Paced by housing and energy, the U.S. recovery is likely to accelerate this year and budget deficit projections have declined as well.  Unfortunately the European economy remains stagnant though there is some evidence that stimulative policies are gaining traction in Japan.  Around the world the idea of “austerity” is fiercely debated.  This all makes a reconsideration of the principles that should guide fiscal policy opportune. This requires recognizing that policies need to be set in light of economic circumstances.

A prudent government must over time seek to balance spending and revenue collection in a way that assures the sustainability of debts. To do otherwise leads to instability and needlessly slow growth and courts default and economic catastrophe. Equally, however, responsible fiscal policy requires recognizing that when economies are weak and movements in interest rates are constrained ‑ as has been the case in much of the industrial world in recent years ‑ changes in fiscal policy will have significant effects on economic activity that in turn will affect revenue collections and social support expenditures. In such circumstances, aggressive efforts to rapidly reduce budget deficits may actually backfire, as a contracting economy offsets any direct benefits.

It is a truism that deficit finance of government activity is not an alternative to tax finance or to supporting one form of spending by cutting back on another. It is only a means of deferring payment for government spending and, of course, because of interest on the debt, increasing the burden on taxpayers. A household or business cannot indefinitely increase its debt relative to its income without becoming insolvent, and neither can a government. There is no viable permanent option of spending without raising commensurate revenue.

It follows that in normal times there is no advantage to deficit policies. Public borrowing does not reduce ultimate tax burdens. It tends to crowd out private borrowing to finance growth and job-creating investment and foster international borrowing, which means an excess of imports over exports. Or the expectation of future tax increases may discourage private spending. While government spending or tax cutting financed by borrowing creates increased demand in the economy, the Federal Reserve can in normal times achieve this objective by adjusting base interest rates.

It was essentially this logic that drove the measures taken in the late 1980s and in the 1990s, usually on a bipartisan basis, to balance the budget. As a consequence of policy steps taken in 1990, 1993 and 1997, it was possible by the year 2000 for the Treasury to use surplus revenue to retire federal debt. Deficit reduction and the associated reduction in capital costs and increase in investment were important contributors to the nation’s strong economic performance during the 1990s, when productivity growth soared and the unemployment rate fell below 4 percent. Essentially, we enjoyed a virtuous circle in which reduced deficits led to lower capital costs and increased confidence, which led to more rapid growth, which further reduced deficits, which reinforced the cycle.