U.S. Fiscal Policy

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The economy of the United States is experiencing a decline after a long period of expansion. Consumer spending has fallen off substantially, and the housing market has felt the effects of the mortgage crisis. Energy prices remain high, unemployment continues to increase, and access to capital has tightened due to the subprime mortgage crisis. A stagflationary environment could emerge, in which prices rise while GDP declines.

Treasury Secretary Henry Paulson predicts that the credit crisis last year is beginning to fade (1). The crisis peaked last August, when many homeowners with subprime mortgages found themselves in default. The financial crisis led to the sale of Bear Stearns, the nation's fifth largest investment firm, to JP Morgan Chase & Co. Still housing prices have fallen in many parts of the country, severely impacting the construction industry.

Fiscal policy involves the use of taxation and government spending to control the business cycle. To spur the economy, the government can lower taxes, hire more workers, or buy materials. This is called expansionary fiscal policy. Contractionary fiscal policy works in the opposite way to slow the economy when it is growing too rapidly. Fiscal policy affects output directly though increasing consumption and government spending and indirectly through the tax and government spending multipliers. Increasing government spending requires either deficit spending or an increase in taxes, unless the government has a surplus.

The current use of expansionary fiscal policy will come at the expense of a larger budget deficit, since tax reductions are part of the package. Budget deficits were first proposed as a method of stabilizing the economy by Keynes. Because of the multiplier effect, government spending can bring the economy out of a recession or depression. Fiscal policy affects output directly though increasing consumption and government spending and indirectly through the tax and government spending multipliers. Increasing government spending requires either deficit spending or an increase in taxes, unless the government has a surplus. Fiscal policy is limited primarily by its speed of implementation. For example, by the time the government is aware that there is a recession, makes a law, and puts law into effect, the recession may very well be over. Fiscal policy is generally more suited for short term stabilization.

Deficits are therefore not in and of themselves bad; if they allow the government to keep us out of a recession, most people agree that's a good thing. Ideally, ...