of the domestic economy and into foreign hands through international trade. Imports mean foreign goods are flowing into the US and so, US Dollars are flowing out of the US. Exports mean US goods are flowing out of the US and so, US Dollars in foreign hands are now flowing into the US to purchase US goods. If the total flow of US Dollars out of the domestic economy through imports is greater than the number of US Dollars added from exports, then that is what we call, in technical terms, a “current account deficit”. To quickly answer concerns – No, there is no such thing as a trade imbalance. There is also something that we call the “capital account”. If there is a current account deficit of $1 billion then there will also be a capital account surplus of $1 billion:

$1 billion – $1 billion = $0

There is no trade imbalance. Ignore politicians and the CATO institute, who carry on about the coming Armageddon because there is a dangerous trade imbalance with China, for the sake of your own sanity and well-being.

So, the domestic economy is squeezed between the two giants and needs US Dollars to ensure that everyone who is willing and able to work can find a decent paying job and the economy stays healthy. But when more US Dollars are flowing out into the rest of the world through greater imports than coming in through exports, the domestic economy is losing much needed dollars to remain stable.

The basic, fundamental rule of macroeconomics is that someone’s spending is someone’s income. There is simply no way around this reality. The economy operates on spending. It is the fuel that makes the car go. Consumers spend and business gets an income from that spending. When consumers persistently spend more, it puts pressure on business to increase the production of goods and services to meet the increased demand. More labour is required to increase production and so, the end result of increased consumer spending is job creation. Thus, if more US Dollars are flowing out into the rest of the world, then eventually there will not be enough US Dollars to go around in the domestic economy.

Consumers wish to save some portion of their total income. That is a given on the macro level. There is a desire to save some US Dollars. Spending is also a given. Consumers desire to spend some of their income as well. When there are not enough US Dollars in the domestic economy to meet consumers’ desire to save, they will not have enough extra US Dollars to spend. In short, they will cut back on spending. On the macro level, we call this a “spending contraction”. If there are not enough US Dollars in the domestic economy to meet the desire of consumers to net save, then a “spending gap” exists. The fewer dollars in the economy, the more consumers will slow their spending.

A spending gap can be created by too many dollars flowing out into the rest of the world as well as through wage suppression – a neo-liberal initiative designed to reduce real wage growth which creates a spending gap that the financial industry can fill with consumer credit. In the latter instance, wages are a stable method to guarantee that consumers can purchase what the nation produces. With wage suppression, production increases while wages stagnate, which then transfers more of the Gross Domestic Product (GDP), also called the “national income” to capital and away from workers. In doing so, the income of consumers is reduced and a spending gap occurs. Banks then step in with credit cards, loans and other products to fill the spending gap. Those consumers with lower credit scores get higher interest rates. Thus, private debt expands to consume production and banks then profit enormously by filling the spending gap. The system is highly unstable, since with the absence of added US Dollars from deficit spending and with reduced incomes, consumers quickly exceed their ability to take on more debt and then contract their spending, resulting in unemployment and recession. As unemployment rises, so does the federal deficit automatically when the unemployed apply for welfare and unemployment insurance. This then leads us to the purpose of fiscal policy:

The purpose of a national government’s fiscal policy is to fill any spending gaps that are present or are developing in the domestic economy. In plain English, the purpose of fiscal policy is for the federal government to manage its domestic economy efficiently. Through deficit spending, it must first create a situation of full employment and then, at all times, observe the behaviour of the economy and stand ready to add US Dollars to correct any deficiencies before they develop into real problems. If consumer spending is slowing down, it must speed it up to maintain full employment. If it waits too long, unemployment will result.

One fiscal policy method used to boost the economy is what we call “Keynesian pump-priming”. In this instance, the federal government spends to increase consumer demand to the point of full employment. The problem with pump-priming is that bottlenecks in supply chains will occur prior to actual full employment, resulting in inflation. Should inflation occur, the government would then manipulate fiscal policy to reduce the pressure and in doing so, create unemployment again. The most efficient and ideal method to achieve actual full employment and price stability is by fixing the price of the wage floor through an automatic stabilizer, rather than having lawmakers wantonly issue US Dollars to pump up private sector job creation.

As mentioned earlier, when unemployment rises, so does the federal deficit automatically, because the unemployed apply for welfare and unemployment insurance. Welfare and unemployment insurance are what we call “automatic stabilizers” for the economy. Most nations employ stabilizers, because they create a floor in consumer spending, thus preventing a sharp fall or “contraction” in consumer spending. If consumer spending decreases resulting in unemployment, when unemployed workers apply for food stamps, this adds to their lost income and guarantees some level of continued spending on food. Without food stamps, consumer spending would fall further, resulting in greater unemployment. Without food stamps, welfare and unemployment insurance, consumer spending would collapse and a depression would ensue. Thus, the purpose of an automatic stabilizer is to automatically manage the federal deficit to some degree without the need to wait for lawmakers to act. A federal Job Guarantee program is an automatic stabilizer that achieves this end.

The Job Guarantee is funded by the federal government but administered locally by communities who have the exclusive right to both determine what work needs done in their communities and the hiring of workers. The federal government would have no authority in this regard. Its sole purpose would be to provide the funding and set the floor price of labor, which then becomes the national minimum wage. In fixing this floor price, the federal government disciplines the growth rate of money wages, thus creating a nominal anchor against inflation. The Job Guarantee would then offer a job at a decent wage to any and all persons who are willing, able and ready to work. From there, the Job Guarantee creates a pool of employed workers that would be large at the onset of the program. Private sector employers are free to hire from this pool to meet their production needs by paying a little more than what the Job Guarantee wage pays. In good economic times, workers will leave the Job Guarantee for better paying private sector employment. Each worker that leaves the Job Guarantee is one less worker that the federal government pays. So, as the Job Guarantee pool shrinks, the federal deficit automatically shrinks. In a poor economy, when workers lose their private sector jobs, they transfer back into the Job Guarantee. Each worker that enters the Job Guarantee is one more worker that the federal government pays. So, as the Job Guarantee pool expands in a poor economy, the federal deficit automatically expands. In an extreme case, were a wage-price spiral to occur in the private sector requiring government action, when the government adjusts fiscal or monetary policy to reduce demand, workers simply transfer from the private sector into the Job Guarantee and inflation is disciplined without compromising full employment. Over time, the private sector is enhanced by the stability and so, the Job Guarantee pool will become much smaller than it was at the Job Guarantee’s introduction and remain so. Good economy or bad, there is always full employment and the federal deficit automatically adjusts to ensure that full employment is sustained indefinitely.

So, now we understand the purpose of a national government’s fiscal policy, as well as having a better understanding of the central concern of macroeconomics. Fiscal policy must fill any spending gaps that are present or developing. It must meet the net savings desires of the private sector. Federal deficit spending lifts the pressure on consumer savings allowing them to spend more US Dollars, which in turn, increases production demands on business, resulting in job creation. By initiating a Job Guarantee, the federal deficit is managed automatically, always ensuring that the right amount of deficit spending is present to ensure perpetual full employment, which in turn, results in efficiency – the central concern of macroeconomics.