Here’s How Fiscal Policy Is Slowing Down the Economy

“Federal fiscal policy during the recession was abnormally expansionary by historical standards. However, over the past 2½ years it has become unusually contractionary as a result of several deficit reduction measures passed by Congress. During the next three years, we estimate that federal budgetary policy could restrain economic growth by as much as 1 percentage point annually beyond the normal fiscal drag that occurs during recoveries.”

Brian Lucking and Daniel Wilson, a research associate and a senior economist in the Economic Research Department of the Federal Reserve Bank of San Francisco, respectively, published a report on June 3 that argued about one basic idea: federal fiscal policy has been a modest headwind to economic growth during the recovery, but that headwind will blow more severely over the next three years.

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This isn’t a new argument, but its importance to the economic conversation — the same conversation that informs investment decisions — is increasing. The American economic recovery officially began in 2009, but growth has been tediously slow. San Francisco Fed President John Williams recently offered an analogy, saying: “If we were in a car, you might say we’re motoring along, but well under the speed limit. The fact that we’re cruising at a moderate speed instead of still stuck in the ditch is due in part to the Federal Reserve’s unprecedented efforts to keep interest rates low. We may not be getting there as fast as we’d like, but we’re definitely moving in the right direction.”

If monetary policy has kept us out of a ditch, then fiscal policy needs to get us up to speed. The problem is that of the three primary tailwinds that help drive a recovery — investment in housing, consumer confidence, and discretionary fiscal policy — one is blowing in the wrong direction.

1) Failure to spend sufficiently

“Bad timing” is about as useless an excuse as can be offered for why the current recovery has been so slow, but there may actually be some weight to the idea. Policymakers chose to escalate debate over federal debt shortly after the recovery got under way. In the pursuit of balancing the budget — which is admirable — policymakers chased tremendous spending cuts and increased revenues. This, as Janet Yellen, Vice Chair of the U.S. Federal Reserve, has pointed out, is the opposite of what should have happened.

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“History shows that fiscal policy often helps to support an economic recovery,” she said in a speech delivered in February of this year. “Government spending on unemployment benefits and other safety-net programs rises in recessions, helping individuals hurt by the downturn and also supporting consumer spending and the broader economy by replacing lost income.”

“But,” she continued, “instead of contributing to growth…discretionary fiscal policy this time has actually acted to restrain the recovery.”

yellen-figure3-20130211

Source: http://www.federalreserve.gov/newsevents/speech/yellen20130211a.htm

2) Failure to ease the tax burden

To continue with Yellen’s comments on the subject: “The income loss that individuals and businesses suffer in a recession is partly offset when their tax bills fall as well,” which is traditionally what happens in a period of recession. This recovery has seen the expiration of the payroll tax holiday and an abnormal growth in tax revenue given the weak recovery.

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As Lucking and Wilson state in their report, fiscal policy has only been a modest headwind to date, but the drag is expected to intensify in the coming years. This is what they have to say about taxes: “The excess fiscal drag on the horizon comes almost entirely from rising taxes. Specifically, we calculate that nine-tenths of that projected 1 percentage point excess fiscal drag comes from tax revenue rising faster than normal as a share of the economy.”

2013-16-1B

Source: http://www.frbsf.org/publications/economics/letter/2013/el2013-16.html

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