Fiscal Nostrums

STEVE H. HANKE and ALAN A. WALTERS

December 11, 1992|By STEVE H. HANKE and ALAN A. WALTERS

One group that will give President-elect Clinton an earful a his economic brain-storming session in Little Rock next week is the fiscalists. They believe that fiscal fine-tuning can keep the economy humming at ''full employment'' and that a fiscal stimulus is needed now to jump-start the economy.

They dominate Democratic Party thinking. In Little Rock they will dust off their March letter, signed by 100 economists, including six Nobel Laureates, counseling a $50 billion-a-year stimulus package. They will wheel out the November report of Gov. Mario Cuomo's Commission on Competitiveness, ''America's Agenda: Rebuilding Economic Strength.'' Lo, $50 billion is the figure that pops up again.

If Mr. Clinton wishes to avoid delivering a blow to the weak economic recovery, he should eschew the fiscal nostrums being offered up by his political allies and economic experts.

Keynesian theory suggests that when there are substantial unemployed resources in an economy or when an economy's actual output is below its capacity, an increase in the government deficit will stimulate additional demand. Idle or underused resources will be put to work, the theory says, with little, if any, of that stimulus reflected in higher prices, because unemployment queues and idle machines will keep a lid on wage and price increases.

If fiscalism is accepted, then there seems to be a case for its present application. Even though the economy has grown by a 2.9 percent annual rate over the last three quarters, unemployment is 7.2 percent, up from 5.2 percent in 1989, and capacity utilization is 78.5 percent, down from 84.2 percent in 1989.

Yet we believe fiscal stimulus under current conditions would reduce economic growth and raise prices. The reason is the role of confidence in economic decision making.

Ironically, it was John Maynard Keynes himself who put his finger on this mysterious factor that explains why the facts don't always support Keynesian doctrine. Keynes said that ''the state of confidence, as they term it, is a matter to which practical men always pay the closest and most anxious attention.'' But, alas, ''economists have not analyzed it carefully and have been content, as a rule, to discuss it in general terms.''

Since Keynes wrote in 1936, we have had an opportunity to analyze the concept of confidence, particularly in the context of Keynesian fiscalism. Although there is no formal measure of confidence, we can fairly certainly describe general periods of ''low'' and ''high'' confidence. For example, when the economy is operating at less than full employment and government deficits exceed roughly 5 percent of GDP, a state of low confidence is reached.

It is during those periods that the application of a fiscal stimulus -- produces results directly contrary to the outcomes suggested by fiscalists. When resources are unemployed and deficits are below about 3 percent of GDP, on the other hand, the fiscalists' propositions generally hold: The economy will grow, but prices will not, or not much.

Why such a negative reaction to orthodox fiscal medicine during periods of low confidence? The markets will anticipate future increases in tax rates and possibly in inflation. Also, the markets will foresee increased uncertainty about interest rates as the consistency and plausibility of the government's economic policies are thrown into doubt.

All these ''negative'' expectations, revealed in the markets, will further erode confidence and inhibit consumer and business commitments. So, fiscalism applied at the wrong time will get the ball rolling, but in the wrong direction.

At present, the U.S. economy is in a ''low'' confidence phase. There are unemployed resources and the government deficit, about which the American public has become hypersensitive, is running about 5.1 per cent of GDP. That is why the Paris-based Organization for Economic Cooperation and Development stated last month that ''There is no scope for any fiscal stimulus without compromising all pretense of controlling the federal budget deficit.''

A $50 billion stimulus, as proposed by the fiscalists, would push the deficit to about 6 percent of the GDP, well over our 5 percent ''low'' confidence threshold. Such a stimulus would not stimulate the economy, but only prices. It would act as a drag on real economic growth.

President-elect Clinton should reject fiscal nostrums. If he doubts the merit of our counsel, he should give his friend, President Mitterrand of France, a ring. He could ask Mr. Mitterrand to recount the economic mess created by his application of fiscalism in 1981, and how the French voters repudiated him at their first opportunity.

Steve H. Hanke is a professor of applied economics at The Johns Hopkins University. Sir Alan Walters, vice chairman of AIG Trading in Washington, was formerly Prime Minister Thatcher's personal economic adviser.

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