Discretionary Fiscal Policy Examples & Lags

In this article I will describe several discretionary fiscal policy examples from recent years and the 'thinking' behind them. To do that successfully it is necessary to frame these policies within the context of the economic cycle in terms of inflation and national income.

Discretionary fiscal policy is, of course, entirely determined by the whims of government policymakers and senate/parliamentary approval:

In the United States any fiscal expansion, which simply means increased government spending programs, need to be proposed by the President and then approved by the Senate.

In the United Kingdom the process is similar but, once the governing political party proposes fiscal expansion to parliament, it will more or less always be approved because the government usually enjoys a significant majority of seats there.

The difference in process does matter, as demonstrated by the inability of the Biden administration to get approval for the bulk of its 'Build Back Better' spending program. There are often some very suspicious ulterior motivations behind discretionary fiscal policy actions, and they frequently seem to address the self-interest of the government rather than the long-term interests of the economy.

The Framework for Policy Examples

Modern macroeconomic policy, with regard to its effect on output and inflation, has been set in accordance with the AD-AS Model as devised by the late economist John Maynard Keynes. For details on that model click the link, but keep in mind that while this model is perfectly reasonable for what it is, it only looks at aggregate demand and supply influences on output and the price level - inflation is related to the price level but it is not equivalent. The important distinction between the two is that inflation means (in common parlance) persistently rising prices, not a one-off increase.

I mention this because, contrary to the thinking of the dominant New-Keynesian policymakers in government circles, it is the money-supply that plays the main role in creating or controlling inflation, and the AD-AS Model does not present the best framework for understanding that. The largely ignored Quantity Theory of Money is a far better model for this purpose.

In essence, since 2008, the New-Keynesian policy-makers have acted as though the money-supply is irrelevant in modern economics. There sits the root of the coming collapse of our financial system. See my article about Quantitative Easing Effects on Inflation for more info.

Another problem with discretionary fiscal policy comes with the various 'policy lags' that severely impede the timing and forecasting difficulties inherent in these actions. I will describe these later in the article and give links to more information, but first I 'll start with some examples of recent spending programs from the US and UK.

US & UK Discretionary Fiscal Policy Examples

US Examples:

  • American Recovery and Reinvestment Act of 2009 – this stimulus package was brought into being by President Barack Obama as a response to the great recession that followed the 2008 financial crisis. It was primarily aimed at protecting existing jobs and creating new jobs. In size it amounted to just over $800 billion of spending.
  • The CARES Act 2020 – this was a $2.1 trillion package signed into law by President Donald Trump. As well as many direct payments to individuals it included expanded unemployment benefits and many grants and loans for businesses.
  • American Rescue Plan Act of 2021 – this stimulus package, amounting $1.7 trillion of spending, was signed into being by President Joe Biden in order to boost the economy during the Covid-19 lockdowns. The package included many controversial elements such as expanded unemployment benefits which have been accused of reducing the labor force participation rate.

UK Examples:

  • UK Job Retention Scheme 2020 – this was the main fiscal stimulus package introduced by the Conservative government as a response to Covid-19. The bulk of the spending was paid to businesses to compensate them for ‘furloughed’ workers during the lockdowns. Up to 80% of wage costs were paid to employers in order to encourage them to preserve jobs. Other provisions included funding for various training schemes to help people learn new skills as a gateway to new job opportunities.

You'll probably notice that these are all examples of expansionary fiscal policy; contractionary fiscal policy is less elaborate, and usually boils down to raising taxes on one thing or another.

What are Inside Lags & Outside Lags?

As mentioned earlier, there are significant time lags that affect the formulation and implementation of any countercyclical fiscal policy. There are some somewhat shorter lags that also affect monetary policy actions, meaning that any sort of aggregate demand management policy is fraught with difficulty, but these difficulties are at their worst with fiscal policy.

That is one reason why short-term management of economic stabilization policies are usually handled by central banks, with monetary policy being the preferred tool. It is only when monetary policy options have been exhausted, with interest rates at zero or near-zero levels that governments tend to step in and make matters worse with ill-conceived fiscal policies.

Here are a few of the lags that can impact on policy:

  • Recognition Lag – this refers to a period of time that elapses before the government has reliable data to inform it that a problem exists.
  • Decision Lag – the time taken to analyze the data and form projections of the likely impact of the problem and what type of remedial action (if any) should be taken.
  • Legislative Lag – once a policy recommendation has been drafted it will take time for it to be debated and approved by Congress/Parliament.
  • Implementation Lag – once a policy is approved it can take significant time to put it into action e.g., increased infrastructure spending will have a long planning process.

The lags above are all different types of ‘inside lags’, but the delays don’t stop there. There will also be ‘outside lags’ that relate to the time taken before the policy actually has an impact on the problem. For example, if increased government spending on infrastructure is approved, in order to stimulate an underperforming economy out of recession, even after construction work commences it will still take time before the economy feels its full expansionary effects. For more details, see:

The whole discretionary fiscal policy process, from start to finish, can easily take months if not years to complete. By that time the economy may well have self-corrected, meaning that the effects of the policy are destabilizing in nature rather than stabilizing, because it leads to overheating and inflation rather than a return to normalcy.

