Budget policy in relation to the trade cycle: lecture III

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^{AFRICAN UNITEDINSTITUTENATIONSFOR ECONOMIC}

DEVELOPMENT AND PLANNING DAKAR

Originals French

Mr. CHAFANEL

IDEP/ET/XXXV/300

NO 3^

Lecture III

BUDGET POLICY IN RELATION TO THE TRADE CYCLE

Introduction.- At our first meeting we noted that the modern budget

is a powerful means of intervening in the nation's economic life; it

is therefore natural that attempts should be made to use this tool

to iron out the trade cycle and particularly to counteract the depres¬

sion which shook the liberal economies in the fairly -recent past.

This dynamic effect is made feasible because of the considerable proportion of the national income which the budget of a modern state represents and because the principle of budget neutrality has been dropped in favour of more active concepts.

After considering the possible effects of the budget on the

conditions for achieving financial equilibrium, we will rapidly review

the various experiments in counter-cyclical budget policy.

I - THE BUDGET AND INFLATION -

The budget may be of a more or less inflationary nature. There

is inflation if the means of payment are growing faster than the supply of goods and services. Inflation may have only limited effects

if there is an abundance of commodities

(e,g, USA)

^or if prices and

distribution are controlled

(UK, Germany),

but it can also have profoundly disruptive repercussions on the national economy;

social repercussions; reduction of the purchasing power of those

whose remuneration is slow in adjusting to price changes,

economic repercussions% investment may be hampered by lack of capital,

psychological repercussionsïloss of confidence, a cumulative

process.

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Among the methods of financing the budget, some increase the

volume of disposable incomes and are.hence inflationary, while others

absorb a proportion of the disposable surpluses, thus

producing^a

deflationary effect. Similarly on the expenditure side, an unbalanced budget will play a significant part in star-ting ^up an inflatiomryprocess.

A - The methods of financing a.ccording to whether they are more

or less inflationary.-

a)

Methods which increase the volume of distributed incomes.

1 ^-

aid_from the cash

^reserves

of the bank of issue to

the government;

advances

discounting of

public bills

open—market operations

2 - increase in the holdings of government bills by the

banks

procedures which rely on assistance by the banks are

inflationary.

b)

Methods which absorb a proportion of the disposable surpluses.

1 - case of borrowing s the deflationary effect of borrowing

is highly controversialï in fact it all depends on the-

nature of the sums collected. If the borrowing leads

to a reduction of consumption, the deflationary effect

is obvious:; but this is not usually the casef more

frequently the borrowing does not absorb the purchasing

power but, on the contrary, results in the mobilization

of hitherto idle purchasing power. There are limits to the possibilities of borrowing 5 - true, the State

may have a considerable margin- available

(e-.g.

case of public debt ⁼ 2

1/2

times the national

income),

hut %

- the charges mount up

(e.g.

up to

40^

of the

budget)

^-

danger of slowing down the productive economy - crises of confidence.

page 3

2 - compulsory levies on wealth : here again we must make

a distinction according to;

- whether the operation brings about a restriction of

current incomes : deflationary effect

- whether the operation leads to a reduction of capi¬

talized income : no deflationary effect.

3 ^- taxation ; this is the most effective method since it reduces immediate purchasing power - but :

- it has complex effects on demand and supply : this depends on the social classes affected, - on the frequency

(permanent

or

exceptional),-

the supply

may also diminish.

- its effects on prices must be thoroughly examined;

only direct taxes which do not affect prices are

truly deflationary. If the tax burden does have repercussions, the tendency for prices to rise will

be accentuated

(indirect

taxes, and to a certain

extent taxes on industral and commercial

profits).

Direct taxes with no effect on prices may also only

have a limited influence

(e.g.

death

duties),

a

B - Rôle

of/long-term

unbalanced budget in the inflationary

process.

