Should the Budget Be Balanced?

As we’ll see in the next section, persistent budget deficits can cause problems for both the government and the economy. Yet politicians are always tempted to run deficits because this allows them to cater to voters by cutting taxes without cutting spending or by increasing spending without increasing taxes. As a result, there are occasional attempts by policy makers to force fiscal discipline by introducing legislation—even a constitutional amendment—forbidding the government from running budget deficits. This is usually stated as a requirement that the budget be “balanced”—that revenues at least equal spending each fiscal year. Would it be a good idea to require a balanced budget annually?

Most economists don’t think so. They believe that the government should only balance its budget on average—that it should be allowed to run deficits in bad years, offset by surpluses in good years. They don’t believe the government should be forced to run a balanced budget every year because this would undermine the role of taxes and transfers as automatic stabilizers.

As we learned earlier in this chapter, the tendency of tax revenue to fall and transfers to rise when the economy contracts helps to limit the size of recessions. But falling tax revenue and rising transfer payments generated by a downturn in the economy push the budget toward deficit. If constrained by a balanced-budget rule, the government would have to respond to this deficit with contractionary fiscal policies that would tend to deepen a recession.

Yet policy makers concerned about excessive deficits sometimes feel that rigid rules prohibiting—or at least setting an upper limit on—deficits are necessary. As the following Economics in Action explains, Europe has had a lot of trouble reconciling rules to enforce fiscal responsibility with the challenges of short-run fiscal policy.

!worldview! ECONOMICS in Action: Europe’s Search for a Fiscal Rule

Europe’s Search for a Fiscal Rule

In 1999 a group of European nations took a momentous step when they adopted a common currency, the euro, to replace their various national currencies, such as the French franc, the German mark, and the Italian lira. Along with the introduction of the euro came the creation of the European Central Bank, which sets monetary policy for the whole region.

As part of the agreement creating the new currency, governments of member countries signed on to the European “stability pact.” This agreement required each government to keep its budget deficit—its actual deficit, not a cyclically adjusted number—below 3% of the country’s GDP or face fines. The pact was intended to prevent irresponsible deficit spending arising from political pressure that might eventually undermine the new currency.

Although several European nations have adopted a common currency—the euro—they struggle to establish effective fiscal policy.

The stability pact, however, had a serious downside: in principle, it would force countries to slash spending and/or raise taxes whenever an economic downturn pushed their deficits above the critical level. This would turn fiscal policy into a force that worsens recessions instead of fighting them.

Nonetheless, the stability pact proved impossible to enforce: European nations, including France and even Germany, with its reputation for fiscal probity, simply ignored the rule during the 2001 recession and its aftermath.

In 2011 the Europeans tried again, this time against the background of a severe debt crisis. In the wake of the 2008 financial crisis, Greece, Ireland, Portugal, Spain, and Italy all lost the confidence of investors, who were worried about their ability and/or willingness to repay all their debt—and the efforts of these nations to reduce their deficits seemed likely to push Europe back into recession. Yet a return to the old stability pact didn’t seem to make sense. Among other things, it was clear that the stability pact’s rule on the size of budget deficits would not have done much to prevent the crisis—in 2007 all of the problem debtors except Greece were running deficits under 3% of GDP, with Ireland and Spain actually running surpluses.

So the agreement reached in December 2011 was framed in terms of the “structural” budget balance, more or less corresponding to the cyclically adjusted budget balance as we defined it. According to the new rule, the structural budget balance of each country should be very nearly zero, with deficits not to exceed 0.5% of GDP. This seemed like a much better rule than the old stability pact.

Yet big problems remained. One was the question of how reliable were the estimates of the structural budget balances. Also, the new rule seemed to ban any use of discretionary fiscal policy, under any circumstances. By early 2015 it was clear that this fiscal straight-jacket was a problem: a weakening European economy clearly needed stimulus but the fiscal rule prohibited it.

Before patting themselves on the back over the superiority of their own fiscal rules, Americans should note that the United States has its own version of the original, flawed European stability pact. The federal government’s budget acts as an automatic stabilizer, but 49 of the 50 states are required by their state constitutions to balance their budgets every year. When recession struck in 2008, most states were forced to—guess what?—slash spending and raise taxes in the face of a recession, exactly the wrong thing from a macroeconomic point of view.

Quick Review

  • The budget deficit tends to rise during recessions and fall during expansions. This reflects the effect of the business cycle on the budget balance.

  • The cyclically adjusted budget balance is an estimate of what the budget balance would be if the economy were at potential output. It varies less than the actual budget deficit.

  • Most economists believe that governments should run budget deficits in bad years and budget surpluses in good years. A rule requiring a balanced budget would undermine the role of automatic stabilizers.

13-3

  1. Question 13.7

    Why is the cyclically adjusted budget balance a better measure of whether government policies are sustainable in the long run than the actual budget balance?

  2. Question 13.8

    Explain why states required by their constitutions to balance their budgets are likely to experience more severe economic fluctuations than states not held to that requirement.

Solutions appear at back of book.