In practice, the use of fiscal policy—in particular, the use of expansionary fiscal policy in the face of a recessionary gap—is often controversial. We’ll examine the origins of these controversies in detail in Chapter 18. But for now, let’s quickly summarize the major points of the debate over expansionary fiscal policy, so we can understand when the critiques are justified and when they are not.

Broadly speaking, there are three arguments against the use of expansionary fiscal policy.

The first of these claims is wrong in principle, but it has nonetheless played a prominent role in public debates. The second is valid under some, but not all, circumstances. The third argument, although it raises some important issues, isn’t a good reason to believe that expansionary fiscal policy doesn’t work.

Claim 1: “Government Spending Always Crowds Out Private Spending” Some claim that expansionary fiscal policy can never raise aggregate spending and therefore can never raise aggregate income, with reasons that go something like this: “Every dollar that the government spends is a dollar taken away from the private sector. So any rise in government spending must be offset by an equal fall in private spending.” In other words, every dollar spent by the government crowds out, or displaces, a dollar of private spending.

So what’s wrong with this view? The answer is that the statement is wrong because it assumes that resources in the economy are always fully employed and, as a result, the aggregate income earned in the economy is always a fixed sum—which isn’t true. In reality, whether or not government spending crowds out private spending depends upon the state of the economy. In particular, when the economy is suffering from a recessionary gap, there are unemployed resources in the economy and output, and therefore income, is below its potential level. Expansionary fiscal policy during these periods puts unemployed resources to work and generates higher spending and higher income. Government spending crowds out private spending only when the economy is operating at full employment. So the argument that expansionary fiscal policy always crowds out private spending is wrong in principle.

Claim 2: “Government Borrowing Always Crowds Out Private Investment Spending” In Chapter 10, we discussed the possibility that government borrowing uses funds that would have otherwise been used for private investment spending—that is, it crowds out private investment spending. So how valid is the argument that government borrowing always reduces private investment spending?

Much like Claim 1, Claim 2 is wrong because whether crowding out occurs depends upon whether the economy is depressed or not. If the economy is not depressed, then increased government borrowing, by increasing the demand for loanable funds, can raise interest rates and crowd out private investment spending. However, what if the economy is depressed? In that case, crowding out is much less likely. When the economy is at far less than full employment, a fiscal expansion will lead to higher incomes, which in turn leads to increased savings at any given interest rate. This larger pool of savings allows the government to borrow without driving up interest rates. The Recovery Act of 2009 was a case in point: despite high levels of government borrowing, U.S. interest rates stayed near historic lows. In the end, government borrowing crowds out private investment spending only when the economy is operating at full employment.

Claim 3: “Government Budget Deficits Lead to Reduced Private Spending” Other things equal, expansionary fiscal policy leads to a larger budget deficit and greater government debt. And higher debt will eventually require the government to raise taxes to pay it off. So, according to the third argument against expansionary fiscal policy, consumers, anticipating that they must pay higher taxes in the future to pay off today’s government debt, will cut their spending today in order to save money. This argument, first made by nineteenth-century economist David Ricardo, is known as Ricardian equivalence. It is an argument often taken to imply that expansionary fiscal policy will have no effect on the economy because far-sighted consumers will undo any attempts at expansion by the government. (And will also undo any contractionary fiscal policy, for that matter.)

In reality, however, it’s doubtful that consumers behave with such foresight and budgeting discipline. Most people, when provided with extra cash (generated by the fiscal expansion), will spend at least some of it. So even fiscal policy that takes the form of temporary tax cuts or transfers of cash to consumers probably does have an expansionary effect.

Moreover, it’s possible to show that even with Ricardian equivalence, a temporary rise in government spending that involves direct purchases of goods and services—such as a program of road construction—would still lead to a boost in total spending in the near term. That’s because even if consumers cut back their current spending in anticipation of higher future taxes, their reduced spending will take place over an extended period as consumers save over time to pay the future tax bill. Meanwhile, the additional government spending will be concentrated in the near future, when the economy needs it.

So although the effects emphasized by Ricardian equivalence may reduce the impact of fiscal expansion, the claim that it makes fiscal expansion completely ineffective is neither consistent with how consumers actually behave nor a reason to believe that increases in government spending have no effect. So, in the end, it’s not a valid argument against expansionary fiscal policy.

In sum, then, the extent to which we should expect expansionary fiscal policy to work depends upon the circumstances. When the economy has a recessionary gap—as it did when the 2009 Recovery Act was passed—economics tells us that this is just the kind of situation in which expansionary fiscal policy helps the economy. However, when the economy is already at full employment, expansionary fiscal policy is the wrong policy and will lead to crowding out, an overheated economy, and higher inflation.