In order to assess th rôle of an unbalanced budget

(insufficient

tax revenue to cover all government

expenditure)

in the inflationary process, we must study the effect of the deficit on the

two quantities in the ratio which defines inflation ;

- the quantity of disposable incomes

- the supply of goods and services

It is thus clear that the rôle of the unbalanced budget is a complex one because, depending on which phase of the trade cycle

we are in, the effect on the two quantities in this ratio will be ;

. in the same direction and will contribute to the

general equilibrium,

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. in the reverse direction,, in which case it will lead to

economic and monetary disequilibrium,,

A budget deficit, added to private spending constitutes a demand greater than the total value of the supply of goods and services

at prevailing prices. To the extent to which the balance can or cannot

be restored by an encrease in supply, there will or will not be an

inflationary movement of prices. Two cases must therefore be considered, depending on whether we axe in a period of full employment or in a

period of underumployment.

a).

Period of full employment.-

ffhen_the production capacity of

a

country is already being

fully utilized, an unbalanced budget means an increase in aggregate demand with no possible counterpart on the supply

side,. The consequence of a deficit, can then only be an acce¬

lerated rise in prices. This is so. regardless of how the g)vernment intervenes in the formation of aggregate demand,

whether directly,if it is buying for its ^own needs, or in¬

directly, if it pays out salaries, wages, allowances or sub¬

sidies to privât individuals who make these purchases themselv

b)

Period of under-umployment

In theory, so long as production is not operating at full capacity a deficit may occur- without causing inflation, even if it is covered by the creation of money. For any increase

in aggregate demand will then be reflected in an increase in output without prices being appreciably affected. But here again, the budget deficit will produce all its inflationary

consequences if bottlenecks accur which hamper the adjustriiqnt

of output,e.g. shortage of row materials or insufficient

manpower.

Inadequacy of a return to the balanced budget to halt an

inflationary ^. process.

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The aim to be achieved is to reduce aggregate demand so as to keep it below the inflationary level. But the budget only affects

a fraction of this aggregate demand and inflation may have a private origin :

from wages : the occurrence of a vicious spiral of wages and prices does not depend on a prior creation of money

(the

rise

in prices precedes and intensifies the increase in money

circulation);

from credit

(speculation

or

investment);

speculative origin : creation of bank money, reduction of supply through holding of stocks and increase in the quantity of money in circulation;

investment origin : time-lag between the putting into circula¬

tion of means of payment and the appearenceof new goods on the

market.

To sum up : The budget deficit plays the rôle of prime mover, but the other

causes of inflation _may become so decisive when flight from money has reached

a certain level that a return to perfect budget equilibrium with no other li¬

mitation of aggregate demand is not sufficient to stop inflation and may even to some extent help to accelerate it

(by

^the indirect effect of taxation, by the abolition of

subsides).

Inflation is in fact a complex phenomenon vhich_cannot_be combated

solely

by budget

adjustments; it involves the whole

economic and social policy of the government.

II.- COUNTER—CYCLICAL BUDGET POLICIES.

It is interesting to see how different countries have tried to conteract the

.of

downswing/the trade cycle and to start off the recovery.

A.- Budget policy in a period of depression.and in a period of prosperity.

The idea is to use the budget to help iron out the trade cycle :

depression period the budget intervenes

to_assist

recovery,

and in a period of expansion attempts will be made to stop the boom getting out of hand.

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1)

In the boom phase

j

- the government will use taxation to hold down excess demand, it will bring its weight to bear and will use the discrimina¬

tory procedures available to it. Similarly it will act on the industrial prices of the enterprises it controls, endea¬

vouring to incorporate a margin for self-financing so that depreciation can subsequently be slowed down.

- On the expenditure side, it will try to limit spending, it

will assess productive expenditures on their merits and will earmark, surplus fiscal revenue for debt redemption.

2)

In the depression phase :

- The government will grant, discriminatory tax relief

(reduction

of taxes on enterprises, attempt to find stable

revenues).

