Balancing the Budget Over the Cycle

It seems to me that those, including New Keynesians, who support the maintenance of a “balanced budget over the cycle” are either not recognizing or rejecting a number of points made by heterodox Keynesian (or Kaleckian) critics of such a policy approach, including proponents of Modern Monetary Theory (MMT) as well as many other Post Keynesian and Sraffian economists.

1. Growth with financial stability – which depends on maintaining strong demand without excessive reliance on private debt – probably requires, among other things, ongoing domestic private sector surpluses (S – I > 0), at least in most years and on average. A capacity for the private sector persistently to net save (maintain S > I) will reduce the likely incidence of private debt stress and bankruptcy, other factors (notably distribution and the regulatory regime) remaining equal. For most countries, the average government budget over the cycle and over the long run should be in deficit to an extent consistent with a domestic private sector surplus conducive to (private-sector) financial sustainability. (A stylized illustration of this point is provided in a previous post.)

2. Just as proponents of a balanced budget over the cycle understand the need for the government’s budget position to move countercyclically, Modern Monetary Theorists see the same need except that the fluctuation, in their view, should be around an average government budget that is, for most countries, somewhat in deficit rather than balanced (due to point 1 above). The appropriate level of the government’s deficit will be the one that enables net private saving, on average, alongside full employment while preventing the emergence of excessive demand-side inflationary pressures.

3. Scott Fullwiler has argued that the functional finance approach (implicit in point 2) is, by coincidence, “Ricardian”. That is, the public debt-to-GDP ratio will not rise without bound. To the extent proponents of a balanced budget over the cycle take their position in order to be Ricardian, perhaps they are unaware (or reject) Scott’s point that functional finance would cause no disappointment of this aspiration.

4. Among economists and the community in general, we appear to lack a unified understanding of what is meant by “austerity”. The term seems to mean different things to different people, including to heterodox Keynesian economists. From a heterodox Keynesian perspective, I think it would make sense to define austerity as policy that, by being too tight, prevents the economy from moving toward – and then from maintaining – a level of full employment. Since, in heterodox Keynesian approaches, there is no automatic tendency to full employment (even with flexible prices), and fiscal policy clearly matters, this suggested definition might have merit. It would reflect, for instance, that a shrinking of the government deficit during an upturn is not necessarily due to austerity, as economists of all persuasions understand. A rise in tax revenues due to growth might well be consistent with the re-establishment of full employment, and so not provide evidence of austerity, on this definition.

The trouble is, the mainstream (including the liberal wing of the New Keynesian school) still does, implicitly, assume a long-run tendency to full employment in the (hypothetical) absence of so-called rigidities and imperfections. The liquidity trap is one example of a rigidity, and it is the one the New Keynesians mostly blame, at the moment, for a persistence of unemployment. But if it is believed that under ideal conditions there would be an automatic tendency to full employment, then defining austerity in terms of full employment, which would make sense within the context of heterodox Keynesian economics, does not make sense in the context of New Keynesianism. In the New Keynesian view (even though only implicitly), no fiscal policy stance could prevent a long-run convergence to full employment in the absence of (so-called) rigidities and imperfections. So, in that view, austerity must have some other meaning.

5. The fundamental disagreement between New Keynesians and heterodox Keynesian economists largely seems to come down to this difference in view over the existence or otherwise of an automatic tendency to full employment (absent imperfections). New Keynesians either reject, ignore or remain unaware of what heterodox economists regard as one of the key implications of the Cambridge Capital Controversy, which is that there is currently no valid theoretical basis for supposing an automatic tendency to full employment, even under the assumption of full price flexibility. Most heterodox economists take this finding as read. Samuelson himself appears to have conceded it in his famous “summing up”. John Eatwell gives a succinct statement of the heterodox position from about 39:45 – 49:40 in this video (h/t Matias Vernengo):

Since, for New Keynesians, the economy will return to full employment irrespective of fiscal policy (again, in theory, under idealized conditions), it will seem to them that any additional demand created now through fiscal stimulus will need to be reversed in the future, once full employment is re-established. For heterodox Keynesians, that is not necessarily the case, and there is no general tendency for it to be the case. In the absence of ongoing injections of demand through government expenditure, aggregate demand both now and later will, on average, simply be lower than otherwise, as would the level of employment. In the future, growth might – but will not necessarily – call for tighter fiscal policy (the enactment of higher tax rates or spending cuts). If it does, such fiscal tightening will not amount to austerity (in the sense suggested above) since all that is necessary is application of the functional finance principle of alleviating inflationary pressures associated with full employment and moderating an aggregate demand that is growing faster than productive capacity can be expanded to accommodate it. (Again, according to Scott Fullwiler, such a functional finance rule will actually turn out to be “Ricardian”.)

6. The New Keynesian rejection or unawareness of the implications of the Cambridge Capital Controversy also appears to manifest in a fundamental disagreement over the rate of interest. In the heterodox Keynesian view, the controversy established that there is no valid theoretical basis for supposing the existence of a natural rate. Consistent with this, heterodox Keynesians take as read that there is no such thing as a natural rate of interest. For most heterodox Keynesian economists, the rate of interest is a policy variable and exogenous. In their view, the monetary authorities are not compelled, in the long run, to conform to a supposed (real) natural rate of interest. For this reason, the extent of any interest obligation associated with ongoing budget deficits is considered to be entirely at the discretion of the consolidated government.