Discretionary Fiscal Policy Vs Automatic Stabilizers

The cumulative effect of all the various inside lags and outside lags is a major obstacle in the way of successful discretionary fiscal policy. Carrying out consistently accurate economic forecasting in economic modelling is an almost impossible task, and without it there is little to no chance of constructing appropriate contractionary or expansionary fiscal policy.

An alternative method of stabilizing the economy when it deviates from its long-run growth path is to use ‘automatic stabilizers’ to a greater extent. These do not need any data to be gathered, or analyzed. They don’t need any bureaucrats to make decisions on what to do, or any policymakers to construct proposed legislation to be deliberated on and so on and so forth. Automatic stabilizers, by definition, immediately work to mitigate any deviations from the growth path before anyone even notices a problem.

The main types of automatic stabilizers are well known, even if the moderating impacts on the economy are not so well known. They include:

  • Marginal Income Tax – a high marginal income tax means that workers pay a large amount of tax on any increased earnings when the economy expands too quickly (and avoid a lot of tax when their incomes fall during a recession). Both of these effects help to smooth out spending levels.
  • Unemployment Benefits – if a recession develops that causes unemployment to increase, access to unemployment benefits will help to subsidize spending to some degree.
  • Sales Tax – if a boom in consumer spending causes the economy to overheat, high sales/expenditure taxes will help to cool down overall spending.

The list goes on but you get the idea. Setting optimal tax rates and benefit payments is a key component of supply-side economics, and combined with a replacement of the fractional reserve banking system with full reserve banking would go a long way towards eliminating the business cycle, and thereby eliminating any need for discretionary fiscal policy.

Note on Non-Discretionary Fiscal Policy

It’s important to note that not all fiscal policy relates to discretionary spending, in fact the vast bulk of it is non-discretionary. General expenditures by the government on key services like health, education and national defense has nothing at all to do with discretionary spending.

The distinction between the two comes down to its purpose i.e., is it meant to stimulate the economy out of a cyclical downturn (a recession) or not? If it is then it can be classed as discretionary spending.

The Government Spending Multiplier

The government spending multiplier relates to the Keynesian multiplier where an increase in government spending leads to a more than proportional increase in the level of economic output. The theory is sound, but only up to a point.

Research has shown that once the level of national debt exceeds a certain amount, the expansionary effect of extra ‘deficit spending’ (borrowing more to spend more) falls below one. In other words, the multiplier effect falls below one, meaning that every extra dollar of spending causes less than a dollar of expansion, and the policy becomes less and less effective.

The level of national debt at which this is thought to occur is equivalent to around 90% of GDP – a level that most western countries have already far surpassed.

Conclusion: The Effectiveness of Discretionary Fiscal Policy Stabilization

In the post 2008 western world, attitudes towards discretionary fiscal policy as a potential tool for achieving a greater degree of stabilization in the economy began to change. Prior to the financial crisis the preferred policy tool for economic management had been monetary policy.

The advantages of monetary policy are indeed significant, since the inside lags described above are much reduced. The outside lag, on the other hand, is elevated because monetary expansion or contraction takes longer to affect spending levels. The Federal Reserve Bank can quickly raise interest rates, but consumer and business responses to those rates only build up slowly.

Nevertheless, prior to 2008, monetary policy was the almost exclusive tool for stabilization policy. Things changed dramatically after the financial crisis, because monetary expansion was maxed out with interest rates set to near zero levels in order to mitigate the recession that followed the crisis. This, as we know, was not sufficient and in addition to near zero interest rates there was an accompanying policy of ‘quantitative easing’ in order to buy up the bad debts that the banks had built up, and thereby keep them solvent.

The effect of all this was to push the economy into a ‘liquidity trap’, and thereby enhance the power of fiscal policy to influence economic output. The problem here is that, whilst a ‘discretionary’ role for fiscal spending had not been used prior to 2008, there absolutely was a very significant and perpetual presence of fiscal deficit spending regardless of the economic business cycle.

The point is that perpetual deficit spending on public goods and services, i.e., spending more than is raised in taxes, leads to perpetual growth in debt levels. The growth in the debt to GDP ratio prior to 2008 had been historically very high, but after the crisis it ballooned. The Covid-19 pandemic, or more precisely the government response to it, has further driven national debt to levels at which there is a real threat of national insolvency i.e. a situation whereby debt default is inevitable – unless inflation is allowed to erode it away. Inflation of that size would, of course, come with all the serious consequences described in my article about Inflation and why it is bad.

It is in this context, with federal spending and national debt levels already at sky-high levels, and with the highest inflation levels for forty years (and still growing at the time of writing) that a number of economists (New-Keynesians of course) are pushing the insane idea that more discretionary fiscal policy to further expand our economies would be an effective solution to our problems.

This is not logical – and that’s because we are not in a normal business cycle downturn. Rather, we are at the end of a long-term debt cycle, and if we fail to respond to this growing crisis with appropriate economic policies, then the catastrophic consequences ahead of us will be all the more severe.

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