What type of fiscal policy is the United States following in 2004?
How does fiscal policy impact the economy?
Fiscal policy refers to the federal government’s spending and
tax policies. The federal government is currently running a record deficit
for the fiscal year 2004 that is a very expansionary fiscal policy even
though the economy expanded at above average rates of growth from the
second quarter of 2003 to the first quarter of 2004.
Economists typically expect budget deficits to stimulate economic growth.
In contrast, budget surpluses tend to slow economic growth. Your question
has significant public policy implications as well; many economists also
believe that large government deficits tend to crowd out private sector
investment and place upward pressure on interest rates.1
From surplus to deficit
From fiscal year 1998 to 2001, toward the end of the record economic
expansion from March 1991 to March 2001, the federal government ran four
budget surpluses. These fiscal surpluses, shown
in Chart 1, had the effect of moderating the strong economic expansion
then taking place, because budget surpluses tend to slow economic growth.
Projected future budget surpluses were provided as a justification for
tax cut policies adopted after 2000.2 As Federal Reserve Bank Economist
Kevin Lansing noted in his insightful April 13, 2001, Economic Letter, “Uncertainties
in Projecting Federal Budget Surpluses”: “When thinking about
these issues, it is important to keep in mind that ten-year budget projections
are subject to considerable uncertainty.”
By 2001, the budget surplus began to melt away. Federal budget receipts
began to fall sharply in 2001, shown by the heavy red line in Chart 2.
The steep decline in tax revenues after 2000 reflects a series of tax
cuts and a period of slower revenue growth resulting from the March 2001
to November 2001 recession and the decline in capital gains tax revenues
following the dot-com bust (See the June
2003 Ask Dr. Econ and the National
Bureau of Economic Research for more information about the 2001 recession).
Government spending also accelerated somewhat after 2001, shown by the
thin blue line in Chart 2. However, as can be seen from Chart 2, the
dramatic cuts in federal government revenues completely changed the budget
outlook from one of large surpluses to one of large deficits after 2001.
estimates—from the Congressional Budget Office
(CBO) in March 2004—suggest that large deficits are likely to continue
well into the future.3
How large is the current deficit?
In fiscal year 2003, the federal government ran a deficit of $375 billion.
According to the CBO (March Baseline Estimate), the projected fiscal
year 2004 deficit will be about $477 billion. Budget deficits tend
to stimulate economic growth. Such a stimulative economic policy is
immediately after recessions when economic growth is negative or weak.
However, rapid growth in recent quarters has brought the economy closer
to its potential long-run growth path. In the four quarters ending
in March 2004, the U.S. economy averaged quarterly growth rates of
about 5 percent, far faster growth than the non-inflationary potential
GDP growth rate the CBO estimates to be in the 3.3 percent range.4
In addition to the absolute measures of the deficit, one may also look
at the deficit (or surplus or revenues or spending) as a percent of
output or GDP. This ratio measures the size of the deficit relative
to the overall economy. While this ratio also has risen sharply according
to CBO data, reaching 4.2 percent
in fiscal year 2004, shown in Chart 3, it still remains below the post-World
high of 6.0 percent reached in 1983. Still, the turnaround in the ratio
is dramatic, falling from a positive 2.4 percent in 2000 when the federal
government surplus reached a peak to a negative 4.2 percent in 2004.
Impact on the economy: Increased borrowing by U.S. Treasury
One direct impact of the current record federal budget deficits is a
sharp increase in the amount of borrowing the U.S. Treasury must undertake
to finance the large annual deficits.5 That
borrowing is then added to the total cumulative amount of outstanding
borrowing from the public.
Outstanding borrowing from the public reached an all time high of over
$4 trillion in 2003, shown in Chart 4. Of course, as the deficit rises,
so do the net interest payments the government must pay each year.
In March 2004, the CBO estimated that annual net interest payments
on the outstanding debt will rise from approximately $150 in 2004 up
to $300 billion in 2009.
