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Op-ed

How the United States Benefited from Fiscal Activism

by Adam S. Posen, Peterson Institute for International Economics

Op-ed in Die Zeit
September 8, 2005

© Die Zeit


Sometimes it is better to do the right thing for the wrong reasons than to keep the government’s principles correct.  US fiscal policy in recent years has been a huge success in stabilizing the US economyeven though many of the policies pursued were driven by misguided ideological commitments to cut taxes.  Meanwhile, Germany’s principled reluctance to engage in "activist" macroeconomic policy and to be seen violating the original spirit of the Stability and Growth Pact (SGP) (even if the deficit limits were exceeded) has served it badly since the launch of the euro.  Ironically, many of the unfounded arguments given in the United States for why tax cuts were a good idea are actually valid when applied to Germany today. 

 

At the same time, the big lesson from US fiscal mistakes—freshly and sadly illustrated by Hurricane Katrina—is that it matters at least as much what a government spends its money on and what it taxes as it does how much it spends and taxes. Germany should not miss the opportunity after this election to reorient its fiscal policy towards stabilization and to spend its public funds judiciously.  The oft-invoked demographic threat to public finances is both exaggerated and more likely to be assisted by steady growth than by short-term frugality.

 

The effort to stabilize business cycles using fiscal policy has had a bad reputation since at least the 1970s, when American lack of budget discipline and British "stop-go" policies seemed to lead to nothing but inflation.  Ultimately, however, barring a political discipline breakdown of Argentine proportions, it is monetary policy not fiscal policy that determines the rate of inflation.  So long as the central bank stands up to the budget policymakers, something the Federal Reserve and the Bank of England did not do in the 1970s, there is no inflation risk from utilizing fiscal policy to stabilize the economy.

 

In fact, when monetary policy is not being used sufficiently to offset the business cycle by erring on the side of tightness, it is all the more important to be ready to use fiscal stimulus.  For a Germany whose economic performance and inflation rate are consistently below average in the eurozone, ECB monetary policy will inherently be too restrictive, leaving need for countercyclical fiscal policy.  While the Federal Reserve was indeed more aggressive than the European Central Bank in cutting rates following the IT bubble and the 9/11 attacks, the blow to investment and confidence did limit the impact of rate cuts on the economy.  Thus, the tax cuts and defense spending of 2001–2002 in the United States had a more rapid impact and kept the economy going until monetary policy took effect.

 

By keeping economic growth relatively stable in the face of shocks, the United States maintained to a greater degree the positive flow of corporate investment and the business intake of new workers into the economy, both of which have lasting benefits for productivity.  In contrast, Germany, by only running as countercyclical a budget policy as it did pre-EMU, but facing a large downturn given the shocks and the lesser response by the European Central Bank than the German situation alone would have justified, saw jobs destroyed and a lasting shortfall of investment.  Even the reform achievements of the Red-Green government in the areas of labor, taxes, and pensions were insufficient to overcome the drag on confidence to invest and hire from the cyclical downturn. 

 

The distinction between cyclical and structural economic policy is not as sharp as that drawn by some fiscal conservatives.  This is especially true in economies like Germany where the labor market tends to treat those who are out of work for a longer period as poor prospects to hire.  Even in the more flexible United States, much of the improvement in productivity and in the federal budget balance in the 1990s was due to the economy running at full capacity for a long period without inflation, that is through judicious stabilization policy.  Fiscal consolidation was driven at least as much by the rise in potential and actual US growth as the other way around.

 

That is not to say that fiscal stimulus is always a good idea or that stabilization policy is a total substitute for structural reform.  If anything, the US experience from the mid-1980s to the end of the 1990s demonstrates that there can be a positive feedback between maintaining economic growth and the implementation of structural reforms.  Labor market policies, such as the US welfare reform of 1996, are particularly responsive to economic conditions—they gain political acceptance and are more successful in employing the unemployed when the economy is growing.  They also impose lower budget costs in the transition to new incentives during an expansion.  The recent poor response to the well-motivated and designed Hartz IV reforms is at least in part due to the insufficient stabilization policy to cushion its implementation.

 

The Bush Administration’s evident belief that tax cuts would be the right policy no matter what the conditions in the US economy is mistaken.  They clearly stated that they would have pursued such cuts even if the federal budget surpluses had continued, and the IT bubble had not burst—the very opposite of stabilization policy, adding stimulus to a recovery.  Their structural arguments for tax cuts were mostly ill-founded as well, since marginal tax rates were already quite low in the United States, and distortions of investment decisions were rather limited (as demonstrated by the modest changes in investment behavior since the Bush tax cuts).

 

Yet, just as stabilization policy is lacking in Germany as opposed to the United States today, the structural arguments for tax cuts are far more valid in Germany than in the United States.  Marginal income tax rates are still very high, particularly at the bottom end of the wage distribution, discouraging people to take lower-wage jobs.  Germany could use an "earned income tax credit" that rewards work beyond its wages.  There remain large distortions in how activities are taxed, ranging from the complicated treatment of capital gains to the extraordinary nonwage costs employers bear.  While a "flat tax" has some disadvantages, anything that reduces the impact of the German tax system’s subsidies and disincentives on economic decisions would be welcome irrespective of its effect on rates.

 

The reasons why tax cuts have been risky in the United States also do not apply in Germany today.  The United States is a low-savings country whose public debt is in large part held abroad, putting the currency at risk and exposing the country to dangerous swings in investor sentiment and interest rates.  In contrast, Germany is a high-savings country whose public debt is almost totally held domestically, so it is not subject to such dangers.  The United States has low tax rates on both corporate and household income, as well as a very low average (state-level) VAT, so the response of government revenues to tax cuts will be negative.  In Germany, the still high tax rates in some areas place the economy on the other side of the Laffer Curve—one can imagine near net zero budgetary impact or even revenue gains from rate cuts. 

 

Finally, despite Germany’s violations of the SGP deficit rule, the cyclically adjusted deficit in the United States has widened far more than Germany’s in recent years, reaching in excess of 4 percent of GDP, as compared to only 2.3 percent in 2005 for Germany.  This means that the sustainability of US budget deficits is far more in question than in Germany because the cycle accounts for a smaller proportion of the deficit.  And this deficit widening has taken place in the United States even as the economy has continued to grow, while Germany’s more limited fiscal erosion has understandably occurred during a time of high unemployment and structural reform.

 

The point is that Germany can benefit from the US example of greater fiscal stabilization with its attendant benefits for growth and productivity, while suffering far fewer of the costs and risks than the United States does from such activism.  It still matters that Germany maintain its progress towards making social security and pension transfers sustainable, but that will only happen through raising economic potential while cutting the rate of growth in benefits.  Meanwhile, the achievements of the Red-Green government in the area of pension reform should be taken advantage of as legitimate justification for worrying less about the long-term debt today (and the Maastricht 3 percent limit) than before those measures were undertaken. 

 

Instead, the German government can aggressively pursue tax cuts on labor as parts of the CDU/CSU recommend without any hurry to raise the VAT to compensate.  In both the United States and Germany, fiscal discipline should be more about cutting wasteful subsidies in agriculture and favored industries than about foregoing stabilization of the economy through well-timed tax cuts.


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