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Pro-cyclical fiscal policy

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Cross-posted from Credit Writedowns

Looking up the term procyclical on the Internet, I see the Wikipedia entry defines it as:

Procyclical is a term used in economics to describe how an economic quantity is related to economic fluctuations. It is the opposite of countercyclical

In business cycle theory and finance, any economic quantity that is positively correlated with the overall state of the economy is said to be procyclical. That is, any quantity that tends to increase when the overall economy is growing is classified as procyclical. Quantities that tend to increase when the overall economy is slowing down are classified as ‘countercyclical’…

Procyclical has a different meaning in the context of economic policy. In this context, it refers to any aspect of economic policy that could magnify economic or financial fluctuations. An economic policy that is believed to decrease fluctuations is called countercyclical.

I talked about this in the first context in 2008. What got me thinking about procyclicality again was the chatter about cut, cap and balance which the Republicans in the US Congress are proposing. The goal is to reduce deficits. The plan is to cut spending, cap spending increases and pass a balanced budget amendment to the US Constitution.

Balanced budget amendments are another one of these artificial constraints that look better on paper than they do in reality because they are procyclical.

In the euro zone, the stability and growth pact provides a 3% deficit hurdle which almost all of the euro zone breached during the recession. Austerity attempts to meet the hurdle have created larger deficits in the periphery (Spain, Greece, Portugal and Ireland).

The same problems were apparent in the US states where balanced budget amendments are the order of the day. Before Barack Obama entered the White House, I asked in January 2009 “Will federal largesse be countered by state and local cutbacks?” By June 2010, it was obvious the answer was yes. That’s what procyclicality means.

Procyclicality is fine for states as a constraint despite how it exacerbates the swings in the business cycle, and creates deadweight losses. That is because the federal government can always counter this pro-cyclicality and smooth out the cycle. Procyclicality is one of the structural flaws of the euro zone; there is no federal agent to do counter procyclical budget cuts during a recession. Thus, the euro zone business cycle will invariably be volatile, making current account imbalances a lightening rod for intra-European recrimination.

Now, America is looking to impose the same sort of procyclicality on the US federal government. When downturns hit, revenues drop because tax receipts drop due to income shortfalls and spending increases because of automatic stabilisers. So, a balanced budget amendment would require even more cuts. But since those cuts reduce income and tax receipts, you need enough cuts to overcome the negative revenue effects on the budget. That means a balanced budget amendment would require deep, deep cuts in federal spending at precisely the worst moment in the business cycle. That’s procyclicality.

This is a recipe for disaster. And it will lead to huge volatility in the business cycle, deadweight economic losses and growth underperformance. If you hear anyone telling you this is a good mechanism for reining in deficit spending, you will know they haven’t thought through the effects of procyclicality.

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This entry was posted in Curiousities, Economic fundamentals, Guest Post, Macroeconomic policy on by .

About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward

32 comments

  1. Hugh

    If you are approaching the edge of a cliff, the procyclical thing to do is to run off it.

    1. craazyman

      there is no doubt that the strong winds of private sector investment would blow you right back up to the edge, or even higher!

      1. okie farmer

        No, craazyman, that isn’t the deal. The onlys folks who get blown “right back up to the edge” are way rich. This whole post and all comments fail to note that deregulating greed with the Kennedy (1963) and Reagan (1983) tax cuts in top marginal rates effectively deregulated greed in this country and we’ve been headed straight down hill ever since.
        Until this is fixed, nothing can save us.

  2. tz

    But Washington has NEVER CUT SPENDING IN A BOOM!

    During the Reagan recovery we could have afforded cutting the budget, but instead we blew it out.

    During the Clinton boom – the dot-com bubble that provided a windfall of taxes, instead of paying down the debt we INCREASED SPENDING.

    During the Real Estate Bubble, municipalities blew out their budgets and went on a spending spree with all the new revenue creating a multiplier effect, and what happened in DC?

    Maybe if there were 536 Mother Theresas in DC we could actually have a countercyclical policy. Instead it is pro-cyclical during the big boom times (don’t want to cut off the recovery, besides we are at a permanently high plateau of prosperity…”. But that leaves nothing left when the bust comes – the interest payments are still there but the income has been cut.