- As to expenditure, it will carry out transfer spending in

order to redistribute the national income and generate purcha¬

sing power; for this purpose it may also contemplate a programme of public works to expend employment. There is

obviously a danger that an inflationary process may be started and that "artificial" employment is promoted

(are

the jobs

created through state intervention the most useful in the long run

?)

This remedial treatment should therefore be wisely meted out and should form part of an overall economic policy covering not only the budget but also credit, prices and wages.

German experiment in pre-financing

(manipulation

of public finance

in order to eliminate economic

fluctuations).

This method amounts

to discounting, in a depression period, the increased revenue expec- ted from the future recovery

(draft

on the

future).

In order to carry out its programme of public works, the national-socialist

state had specialized establishments issue so-called "work-creating!

drafts. Endorsed by the public.authority which committed ^: the expenditure and accepted by the specialized .establishments, these

short-term drafts were discounted by the banks and if necessary

Page 7

rediscounted by the Reichsbank. Extended many times, the drafts

were gradually reimbursed thanks to the tax surpluses of the reco¬

very period, the savings realized by the reduction of unemployment

and consolidation borrowing. But ultimately inflation was only

avoided through the strict organization of the economic circuit;

where purchasing power is continually being absorbed by short and

medium-term borrowing to the extent that taxation is insufficient

for this.

C. "Cyclical"budgets

The budget balanced over a cycle represented an attempt at a synthesis

between an expected future economic equilibrium and a financial equilibrium achieved over a fairly long time.

a)

Sweden : The government takes advantage of the financial optimism

of the boom phases to constitute reserves which can be used for

the partial coverage of extraordinary expenditure in a depression.

The loans contracted during the depression period will be repaid by means of the surpluses of the boom phase» Adaptation of

budget technique : a capital expenditure budget and a current budget, a"cyclical equalization fund" is set up. The annually

balanced current budget is replaced by a budget balanced over several _years. Since there is bound to be a deficit during the

bad years, it is carried over to the boom-period budget by means of the "fund" which can borrow if necessary. A special contingency budget makes prior, and conditional, provision for expenditure

to be undertaken in case there is a depression.

b)

Finland : A law of 1934 established a "Reserve fund for the econo¬

mic conjuncture" for the purpose of financing public works in times

of depression

(maintained

^{by an annual} grant and by the surpluses

of the boom

period).

In order to avoid all temptation, 4 types of financial assets were provided for : deposits at the National Bank, conversion into gold, conversion into public debt securities, deposits in foreign banks. This quasi-freezing ^was due to a dual preoccupation : to prevent the fund"s resources from feeding the

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money market in a boom period, and to guarantee the liquidity

of the reserve in a depression period. So as to be able to set the machinery going quickly at the appropriate time, the govern¬

ment had prepared a "preliminary plan of public works to combat unemployment".

c)

Belgium : During the prosperous period from 1927 to 1929, a reserve

was constituted and invested abroad, and it was used in 1930

to start up the recovery. . - .

The only country which has established a real solidarity between

successive annual budgets is Sweden. Finland has not gone beyond the stage of accumulating reserves. Why has this idea of a budget balanced over a cycle remained so limited ? Perhaps because,

while fluctuations are inevitable, preference is given to attenuating them by purely economic methods of state control

(dirigisme),

as credit policy and the supervising of investment

would seem to be more flexible.

Conclusion.- The budget is clearly a powerful method of promoting financial equilibrium, both because of the place it occupies in relation to national

income and because of its structure. While care must be taken to see that it does not become a cause of initial disturbance which might subsequently be uncontrollable, it clearly cannot by itself ensure the _recovery of a compro¬

mised situation; its action must then be combined with other instruments of economic and financial policy which the government may have available.

The African countries, most of which ^are still practically helpless in

the face of the vicissitudes of the economic situation, might derive

valuable lessons from counter-cyclical budget policies.