The debate on the correct setting for fiscal policy at a time of recession is probably the oldest debate in macro-economics. One key element in the debate is the trade off between supporting output growth in the short term, versus the need to control the growth of public debt in the long term.
There are some economists who do not recognise that this trade off exists at all, because they claim that an increase in the fiscal deficit cannot impact aggregate demand, even in the short run. But this is not a view which I believe to be supported either by empirical research or by economic theory (except on some very restrictive assumptions about Ricardian Equivalence or Says Law).
I recognise that this last statement is very contentious, but it is not my subject today. Instead, I would like to take as given the assumption that a temporary easing in fiscal policy (of the type advocated last week by Martin Wolf for the UK) will increase aggregate demand in the near term. Accepting this, I would then like to ask whether the benefits of an immediate boost to aggregate demand outweigh the costs of higher public debt, and the consequent risks of a fiscal crisis. That is the nub of the issue which is, or should be, exercising policy-makers in the real world today. Read more