When does fiscal policy work?

by on April 7, 2005 at 6:01 am in Economics | Permalink

Brad DeLong notes:

When can deficit spending in a recession help?

  1. When it is part of a stable and sustainable structure of economic policy, so that nobody fears that it is the beginning of a process of rampant inflation or expropriation. In that case deficit spending will have no deleterious effects on investment, and to the extent that it gets more money into the hands of those who are temporarily short of cash it will boost demand and employment.
  2. When things are already so bad (as in 1933 and 1934) that there is no investment anyway: if business confidence is already at its nadir, deficit spending cannot do any harm by reducing investment, and does good by putting people to work and boosting their incomes and their demand.

I’ll add further conditions, none of them absolute.  First, it should be accompanied by an expansionary yet stabilizing monetary policy (similar to Brad’s first condition).  Second, the money should be well spent, ideally on durable infrastructure.  Third, fiscal policy should be a signal of a government’s competence or seriousness about fighting the recession.  Fourth, I doubt it does much good if the core problem is bankrupt or otherwise malfunctioning financial institutions.

Mostly I am a skeptic about fiscal policy, if only because discretionary fiscal changes tend to be small relative to modern wealthy economies. 

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