A Balancing Act Between Monetary, Fiscal Policies

Economics is a constantly changing discipline. One thing economists could depend on, however, was economic policy. As sure as the sun rises in the east and sets in the west, monetary and fiscal policy could be counted on to tighten when the economy overheated and loosen when business was slipping.

Moreover, these policies could be relied on to operate in tandem. When tightness was needed, monetary and fiscal policy would tighten; the opposite would occur when the economy needed a lift.

Gradually over the postwar years, the workings of economic policy began to change. More and more, the burden for managing the economy fell to the Federal Reserve, because fiscal policy became less and less flexible. This was because fiscal policy became increasingly politicized. Elected officials got in the habit of promising the electorate more than revenues would buy.

Federal budget deficits became the rule rather than the exception they were in the prewar era. In the past 30 years, there have been only two in which Washington’s budget was not in deficit, the last being 1969!

This two-decade string of deficits alone did not render fiscal policy inoperative. It is theoretically possible for the economy to be just as restrained from a sharp reduction in a budget deficit as from an actual surplus, depending on how much government spending is cut and/or revenues are raised.

The problem is, even a shrinkage in the deficit has been hard to achieve. Indeed, after averaging $2 billion, or 0.4% of gross national product in the 1950s, Washington’s budget deficit rose to $6 billion, 0.8% of GNP in the 1960s; $35 billion, 2.1% of GNP, in the 1970s, and $157 billion, 4.1% of GNP, in the 1980s.

With policy becoming more one-sided, it was little wonder that many economists’ analyses and forecasts soon came a cropper. For example, many thought that the huge budget deficit that developed in 1982 in the wake of the Economic Recovery Tax Act of 1981 would stimulate the economy.

But fiscal policy was not working in tandem with monetary policy. The Federal Reserve was actively fighting inflation in this period by restricting money growth.

On the other hand, budget deficits must be financed, and bigger budget deficits require more federal borrowing. Washington always gets first claim on the nation’s financial resources. So with the backdrop of reduced credit availability and a low domestic savings rate, Washington’s greater financings left less money for the private sector along with comparatively high interest rates.

The result was one of the longest and deepest recessions of the postwar era, which came to an end only after the Fed eased its grip and allowed more money and credit to flow into the economy.

Unfortunately, the economic recovery did little to narrow the now 12-digit budget deficit. As a consequence, other side effects began to appear.

For one thing, Washington’s borrowing needs had the effect of keeping interest rates relatively high, especially when adjusted for inflation. This inhibited industries--such as construction, household furnishings and automobiles--that rely on low-cost credit.

But that’s not all. Washington’s budget deficits soon began crowding out the entire goods-producing sector of the U.S. economy. It did this not by pulling money away directly, but by creating conditions such that goods producers didn’t need to borrow the funds. Of course, I am referring to another big deficit that developed: the one in our foreign trade.

The dollar nearly doubled in value between July, 1980, and February, 1985, as foreign investors sold their currencies and bought dollars to partake of our high interest rates. U.S. exporters saw their sales slump, while those domestic businesses that competed with goods produced abroad found their market share diminishing as well.

Meanwhile, back home, Washington’s debt outstanding tripled during the 1980s, eventually reaching 55% of GNP--the highest in nearly 30 years. Several years ago, Washington’s annual interest expense alone exceeded all outlays for such programs as grants to state and local governments, foreign aid, housing assistance, student financial aid, veterans’ medical care, plus the cost of government-sponsored research. In 1988, these interest outlays about equaled Washington’s total budget deficit.

This year they could exceed it by at least $20 billion, as the share of federal spending that must be devoted to servicing Washington’s debt has become the largest in history.

It is to their credit that, in this congressional election year, the President and leaders of Congress are seriously examining ways to reduce the budget gap--even if that means raising taxes.

The old rules of the game would have called for an easing of both fiscal and monetary policy to stimulate business activity. Right now, however, we have the same combination we had in 1982: a loose fiscal policy accompanied by a tight money policy. We saw eight years ago that big budget deficits and tight money do not mix. The right combination for that era--and this one as well--is for fiscal policy to tighten so that monetary policy can ease.

This prescription should produce lower interest rates. In turn, this would lower the cost of servicing Washington’s debt--not to mention the cost of financing a car or a home. The dollar might even fall as foreigners find rates abroad more attractive than in the United States, and this, of course, would help our exports while slowing imports.

Once monetary and fiscal policy are in better balance, the economy will be, too. The rules of economic behavior may still change from time to time, but the economy as a whole might well become more manageable, if not more predictable.