Impact on the economy: Higher interest rates
One key concern arising from the sharp increase in both the deficit and
the deficit relative to GDP since 2001 is the potential impact that deficits
might have on interest rates. For example, N. Gregory Mankiw, noted the
following relationship in his 1998 textbook, Principles of Economics:
Thus, the most basic lesson about budget deficits follows directly from
their effects on the supply and demand for loanable funds: When the government
reduces national saving by running a budget deficit, the interest rate
rises, and investment falls. Because investment is important for long-run
economic growth, government budget deficits reduce the economy's growth
A 2003 study by Federal Reserve Board economist Thomas Laubach, titled, "New
evidence on the interest rate effects of budget deficits and debt,” reported
the following evidence of a link between an increase in the projected
ratio and long-term interest rates:
The estimated effects of government debt and deficits on interest rates
are statistically and economically significant: a one percentage point
increase in the projected deficit-to-GDP ratio is estimated to raise
long-term interest rates by roughly 25 basis points (or 0.25 percentage
Monetary and fiscal policy
As the economy approaches mid-year 2004, it has experienced several quarters
of well above average output growth. Furthermore, if recent growth
rates persist through year-end 2004, output may finally approach the
potential real output path for the economy. Not only will the economy
be approaching its potential non-accelerating inflation growth path,
but both fiscal and monetary policy will continue to stimulate
In the case of monetary policy, the federal funds target rate, at 1
percent in May 2004, is at its lowest level in 45 years. Policymakers
face concerns that both fiscal and monetary policy will continue to stimulate
the economy as it approaches full employment. Continued stimulus may
create the potential risk that the economy could begin to overheat and
inflation could begin to rise from its current low level. (For more information
on inflation, see Ask
Dr. Econ for October 2002
To review the Federal Open Market Committee’s current assessment
of the economic risks facing the economy, see the Policy
Committee issues after their most recent meeting.
accessed on June 2004)
Lansing, J. Kevin. (2001) “Uncertainties in
Projecting Federal Budget Surpluses.” Federal Reserve Bank of San
Francisco, Economic Letter, No. 2001-10, April 13, 2001.
Laubach, Thomas. (2003) “New
evidence on the interest rate effects of budget deficits and debt." Financial
and Discussion Series, Federal
Reserve Board of Governors, 2003-12 (April).
Mankiw, N. Gregory. (1998) Principles
of Economics. The Dryden Press/Harcourt
Brace College Publishers, page 557.
Samuelson, Paul A., and William D. Nordhaus. (Most recent edition.)
Economics. Irwin/McGraw-Hill Companies, Inc.
Stiglitz, Joseph E., and Carl E. Walsh. (2002) Principles
W.W. Norton & Company, New York.
Walsh, Carl E. (1999) “Projecting Budget
Reserve Bank of San Francisco, Economic Letter, No. 99-27, September
Stiglitz and Walsh, 2002, page 203, (see Wrap-Up:
Government Deficits and Surplus), state that, “When government
spends more than it receives in revenue, it must borrow in order to finance
its deficit. The deficit reduces national saving, leading to higher real
interest rates and lower private investment.”
See Lansing, 2001 and Walsh, 1999.
Congressional Budget Office,
2004 estimates (see Current Budget Projections, March Baseline Projections).
With respect to future deficits,
notes that, “Those figures do not include possible future costs
for ongoing operations in Iraq and Afghanistan, which the Administration did
not include in its budget for 2005 and subsequent years.”
The Congressional Budget Office estimate for potential real GDP growth in 2004
was 3.3 percent, according to data reported by Haver Analytics.
Foreign central banks have been major
purchasers of U.S. Treasury debt in recent years. As of March 2004, foreign and
international owners held $1.7 trillion,
nearly 49 percent of the privately held U.S. Treasury securities. See Table
Estimated Ownership of U.S. Treasury Securities.