Will Fiscal Policy “Fight the Last War”?

Fighting the last war is a metaphor for doing what used to work even though times have changed. For example, French generals in 1940 expected World War II to be like World War I, so they ended up fighting German tanks with French foot soldiers inside forts.

I have been worried about this with U.S. fiscal policy for the last 20 years or so. And it turned out badly in 2007-9, and I think it might turn out worse the next time around. Scott Sumner, writing at EconLog feels the same way.

Because the U.S. is a federalized government, a significant amount of government spending is done at the state and local levels. And, while we don’t stress this detail too much any more, the basis for Keynesian fiscal policy being effective starts with the government actually buying goods and services, not with sending checks to people. So, while a lot of funding for state and local expenditures actually passes through the federal government, its sent right on as a check to the state and local governments. They spend between half and 2/3 of the government spending in this country that goes to goods and services. So, if Keynesian fiscal policy has any relevance in the 21st century, it’s because of spending a that level.

Which scares the crap out of me.

The reason is that at the state and local level, fiscal policy has been taken over (for a few decades), by both Republicans and Democrats, who view balanced budgets as the way to go.

The problem with this is when a recession hits: your tax revenue goes down, and your spending requirements (for welfare and so on) go up. If you have to balance the budget this means you have to raise taxes and cut spending actively, because to offset the passive movements in the other direction from the business cycle.

Here’s how Sumner sees this panning out:

I don't have much confidence in the Keynesian view that the stance of fiscal policy has a big impact on the business cycle. But let's say I'm wrong. Here's what I expect to happen:

1. The President and Congress will enact deep tax cuts and increases in military spending, which will cause the deficit to balloon. Entitlement spending will also rise as boomers retire.

2. The deficit will rise to unsustainable levels, with the national debt steadily increasing as a share of GDP.

3. By the time the next recession is on the horizon, there will be a political backlash against expansionary fiscal policy. Policy will tighten and become effectively pro-cyclical.

I hope that I am wrong, but this is the danger I see from running a series of large budget deficits when the unemployment rate is 4.5%. What will we do if unemployment rises to 7.5%?

I agree. And I have some hard-ish evidence to support this. In 2009 I got a call from a member of the Utah Legislature from this region. They wanted to know if this was a good time to start spending out of their Rainy Day Fund. I was flabbergasted. If the worst recession in a generation isn’t a time to spend your rainy day fund, when is?