There is a school of thought that says fiscal policy doesn’t matter to macroeconomic outcomes because the central bank offsets the impacts. I think it’s logically possible to imagine a world in which that’s the case, but Ben Bernanke keeps telling us we don’t live in that world. His latest statement of his belief in the potency of fiscal policy comes in his testimony on sequestration that he believes could trim 0.5-1 percentage points off of 2013 GDP growth.
What should we do instead?
To address both the near- and longer-term issues, the Congress and the Administration should consider replacing the sharp, frontloaded spending cuts required by the sequestration with policies that reduce the federal deficit more gradually in the near term but more substantially in the longer run. Such an approach could lessen the near-term fiscal headwinds facing the recovery while more effectively addressing the longer-term imbalances in the federal budget.
The sizes of deficits and debt matter, of course, but not all tax and spending programs are created equal with respect to their effects on the economy. To the greatest extent possible, in their efforts to achieve sound public finances, fiscal policymakers should not lose sight of the need for federal tax and spending policies that increase incentives to work and save, encourage investments in workforce skills, advance private capital formation, promote research and development, and provide necessary and productive public infrastructure. Although economic growth alone cannot eliminate federal budget imbalances, in either the short or longer term, a more rapidly expanding economic pie will ease the difficult choices we face.
Translating a bit out of obscurantism, Bernanke is saying that instead of sequestration we should have a gradual approach to deficit reduction. He’s also saying that we should cut income support programs for elderly people rather than non-military discretionary spending. On taxes, he’s trying to stay out of the partisan debate over whether taxes should rise at all while stating a preference for avoiding tax hikes that fall on investment income and capital formation.