    I will never believe one MMT or Keynesian until they condemn in the strongest terms the expansion of spending during the booms as strongly as they are complaining about cuts during the bust.

    They don’t really believe in their own theories. Or don’t have the fortitude and honesty to admit the error.

    1. Foppe

      politicians do not care about theories much, no, and therefore, people who wish to ride on their coattails ((academic) economists) don’t either. Or rather, once they start to tell a story that the politician does not care for, different pet economists are found, who do speak words that the politicians wish to hear.

    2. Stuart

      That is utter bullshit. Krugman for one was making this exact complaint. He gets shit for wanting deficits now but decrying them under Bush.

      It also ignores the small deficits through most of the second half of the 20th century, and the 90′s under Clinton. Only under explicitly non-Keynesian presidents like Reagan and Bush was this and issue. And as Yves just posted, Dean Baker already destroyed the argument that the deficit was even unsustainable at the end of Bush’s tenure.

      1. Because

        Yes, yes. When you are running surpluses like 99-01 you either need to raise spending on spend the surpluses to get rid of them. “Paying down the debt” is not what you want to do. It is contractionary and actually hurt the economy by 2001.

        Just think we had used those surpluses on better infrastructure?

    3. jwbeene

      Keynesian economic did state that you spent during recessions and paid back during good economic business cycles. It did not recommend the government tranfering business losses to the taxpayer which started Reagan’s deregulation and tax cuts.

  3. Birch

    Makes you wonder to what degree extreme volatility is profitable to those calling the shots from the very top.

  4. Stephen Clarke-Willson

    You’re just complaining that when a Ponzi scheme collapses things get worse and worse. Of course they do. Your preference is to keep the Ponzi scheme going with artificial “job creation” via government spending and artificial “value” creation via the Federal Reserve. Part of me wants that too because it postpones the day of reckoning, but I also know it is just going to make the final collapse of the Ponzi scheme that much worse. If Madoff could have just cooked the books a little longer he would still be in business and he could have avoided all that procyclical nastiness.

    1. Because

      What are you talking about? What artificial spending? If the government spends money on infrastructure,public works, energy conservation and innovation, space,R&D ete ete it has been a huge boon to private business innovation and creation as new sectors of economy are developed.

      I am amazed by the stupidity of your post. The only thing “artifical” is the notion of balance points and markets always reach them. They don’t. The free land of the 19th century is long over. Either you come to grips with that or live in a banana republic(aka 3rd world).

      1. Stephen Clarke-Willson

        The spending is real, of course, but the money backing it is debt printed up out of thin air, and there is no productivity resulting from the spending. That’s what I mean by artificial. It doesn’t come from innovation or productive work. Government R&D is a joke. War spending is non productive. The TSA is non productive. The opposite of productive is wasteful. The money is spent and then it is gone with next to nothing to show for it.

        (How can you be surprised by anything you read on the internet?)

    2. Stuart

      You mean ponzi scheme as in “The financialization of ‘post industrial’ economies?” Friend, you have neo-liberals to thank for that, not Keynsians.

  5. Linus Huber

    I love the hot discussions here. One thing is rather clear to me, the Government definitely runs a Ponzi scheme. That is the reason, the contraction of the overall debt level in the economy is fought with all means.
    Now on deficit spending, it is obvious that during the period the whole debt bubble got inflated the Government should have built up the opposite of debt. But during those times, nobody realized that it was a bubble and all just enjoyed the ride. The enabler of that bubble was the FED which at any given time when the economy was showing the slightest weakness lower rates and now manipulates rates even further. If we did not have the FED’s manipulation we would not have been able to build up such debt levels. Anyway, in hindsight it always is easy to criticize; nevertheless, I do think that Central Banks in general do a disservice to the population by intervening in the nature of cycles that clean the weak out the weak elements in an economy. You cannot screw 24/7, you need periods of things going down, hey. The economy got so much viagra by the FED over the past many years that maybe now, despite further stimulation no much is going to happen.

