Americans have long been attracted by the idea of balancing the government budget year after year—so much so that a constitutional amendment to require a balanced budget has been proposed and debated many times. Let us begin our examination of the virtues and vices of a balanced budget by reviewing the basic principles of fiscal policy that we have learned so far (especially in Chapter 11).
These principles certainly do not imply that we should always maintain a balanced budget, much as that notion may appeal to our intuitive sense of prudent financial management. Rather, they instruct fiscal policy makers to focus on balancing aggregate supply and aggregate demand. They therefore point to the desirability of budget deficits when private demand, C + I + (X - IM), is weak and of budget surpluses when private demand is strong. The budget should be balanced, according to these principles, only when C + I + G + (X - IM) under a balanced-budget policy approximately equals potential GDP. This situation may sometimes prevail, but it will not necessarily be the norm.
The reason why a balanced budget is not always advisable should be clear from our earlier discussion of stabilization policy. Consider the fiscal policy that the federal government would follow if its goal were to maintain a balanced budget every year, as most of the 50 states do. Suppose the budget was initially balanced and private spending sagged for some reason, as it did in 2007–2008. The multiplier would pull GDP down. Because personal and corporate tax receipts fall sharply when GDP declines, the budget would automatically swing into the red. To restore budget balance, the government would then have to cut spending or raise taxes—exactly the opposite of the appropriate fiscal policy response to a recessionary gap, and exactly the opposite of what the federal government actually did. Thus:
Attempts to balance the budget during recessions—as was done, say, during the Great Depression—will prolong and deepen slumps.
This is precisely what many observers feel happened to Japan when it raised taxes in a weak economy in 1997. In fact, Ryutaro Hashimoto, Japan’s prime minister from 1996 to 1998, was disparagingly called the "Herbert Hoover of Japan" because he sought to reduce the budget deficit despite Japan’s sinking economy. State and local governments in the United States also often raise taxes or cut spending during recessions because they have balanced-budget requirements.
This problem arises in both directions. Budget balancing also can lead to inappropriate fiscal policy under boom conditions. If rising tax receipts induce a budget-balancing government to spend more or to cut taxes, then fiscal policy will "boom the boom"—with unfortunate inflationary consequences.
Actually, the issue is even more complicated than we have indicated so far. As we know, fiscal policy is not the only way for the government to affect aggregate demand. It also can influence aggregate demand through its monetary policy. For this reason,
The appropriate fiscal policy depends, among other things, on the current stance of monetary policy. Although a balanced budget may be appropriate under one monetary policy, a deficit or a surplus may be appropriate under another monetary policy.
An example will illustrate the point. Suppose Congress and the president believe that the aggregate supply and demand curves will intersect approximately at full employment if the budget is balanced. Then a balanced budget would seem to be the appropriate fiscal policy
Now suppose monetary policy turns contractionary, pulling the aggregate demand curve inward to the left, as shown by the brick-colored arrow in Figure 1, and thereby creating a recessionary gap. If the fiscal authorities wish to restore GDP to its original level, they must shift the aggregate demand curve back to its original position, D0D0, as indicated by the blue arrow. To do so, they must either raise spending or cut taxes, thereby opening up a budget deficit. Thus, the tightening of monetary policy changes the appropriate fiscal policy from a balanced budget to a deficit, because both monetary and fiscal policies affect aggregate demand.
By the same token, a given target for aggregate demand implies that any change in fiscal policy will alter the appropriate monetary policy. For example, we can reinterpret Figure 1 as indicating the effects of increasing the budget deficit by raising government spending or cutting taxes (the blue arrow). Then, if the Fed wants real GDP to remain at Y1, it must raise interest rates enough to restore the aggregate demand curve to D1D1.
It is precisely the preferred mix of policy—a smaller budget deficit balanced by easier money—that the U.S. government managed to engineer with great success in the 1990s. Congress raised taxes and cut spending, which reduced aggregate demand. But the Federal Reserve pursued a sufficiently expansionary policy to return this "lost" aggregate demand to the economy by keeping interest rates low.
So we should not expect a balanced budget to be the norm.
How, then, can we tell whether any particular deficit is too large or too small? From the discussion so far, it would appear that the answer depends on the strength of privatesector aggregate demand and the stance of monetary policy. But those are not the only considerations.