When Fiscal Policy Might Make Matters Worse

If expansionary fiscal policy is paid for by borrowing, taxes will rise in the future. When taxes rise, people will have less money to spend and aggregate demand will fall. Ideal fiscal policy will increase AD in bad times and pay off the bill in good times. Unfortunately, governments often find it easier to increase spending in bad times than they do to increase taxes in good times. As a result, there are deficits in most years and the total debt grows larger, as we discussed in Chapter 17. When the debt is large, governments must spend a large fraction of their budget on interest payments alone. This usually means there is less room for expansionary fiscal policy when it is needed.

In extreme situations, debt can be such a problem that expansionary fiscal policy can reduce real growth. Some countries are so heavily in debt that any more government borrowing runs the risk of total economic collapse. Take, for instance Argentina, which had a major financial crisis in the 1999–2002 period; in those years, Argentine GDP fell by rates of −3.4%, −0.8%, −4.4%, and −10.9%, respectively.1 That’s not a good record. In the years leading up to this collapse, the Argentine government spent more and more, and did not pay off its bills. By 2002, Argentine government debt was 150% of GDP, a very high level. (For purposes of contrast, the U.S. federal government has net debt of about 73% of GDP, although that level is rising.) The Argentine government could not pay off these debts and the final result was the largest default by a government in the history of the world.

In the years leading up to the collapse, many investors feared that the Argentine currency would lose most of its value and that the economy would fall apart. More government spending led to more anxiety, rather than economic stimulation.

So, in this setting, if the government increases spending, aggregate demand does not go up. Instead, private spending and production fall by so much that real GDP falls (i.e., more than 100% crowding out!). Aggregate demand falls because in times of great uncertainty, people save or hoard their money in anticipation of hard times ahead. In the case of Argentina, people put their wealth into bank accounts in Miami or Switzerland, rather than investing it at home or spending it in the shops of Buenos Aires. Of course, that flight of capital only hastened the economic collapse.

We’ve mentioned Argentina, but similar scenarios (the details differ) have occurred in many other lesser developed nations, including Thailand, Indonesia, and Mexico. The lesson is this: Too high a debt can drive a nation to ruin by undercutting the credibility of everything a government does and whether that government can meet its commitments. The United States isn’t in that position at this time, but if you wish to understand global events, you need to realize that fiscal policy has an immediate negative effect in many economic situations, especially when the credibility of the government is low.

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