Question

A paradox occurs when the government tries to influence full employment by utilizing the government budget as a surrogate with tax cuts, high tariffs, and increased government spending because increasing employment, government spending, and lower taxes will also drive up inflation and interest rates which will slow the economy. Discuss which one should be a government priority when setting the budget and why you believe that to be true.

Answer 1

Governments are generally considered to be no different than individuals and firms, whose optimizing behave subject to budget constraints. Because of the distortionary supply side effects of government spending, it is commonly believed that “good housekeeping” in the “sound finance” must be generally practiced. Governments must abide by their intertemporal budget constraints and offset today’s spending by current or future taxes. Ideally, these offsets should not occur too far into the future, in order to guarantee intergenerational equity.

Furthermore, large deviations from these constraints are believed to undermine the sustainability of the government budget. Sustainability, therefore, is a major common concern for mainstream economists, but there is a growing disagreement about what exactly it means. In most analyses, it means that the government will simply be unable to borrow from the private sector, making deficit spending unsustainable. But others have argued that sustainability should mean solvency, since ns the government, unlike the private sector, could always borrow from its Central Bank.

Fiscal policy has had a checkered past. Keynes’s revolutionary theoretical approach erected an important place for fiscal policy—a place which was later dismantled by mainstream theory. And while the mainstream is trying to salvage some role for fiscal policy from the ashes, Post-Keynesians have long championed bona fide Keynesian ideas. In the final analysis, the New Economic Consensus places monetary policy at the helm of the economic steering wheel. For Post-Keynesians, in the true spirit of Lerner and Keynes, this role is attributed to fiscal policy.

To the extent that the New Economic Consensus (NEC) restores some role for fiscal policy, it is neither a dominant role, nor is it clear what exactly that role should be. It only reaffirms that fiscal policy is inherently inflationary. While the NEC has opened the possibility to escape false logic of government finance and to argue that there is nothing inherently unsustainable about government deficits, this inflationary impact, coupled with early supply side notions of the distortionary impact of fiscal policy, reasserts the need for “sound finance” as the norm.

Post-Keynesians have long advocated fiscal policy as a policy for macro-coordination and full employment, suggesting that in a world of administered prices and money contracts where fundamental uncertainty, involuntary unemployment, and capacity underutilization are the norm, there is nothing inherently inflationary about fiscal policy. In fact, it can serve as an important stabilization tool that reestablishes the link between fiscal policy and full employments. Recent contributions from the Post-Keynesian camp have resurrected the Lerner’s functional finance approach via two distinct methods – one is an indirect approach to full employment via aggregate demand management and the other is a direct approach to full employment via a job guarantee.

Fiscal policy has to be designed and implemented in a way that ensures there is sufficient aggregate demand in the economy relative to its real productive capacity so that full employment is achieved and sustained. Second, it should be designed and implement so as to reduce inequality. The two goals are interdependent despite the myths that economics students learn about the trade-off between efficiency and equity. It is now clear that rising inequality harms the prospects for sustainable economic growth. The evidence is now starting to come in that during the neo-liberal era, fiscal policy was actively used to reduce its redistributive capacity and its capacity to reduce market-generated inequality was severely compromised.

Fiscal spending can also be designed to address gaps in productive capacities and contribute to greater accumulation of physical and human capital. This encompasses not just the longer-term effects of public investments in infrastructure, R&D and innovation but also ensuring broad and equitable access to education, training and health. Countries that have a sufficiently educated and skilled work force, for instance, are better able to develop and absorb technological and organizational advances that are a country’s “endogenous” sources of growth.

The post-crisis rethinking has largely focused on the cyclical components of fiscal policy in the advanced economies, but it has also led indirectly to a better appreciation of the role of fiscal policy in fostering long-run economic growth, employment and development. This is of special importance to developing countries. A number of channels whereby the fiscal policy stance has long-term effects are commonly emphasized. At the macro level, it is widely accepted that counter-cyclical policies stance does help smooth output shocks, contributing to more stable patterns of consumption and less volatile returns from investment, in turn fostering a strong and stable flow of private investments. At the micro level, it is acknowledged that tax reforms can enhance the incentives for firms to invest and for individuals to participate in the labour market

shortfalls in demand can drive capital investment down, impairing technological progress and productivity growth and setting the economy on a lower growth path. Capital investments, in fact, do tend to move in line with the business cycle. With a slack in demand and unused productive capacity, employers can be less keen on investing in equipment and machinery, R&D and the introduction of new technology. At the opposite, where demand is buoyant the incentive to invest in new equipment that embodies the latest technology is greater. This can be the more so, the more the economy nears full employment.

. Budget-neutral shifts towards job-preserving and job-creating programmes that are carefully designed and monitored could encourage job-rich growth