Luis Dumlao, PhD. is an associate professor at the Department of Economics, Ateneo de Manila University. This article was published in the Opinion Section, Yellow Pad Column of BusinessWorld, November 27, 2007 edition, pages S1/4 and S1/5.
In 1985, the Congress of the United States (US) passed the Gramm-Rudman-Hollings Law (GRH) establishing a process of gradually reducing the Federal government’s budget deficits to eventually balance by fiscal year 1991. Among other things, the law contains targeting the budget deficit to US $172 billion for 1986, US$144 billion for 1987, and henceforth reducing the deficit by US$36 billion per year. That is: $108 billion for 1988, $72 billion for 1989, $36 billion for 1990 and $0 or balanced budget in 1991. To make these reductions possible, the law states that Congress and the Executive branches would select and agree on specific spending cuts and tax increases every year that they formulate the national budget. If they did not agree, an automatic across-the-board reduction of expenditure on certain eligible categories would apply.
A lower court eventually ruled the automatic reduction unconstitutional and in July 1987, the Supreme Court of the US itself affirmed its unconstitutionality. The reason for this is purely legal and has nothing to do with economics. In layman’s terms, an annual budget is supposed to be passed as a law every year, which means Congress and the Executive need to agree (except if Congress overrides the President’s veto by a vote of two-thirds of the House of Representatives and the Senate). However, the automatic across-the-board reduction is applied as law even if Congress and the Executive do not agree to pass the budget for a specific year. This is to say that if a budget law is not passed, an overriding law automatically takes effect even if Congress and the Executive do not necessarily agree with the override on that year.
Be that as it may, the GRH law has a certain provision in case of economic downswings in Section 254, titled “Special Procedures in the Event of a Recession.” Accordingly, the deficit reduction is to be suspended when a recession is (1) forecasted by the Congressional Budget Office (CBO) or Office of Management and Budget (OMB) or both, or (2) forecasted by the Bureau of Economic Analysis (BEA). This implies a certain state of mind of the US government on the effect of fiscal policy on the economy. Why would they want to suspend the deficit reduction when the forecast is an economic recession? So that government expenditure may continue and even increase. In this way, the total expenditure of the economy does not slow down economic activity. It may even increase economic activity. The effect will supposedly either minimize the magnitude of the coming recession or even totally prevent the economy from plunging into recession.
Whether the believed effect of government expenditure on the economy is real depends on ideology. According to the dominant neoclassical ideology, the real effect does not exist so that the provision is useless. But according to the Keynesian ideology, the real effect exists so that the provision is necessary to minimize economic slowdown or even to totally avoid it. But because the US government chooses to play a fiscal policy that adheres to Keynesian ideology, does it mean that its state of mind is dominated by such? I propose that the choice of policy is not a matter of whether it believes in one ideology over another, but as a matter of pragmatism.
Keep in mind that the debate over the law occurred at least in the latter part of 1984 and eventually passed in 1985. Four years before, Ronald Reagan became president on an overwhelming mandate based on a certain political-economic platform, one which believes that smaller national government is best for the US as a nation. The role of government and regulation should be minimized to let market forces work: a prescription that is consistent with the neoclassical economic ideology.
Taxes should be reduced and they were drastically reduced, eventually leading to the Tax Reform Act of 1986. Based on the belief that the rich of society are rich because they work harder, the reduction of tax is concentrated on the rich to encourage investment and reward hard work. The reduction of tax revenue calls for reduction of expenditure. Based on the belief that the poor of society are poor because they are not as productive, the reduction of expenditure is concentrated on pro-poor expenditures, including public school education and welfare for the unemployed, to influence the poor to work harder. Supply-side Reaganomics was at its peak. In 1984, the support for such platform was evidenced by President Reagan’s reelection. In the United Kingdom, a similar political economic platform in the form of Thatcherism was also at its peak.
The Keynesian tax-and-expenditure doctrine was at its low. Expenditure was no longer believed to be the driving force of the economy. Neoclassical ideology took over Keynesian ideology as the dominating economic paradigm. Riveting the academe was a new wave of classical macroeconomics, the likes of endogenous growth theory (technical change being affected by previous economic conditions).
It was believed that the ultimate engine of growth was productivity and technological progress. With the revolution in ideology that was happening, Congress and the Executive were not likely ideologically in favor of Keynesian economics. President Reagan himself – a known supply side advocate – signed the law and his ideology could not have been the reason.
The decade of the 1980s is also known for the extended economic growths of the US that started from 1982 to 1990. Whether this was the result of the use of neoclassical policies is debatable, remains unsettled and is beyond the scope of this essay. One thing is certain: Despite the dominance of supply-side and neoclassical economics ideology, the government still chose to insert a provision that is Keynesian in nature. The metaphor is that the government was not married to an ideology in sickness and in health. The government implemented neoclassical-inclined economic policies through the growth years of the 1980s. But it was also prepared to abandon and replace them with Keynesian policies if the economy stumbled. That is as pragmatic as pragmatism gets.
It is a sign of pragmatism to abandon an ideology in favor of another, given the current policy, when the forecast says that the economy is heading towards recession. But it may be foolish to abandon an ideology based on a forecast despite the debatable issues regarding forecasts. One issue of debate has to do with the reliability of forecasts. What if the CBO, OMB or BEA forecast the economy to be heading towards recession when it is actually the opposite? As such, the deferment of deficit reduction does not avoid a forecasted recession, but increases the actual growth that increases the probability of the economy over-expanding.
Still, the US government included the provision, and I argue that it was the pragmatic thing to do. Even if forecasts are not perfect, the government recognized that the scientific methods of the CBO, OMB and BEA are the closest they can get to crystal- ball forecasting. More so, the government decided to use the forecast to be able to determine whether it should stay true or be unfaithful to the prescription of neoclassical ideology.
Another issue of debate has to do with the timing of forecasts. That is: the CBO, OMB and BEA may flag future recessions accurately, but the flagging may be too late. This implies that deficit reduction may already have done its harm on the economy before the provision of the law makes its policy adjustments. More so, it may be too late so that the business cycle is already going out of recession and heading towards expansion. As such, the deferment of deficit reduction does not avoid the recession, but increases the upcoming growth that increases the probability of the economy over-expanding.
Indeed, policy adjustment may come in late, but there is value in this case in the proverbial saying that it is “better late than never.” It may come too late to avoid an upcoming economic contraction, but lateness may come handy to avoid a second wave of contraction. After all, a recession in one period does not guarantee an economic boom the next. So if the first wave of contraction is followed by expansion—and this is a big “if”— policy adjustment will lead to over-stimulation. If the first wave of contraction is followed by a standstill, deficit reduction will worsen what could have been a standstill to a second wave of contraction. Finally, if the first wave of contraction is followed by a second wave of another contraction, the deficit reduction will worsen what could have been an already extended recession. For a pragmatic point of view, better to over-stimulate than to over- drag.