Death of the Fiscal Free Lunch

Ever since the Great Depression, American presidents–regardless of party–have had a religious belief in the beneficial effects of deficit spending.  They abuse whatever economic theories are currently fashionable to justify a very simple narrative: that deficit spending pays for itself by growing the economy and increasing tax revenue.

The simple insight of Keynes–that economies should save during good times and spend during bad–was twisted into “vulgar Keynesianism,” the view that savings is inherently bad and the government should run permanent deficits.  The supply-side insight–that taxes rates above 40-45% lead to lower growth–was twisted into supply-side populism, the view that taxes are inherently bad and the government should run permanent deficits to avoid them.

Both sides have subscribed to the “ratcheting” theory, that spending must be ratcheted ever higher (Democrats) or taxes must be ratcheted ever lower (Republicans).  The resulting structural deficits are good for the economy, because (again) “the economy will grow more and produce more tax revenue”.

This has finally ended.  The debt deal marks a new shift in U.S. fiscal policy.  Permanent deficits are no longer accepted by both parties.  No longer is government borrowing viewed as benign.

The belief that deficit spending pays for itself through higher GDP growth is dead.  The Keynsian multiplier doesn’t exist.  The supply-side tax-cut multiplier only exists if tax rates are already high.  In essence, there is no such thing as a free lunch, and the federal government has finally woke up to this simple fact of life.

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One Response to Death of the Fiscal Free Lunch

  1. Kym says:

    This was so well written! As a very politically and economically uneducated reader, I really appreciated how you took the time to explain the definitions that you used as you went along. Do you foresee any problems with the debt deal?

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