Thursday, July 29, 2010

The Problem with Fiscal Policy

Please note that I am a microeconomist, and focus on industrial economics - the study of firms and markets. As such I have kept out of the fray in regard to the recent recession and appropriate/inappropriate measures to use government policy as a means of offsetting the downturn in the business cycle.

In terms of government policy, I tend to favor monetary policy over fiscal policy for reasons that I will not go explain in this post. Unfortunately, monetary policy was exhausted during the most recent recession as the Fed dropped interest rates to zero - and we find ourselves in a liquidity trap. This has been discussed in depth by Nobel laurette Paul Krugman. Given that monetary policy is at it's limit, the other policy tool is fiscal (government) policy, and is the economic reasoning for the large stimulus spending that many Americans worry about.

At the state level, monetary policy is not an option, so states must seek to balance their budgets via fiscal policy - and that does not always work out so well. California is a prime example. Another example is in Illinois. In this article we see that the elected officials of Illinois have neither the willpower or the insight to see the impact of their unpaid debt on the long-term viability of the state's economy. In other words, the correct fiscal policy is to reduce spending, raise taxes OR BOTH, when a state is in deficit. Illinois politicians are doing neither. To me this is a real problem.

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