Does Fiscal Policy solve unemployment?

Readers Question: Is the fiscal policy effective/the best policy to deal with unemployment?

It is an interesting question and one that is likely to generate different views from within the ranks of economists.

To give a very rough overview:

• Keynesians say yes, fiscal policy can be effective in reducing unemployment. In a recession, expansionary fiscal policy will increase Aggregate Demand (AD), causing higher output, leading to the creation of more jobs.
• Classical/monetarist economists say no. Fiscal policy will only cause a temporary increase in real output. In the long run, expansionary fiscal policy just causes inflation and does not increase real GDP. Monetarists argue that to reduce unemployment it is necessary to use supply-side policies which increase the flexibility of labour markets (e.g. reducing power of trades unions)

Theory – How fiscal policy can reduce demand-deficient unemployment

In a recession, we see a rise in unemployment as firms lay off workers.

• In response to the recession, there is a rise in personal savings as firms cut back on investment and households cut back on consumer spending.
• This reduction in spending causes a negative multiplier effect and magnifies the initial fall in unemployment.
• This leads to a negative output gap, with unemployed resources.

In this situation, the government can usually borrow from the private sector at a relatively low cost of borrowing. The government can spend money on infrastructure projects. This injects money and spending into the circular flow – causing a rise in aggregate demand.

Fiscal policy (cutting taxes and/or increasing spending) can lead to an increase in AD and rise in real GDP.

The increase in economic growth will cause increased demand for workers, providing employment and reducing unemployment.

Limitations of fiscal policy for solving unemployment

Fiscal policy cannot solve supply-side unemployment. (the natural rate)

If there is frictional or structural unemployment, fiscal policy will not solve this. For example, suppose some former miners are unemployed. The problem here is lack of skills and geographical immobilities. Therefore, what is needed is supply-side policies. Increasing AD and economic growth does not solve the mismatch of skills. Therefore, when the economy is at full capacity, classical economists are correct. If the economy is growing and the government pursue fiscal policy, it is likely to be ineffective in reducing unemployment.

• At close to full employment, higher government borrowing will cause crowding out (government borrowing reduces the size of the private sector and reduces private sector investment). Also, with a growing economy, higher government borrowing may push up bond yields and higher interest rates may reduce private sector investment.
• Also, if the economy is at full employment, and the government pursue expansionary fiscal policy, we will see higher inflation.

(Impact of fiscal policy, if the economy is at full employment.)

Other limitations of fiscal policy

• Tax cuts may be saved not spent. In a deep recession, consumers may be reluctant to spend – even if you cut taxes. It may also depend on which taxes you cut. Low-income workers have a higher marginal propensity to consume. Therefore, cutting taxes will have a bigger effect on improving spending.
• Time Lags. Fiscal policy can take time to implement. The government have to decide which projects to follow, and there will be time before the project gets off the ground.
• See: Criticism of fiscal policy for more details

However, despite these limitations, it can play a role in increasing AD and reducing cyclical unemployment.

Case study

US Fiscal policy in 2009

In February 2009, Congress approved President Obama’s $787 billion American Recovery and Reinvestment Act. This was a package of tax cuts and spending increases – financed by higher borrowing. It involved tax cuts of $288 billion. Extended unemployment benefits of $213 and $275 billion in federal contracts, grants, and loans. The package wasn’t implemented immediately and took several months for the higher spending to be spread throughout the economy. The government also approved a bailout of the automobile industry which helped avoid job losses in that sector.

Given the time lags involved, the package was successful in limiting the scope of the 2009 recession and creating an economic recovery. As a result of the economic recovery, unemployment fell at the end of 2009 and consistently fell into 2017.

Strong recovery in the US.

Limitations of fiscal policy

• The fall in unemployment wasn’t just due to this expansionary fiscal policy.
• At the same time, there was also a loosening of monetary policy – with interest rates cut to 0.5% and a policy of quantitative easing. This monetary easing also contributed to the economic recovery.
• Also, the natural economic cycle is for the economy to recover after a period of economic downturn.
• Some economists, such as Paul Krugman argued that the expansionary fiscal policy was insufficient and only a small % of the US economy. A bigger fiscal package would have enabled a stronger recovery.

However, compared to the Eurozone – which didn’t pursue expansionary fiscal policy, the US recovery was stronger.

Also, some economist such as John Taylor of Stanford, and Eugene Fama of the University of Chicago were more suspicious of fiscal policy arguing it leads to higher borrowing costs, crowding out and just ends up with higher government borrowing. However, despite the rise in US borrowing, bond yields fell during this periods, and the budget deficit fell with the economic recovery.

Higher debt did not cause higher bond yields but falling bond yields, suggesting there was strong demand for buying government debt.

Related

• Can UK and US prevent a Recession?
• Expansionary fiscal policy
• US economy under Obama