    1. Cedric Regula

      We called it the Goldilocks economy, which in America means you have a Perfect Porridge Economy – not too hot, not cold…just “right”.

      We know we have the right flame on when we do fiscal and monetary stimulus and regulatory submissiveness. Goldilocks screams for more, more, more and then gets fat. It’s a beautiful thing.

      1. Valissa

        Three leading economists took a small plane to the wilderness in northern Canada to hunt moose over the weekend. The last thing the pilot said was, remember this is a very small plane and you will only be able to bring ONE moose back.

        But of course, they killed one each and come Sunday, they talked the pilot into letting them bring all three dead moose onboard. So just after takeoff, the plane stalled and crashed. In the wreckage, one of the economists woke up, looked around and said. Where the hell are we. Oh, just about a hundred yards east of the place there we crashed last year.

        [and here's another variation on the deer shooting economic joke that I found]

        Three econometricians went out hunting, and came across a large deer. The first econometrician fired, but missed, by a meter to the left. The second econometrician fired, but also missed, by a meter to the right. The third econometrician didn’t fire, but shouted in triumph, “We got it! We got it!”

        1. craazyman

          The first one cracked me up. Then it cracked me up again, when I read it again. purty funnie.

          1. Cedric Regula

            It’s like watching someone get kicked in the groin. It’s funny no matter how often you see it.

    2. joebhed

      Sorry, it’s not the government that runs that ponzi scheme of debt-based money, it is the private banking system known as the federal reserve.

      The flaw of the government is in allowing them to run the country into the ground, creating money out of thin air and lending it TO the government, which said government already HAS the power to create same money.

      It’s a fraud and a ponzi-scheme – as Silas Adams called The Legalized Crime of Banking.
      But it ain’t the government.

  6. joebhed

    If we’re going to look at the problems of pro-cyclicality in the so-called business cycle, rather than look at the fiscal response to the phenomena, why don’t we start with the basic systemic cause for financial and economic cyclicality, which is monetary cyclicality – caused by the fractional-reserve banking system of debt-based money.

    While the learned endogenous money folks might be quick to dismiss the existence of fractional-reserve banking on the basis that banks first make loans and then acquire reserves, it is the debt-nature of the money system that operates as the fractional-reserve banking system that is the real cause for the cyclicality.

    Banking operations are still constrained to meeting their reserve requirements in this country, and even if they were not, it is the expansion of money as debt, and the contraction of money as debt that creates the problem.

    In a contraction, it is not possible to issue the debt necessary to make the interest payments on the debt-money already in existence. This is what debt-deflation is all about.

    The root cause of our perennial economic and financial instability lies in the debt-based nature of our money system.

    Earlier this week, Dr. Kaoru Yamaguchi of Japan’s Doshisha University presented to Congressional staff the results of his research on what is needed to end the cyclically generated crisis we are seeing.

    His solution is the issuance of money without the issuance of debt by the government, and the results of his macro-economic modeling of the present money system and that of the future, titled:
    On the Workings of a Public Money System in Open Macro-Economies, is available here:
    http://www.monetary.org/yamaguchipaper.pdf

    1. psychohistorian

      joebhed said: “The root cause of our perennial economic and financial instability lies in the debt-based nature of our money system.”

      I disagree strongly.

      I see this sort of analysis being similar to MMT stuff. It is analysis of financial perturbations without any regard to the inherited rich that own now everything, top to bottom, around the world. If the sociopaths that the inherited rich have put in place as the heads of many countries, the IMF, World Bank and most other banks and corporations charted a different course of investment and financial machinations the study yo are referring to would be meaningless.

      IMO, it is a huge waste of time and energy to try and build nice models of sociopathic behavior without examining the root decision makers in our world. If they wanted stability we would have it yesterday.

      1. Toby

        Allow me to agree with both of you. The root cause of the root causes you both identify is what Charles Eisenstein refers to as the Self/Other split, a.k.a. Cartesian Duality, a culture/psychology-based illusion conjured by us over time that ‘allows’ us to see ourselves as masters of nature, here to dominate it, turn it into goods and services in the interests of the famous economy. We are not nature, we are separate from it, looking out on it, controlling it to our advantage. Now, after thousands of years of this illusion (since farming more or less) only the economy really matters. Money appears to be the ultimate victor. If a thing does not make financial sense, it doesn’t make sense. Money (the price system) decides almost everything we do. That is not healthy.

        To cut an extremely long story short, we today have a system conducive to and supportive of the sociopathy you hint at, psychohistorian, which is in part a consequence, as well as the origin of the perverse monetary system joebhed rightly has in his sights, which yokes humanity to Perpetual Growth and ‘cyclicality’. Debt-based interest-bearing money forces the economy to grow. When it is not growing, it is collapsing (a ponzi scheme). Understanding this dynamic is crucial to understanding the deadly lunacy of this system. Hence, to fix the money system is to attack the root which allows sociopathic, suicidal policy-making (“money makes the world go around” style).

        Of course, the sociopaths who ‘enjoy’ the violent power this systems affords them will not campaign for its dismantling, but not everyone in positions of power is sociopathic. While we can, we should, at the very least, be calling for (transitional) solutions that offer us a way out of this insanity, an insanity which madly insists the system is more important than humanity itself, more important than the environment that makes it all possible in the first place, an environment we can dominate totally.

        Psychohistorian, I share your view, but share joebhed’s too. I doubt strongly that an intelligent and compassionate system can be built from the decay of the old–it’s just so rotten and corrupt–but the struggle to establish a new vision includes the types of efforts being made by joebhed and others like him.

        1. psychohistorian

          Thank you Toby for your perspective. I get fairly rabid about the lack of focus on the inherited rich and will continue to do so but understand that joebhed is not my enemy.

      2. joebhed

        nice handle.
        Glad you’re paying attention.
        The Deeper Roots of the World Financial Crisis:
        http://blip.tv/file/4111596

        I don’t think the cause is the debt-based system of money-creation. I know it is. Do you know the debt money system is NOT the cause of the cyclicality of our economy, the cause of your dreaded wealth accumulation and the cause of the presently evolving crisis?

        The mechanics of the monetary system and the mathematics of its its fatal flaws and the proof of the need for a new system is contained in Dr. Senf’s lecture.

        It also includes exactly the mechanisms by which that wealth is accumulated – which you seem to think is THE problem. Yet, it is only the resulting mal-distribution that MUST happen when the “debitors”, as he calls them, pay more and more interest over time to the monetary-asset-owning class.

        The solution lies in a new money system, issued without debt. How that transforms our national economy is laid out in the Yamaguchi paper.

        Besides, those MMTers ain’t that far off.

  7. primefool

    I think it is just wonderful that the village chieftains and witch doctors and other socially prominent personages have vigorous and serious arguments abut who has claims on the Yap Stones ( google it). Of course the grand wizard ( BB) is generally understood to possess the largest Yap Stone in the land ( although no one has ever seen it – legend is that it is as large as the moon and for safekeeping purposes kept deep in the ocean).
    It is wonderful and important – because it keeps the peasants from asking the obvious questions – why are Yap Stone valuable – and why should we labor for our piece of a Yap Stone . Why should we sell our harvest to the “wealthy” ( who own the largest Yap Stones).
    It keeps the hapless Asian creditors believing that the money is actually real and in such short supply that highly educated middle aged men in suits will quarrel over it. This is all good.

  8. HarPe

    It’s impossible to have a balanced budget throughout the cycle. Impossible. Out of the last 100 years, how many has been budget surplus years? How many of those have been followed by a recession? How well has the nation fared during those years and how well has the country fared afterwards?

    Budget surpluses are always pro-cyclical unless the economy is already at capacity and additional demand through export-surpluses or credit is created.

  9. RPL

    Just to help TZ with his history, actually federal spending as a percentage of GDP (which is the only metric that basically matters) declined during the Clinton administration and when he left office there was a significant federal surplus. That was the motivation for the Bush tax cuts in 2001 because there was a concern that the surpluses were too small. I am hoping you are too young to actually remember this, it seems the only possible legitimate excuse for your completely inaccurate tirade.

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